Personal consumption expenditures (PCE) price index – Page 5

Has the Federal Reserve Achieved a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from the New York Times.)

Since inflation began to increase rapidly in the late spring of 2021, the key macroeconomic question has been whether the Fed would be able to achieve a soft landing—pushing inflation back to its 2 percent target without causing a recession. The majority of the members of the Fed’s Federal Open Market Committee (FOMC) believed that increases in inflation during 2021 were largely caused by problems with supply chains resulting from the effects of the Covid–19 pandemic.

These committee members believed that once supply chains returned to normal, the increase in he inflation rate would prove to have been transitory—meaning that the inflation rate would decline without the need for the FOMC to pursue a contractionary monetary by substantially raising its target range for the federal funds rate. Accordingly, the FOMC left its target range unchanged at 0 to 0.25 percent until March 2022. As the following figure shows, by that time the inflation rate had increased to 6.9 percent, the highest it had been since January 1982. (Note that the figure shows inflation as measured by the percentage change from the same month in the previous year in the personal consumption expenditures (PCE) price index. Inflation as measured by the PCE is the gauge the Fed uses to determine whether it is achieving its goal of 2 percent inflation.)

By the time inflation reached its peak in mid-2022, many economists believed that the FOMC’s decision to delay increasing the federal funds rate until March 2022 had made it unlikely that the Fed could return inflation to 2 percent without causing a recession. But the latest macroeconomic data indicate that—contrary to that expectation—the Fed does appear to have come very close to achieving a soft landing. On January 26, the Bureau of Economic Analysis (BEA) released data on the PCE for December 2023. The following figure shows for the period since 2015, inflation as measured by the percentage change in the PCE from the same month in the previous year (the blue line) and as measured by the percentage change in the core PCE, which excludes the prices of food and energy (the red line).

The figure shows that PCE inflation continued its decline, falling slightly in December to 2.6 percent. Core PCE inflation also declined in December to 2.9 percent from 3.2 percent in November. Note that both measures remained somewhat above the Fed’s inflation target of 2 percent.

If we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—inflation is closer to Fed’s target, as the following figure shows. The 1-month PCE inflation rate has moved somewhat erratically, but has generally trended down since mid-2022. In December, PCE inflation increased from from –0.8 percent in November (which acutally indicates that deflation occurred that month) to 2.0 percent in December. The 1-month core PCE inflation rate has moved less erratically, also trending down since mid-2022. In December, the 1-month core PCE inflation increased from 0.8 percent in November to 2.1 percent in December. In other words, the December reading on inflation indicates that inflation is very close to the Fed’s target.

The following figure shows for each quarter since the beginning of 2015, the growth rate of real GDP measured as the percentage change from the same quarter in the previous year. The figure indicates that although real GDP growth dropped to below 1 percent in the fourth quarter of 2022, the growth rate rose during each quarter of 2023. The growth rate of 3.1 percent in the fourth quarter of 2023 remained well above the FOMC’s 1.8 percent estimate of long-run economic growth. (The average of the members of the FOMC’s estimates of the long-run growth rate of real GDP can be found here.) To this point, there is no indication from the GDP data that the U.S. economy is in danger of experiencing a recession in the near future.

The labor market also shows few signs of a recession, as indicated by the following figure, which shows the unemployment rate in the months since January 2015. The unemployment rate has remained below 4 percent in each month since December 2021. The unemployment rate was 3.7 percent in December 2023, below the FOMC’s projection of a long-run unemployment rate of 4.1 percent.

The FOMC’s next meeting is on Tuesday and Wednesday of this week (February 1-2). Should we expect that at that meeting Fed Chair Jerome Powell will declare that the Fed has succeeded in achieving a soft landing? That seems unlikely. Powell and the other members of the committee have made clear that they will be cautious in interpreting the most recent macroeconomic data. With the growth rate of real GDP remaining above its long run trend and the unemployment rate remaining below most estimates of the natural rate of unemployment, there is still the potential that aggregate demand will increase at a rate that might cause the inflation rate to once again rise.

In a speech at the Brookings Institution on January 16, Fed Governor Christopher Waller echoed what appear to be the views of most members of the FOMC:

“Time will tell whether inflation can be sustained on its recent path and allow us to conclude that we have achieved the FOMC’s price-stability goal. Time will tell if this can happen while the labor market still performs above expectations. The data we have received the last few months is allowing the Committee to consider cutting the policy rate in 2024. However, concerns about the sustainability of these data trends requires changes in the path of policy to be carefully calibrated and not rushed. In the end, I am feeling more confident that the economy can continue along its current trajectory.”

At his press conference on February 1, following the FOMC meeting, Chair Powell will likely provide more insight into the committee’s current thinking.

Another Middling Inflation Report

Photo courtsey of Lena Buonanno.

On the morning of January 11, 2024, the Bureau of Labor Statistics released its report on changes in consumer prices during December 2023. The report indicated that over the period from December 2022 to December 2023, the Consumer Price Index (CPI) increased by 3.4 percent (often referred to as year-over-year inflation). “Core” CPI, which excludes prices for food and energy, increased by 3.9 percent. The following figure shows the year-over-year inflation rate since Januar 2015, as measured using the CPI and core CPI.

