During the recovery from the Covid–19 pandemic, inflation as measured by the personal consumption expenditures (PCE) price index, first rose above the Federal Reserve’s target annual inflation rate of 2 percent in March 2021. Many economists inside and outside of the Fed believed the increase in inflation would be transitory because it was thought to be mainly the result of supply chain problems and an initial burst of spending as business lockdowns were ended or mitigated in most areas.
Accordingly, the Federal Open Market Committee (FOMC) kept its target for the federal funds rate at effectively zero (a range of 0 to 0.25 percent) until March 2022 and continued its quantitative easing (QE) program of buying long-term Treasury bonds and mortgage-backed securities (MBS) until that same month.
As the following figure shows, by March 2022 inflation had been well above the FOMC’s target for a year. The Fed responded by raising its target for the federal funds rate and switched from QE to quantitative tightening (QT). Although some supply chain problems were still contributing to the high inflation rate during the spring of 2022, the main driver appeared to be very expansionary monetary and fiscal policies. (This blog post from May 2021 has links to contributions to the debate over macro policy at the time. Glenn’s interview that month with the Financial Times can be found here. In November 2022, Glenn argued that overly expansionary fiscal policy was the main driver of inflation in this op-ed in the Financial Times (subscription or registration may be required).We discuss inconsistencies in the Fed’s forecasts of unemployment and inflation here. And in this post we discuss the question of whether the Fed made a mistake in not attempting to preempt inflation before it accelerated.)
Since March 2022, the FOMC has raised its target for the federal funds rate multiple times. In February 2023, the target was a range of 4.50 to 4.75 percent. Longer-term interest rates have also increased. In particular, the average interest rate on residential mortgage loans increased from 3 percent in March 2022 to 7 percent in November 2022, before falling back to around 6 percent in February 2023. In the fall of 2022, there was optimism among some economists that the Fed had succeeded in slowing the economy enough to put inflation on a path back to its 2 percent target. Although many economists had expected that inflation would only return to the target if the U.S. economy experienced a recession—labeled a hard landing—the probability that inflation could be reduced without a recession—labeled a soft landing—appeared to be increasing.
Economic data for January 2023 made a soft landing seem less likely. Consumer spending remained above its trend from before the pandemic, employment increases were unexpectedly high, and inflation reversed its downward trend. A continuation of low rates of unemployment and high rates of inflation wasn’t consistent with either a hard landing or a soft landing. Some observers, particularly in Wall Street financial firms, began describing the situation as no landing. But given the Fed’s strong commitment to returning to its 2 percent target, the no landing scenario couldn’t persist indefinitely.
Many investors had anticipated that the FOMC would end its increases in the federal funds target by mid-2023 and would have made one or more cuts to the target by the end of the year, but that outcome now seems unlikely. The FOMC had increased the federal funds target by only 0.25 percent at its February meeting but many economists now expected that it would announce a 0.50 percent increase at its next meeting on March 21 and 22. Unfortunately, the odds of a hard landing seem to be increasing.
A couple of notes: Although there are multiple ways of measuring inflation, the percentage increase in the PCE is the formal way in which the FOMC determines whether it is hitting its inflation target. To judge what the underlying inflation is—in other words, the inflation rate likely to persist in at least the near future—many economists look at core inflation. In the earlier figure we show movements in core inflation as measured by the PCE excluding prices of food and energy. Note that over the period shown PCE and core PCE follow the same pattern, although core PCE inflation begins to moderate earlier than does core PCE.
Some economists use other adjustments to PCE or to the consumer price index (CPI) in an attempt to better measure underlying inflation. For instance, housing rents and new and used car prices have been particularly volatile since early 2020, so some economists calculate PCE or CPI excluding those prices, as well as food and energy prices. As we discuss in this blog post from last September some economists prefer median CPI as the best measure of underlying inflation. (We discuss some of the alternative ways of measuring inflation in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) Nearly all these alternative measures of inflation indicated that the moderation in inflation that began in the summer of 2022 had ended in January 2023. So, choosing among measures of underlying inflation wasn’t critical to understanding the current path of inflation.
Finally, the inflation, employment, and output measures that in January seemed to show that the U.S. economy was still in a strong expansion and that the inflation rate may have ticked up are all seasonally adjusted. Seasonal adjustment factors are applied to the raw (unadjusted) data to account for regular seasonal fluctuations in the series. For instance, unadjusted employment declined in January as measured by both the household and establishment series. Applying the seasonal adjustment factors to the data resulted in the actual decline in employment from December to January turning into an adjusted increase. In other words, employment declined by less than it typically does, so on a seasonally adjusted basis, the Bureau of Labor Statistics reported that it had increased. Seasonal adjustments for the holiday season may be distorted, however, because the 2020–2021 and 2021–2022 holiday seasons occurred during upsurges in Covid. Whether the reported data for January 2023 will be subject to significant revisions when the seasonal adjustments factors are subsequently revised remains to be seen. The latest BLS employment report, showing seasonally adjusted and not seasonally adjusted data, can be found here.