This report was consistent with other recent reports on the CPI and on the personal consumption expenditures (PCE) price index—the measure the Fed uses to gauge whether it is achieving its target of 2 percent annual inflation—in showing that inflation has declined substantially from its peak in mid-2022 but is still above the Fed’s target.

We get a similar result if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—as the following figure shows. The 1-month CPI inflation rate has moved erratically but has generally trended down. The 1-month core CPi inflation rate has moved less erratically, making the downward trend since mid-2022 clearer.

The headline on the Wall Street Journal article discussing this BLS report was: “Inflation Edged Up in December After Rapid Cooling Most of 2023.” The headline reflected the reaction of Wall Street investors who had hoped that the report would unambiguously show further slowing in inflation.

Overall, the report was middling: It didn’t show a significant acceleration in inflation at the end of 2023 but neither did it show a signficant slowing of inflation. At its next meeting on January 30-31, the Fed’s Federal Open Market Committee (FOMC) is expected to keep its target for the federal funds rate unchanged. There doesn’t appear to be anything in this inflation report that would be likely to affect the committee’s decision.

Can We Now Rule Out One of the Three Potential Monetary Policy Outcomes?

Federal Reserve Chair Jerome Powell (photo from bloomberg.com)

In a blog post from February of this year, we discussed three possible outcomes of the contractionary monetary policy that the Federal Reserve has been pursuing since March 2022, when the Federal Open Market Committee (FOMC) began raising its target range for the federal funds rate:

A soft landing. The Fed’s preferred outcome; inflation returns to the Fed’s target of 2 percent without the economy falling into recession.
A hard landing. Inflation returns to the Fed’s 2 percent target, but the economy falls into a recession.
No landing. At the beginning of 2023, the unemployment remained very low and inflation, as measured by the percentage change in the personal consumption expenditures (PCE) price index from the same month in the previous year, was still above 5 percent. So, some observers, particularly in Wall Street financial firms, began discussing the possibility that low unemployment and high inflation might persist indefinitely, resulting an outcome of no landing.

At the end of 2023, the economy appears to be slowing: Retail sales declined in October; real disposable personal income increased in October, but it has been trending down, as have real personal consumption expenditures; while the increase in third quarter real GDP was recently revised upward from 4.9 percent to 5.2 percent, forecasts of growth in real GDP during the fourth quarter show a marked slowing—for instance, GDPNow, compiled by the Atlanta Fed, estimates fourth quarter growth at 2.1 percent; and while employment continues to expand, average weekly hours have been slowly declining and initial claims for unemployment insurance have been increasing.

The slowing in the growth of output, income, and employment are reflected in a falling inflation rate. The following figure show the percentage change since the same month in the previous year in PCE price index, which is the measure the Fed uses to gauge whether it is hitting its 2 percent inflation target. (We discuss the reasons for the Fed preferring the PCE price index to the consumer price index (CPI) in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) The figure also shows core PCE, which excludes the prices of food and energy. Core PCE inflation typically gives a better measure of the underlying inflation rate than does PCE inflation.

PCE inflation declined from 3.4 percent in September to 3.0 percent in October. Core PCE inlation declined from 3.8 percent in September to 3.5 percent in September. Although inflation has been declining from its peak in mid-2022, both of these measures of inflation remain above the Fed’s 2 percent target.

But if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—we see a much sharper decline in inflation, as the following figure shows.

The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, the 1-month rate shows a sharp decline in PCE inflation from 3.8 percent in September to 0.6 percent in October. Core PCE inflation declined less sharply from 3.9 percent in September to 2.0 percent in October.

The continuing decline in inflation has caused some economists and Wall Street analysts to predict that the FOMC will not implement further increases in its target for the federal funds rate and will likely begin cutting its target by mid-2024.

On December 1 in a speech at Spelman College in Atlanta, Fed Chair Jerome Powell urged caution in assuming that the Fed has succeeded in putting inflation on a course back to its 2 percent target:

“The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”

In terms of the three policy outcomes listed at the beginning of this post, the third—no landing, with the unemployment rate remaining very low while the inflation rate remains above the Fed’s 2 percent target—now seems unlikely. The labor market appears to be weakening, which will likely result in increases in the unemployment rate. The next “Employment Report” from the Bureau of Labor Statistics, which will be released on December 8, will provide additional data on the state of the labor market.

Although we can’t entirely rule out the possibility of a no landing outcome, it seems more likely that the economy will either make a soft landing—if output and employment continue to increase, although at a slower rate, while inflation continues to decline—or a hard landing—if output and employment begin to fall as the economy enters a recession. Although a consensus seems to be building among economists, policymakers, and Wall Street analysts that a soft landing is the likeliest outcome, Powell has provided a reminder that that outcome is far from certain.

Very Strong GDP Report

Photo from Lena Buonanno

This morning the Bureau of Economic Analysis (BEA) released its advance estimate of GDP for the third quarter of 2023. (The report can be found here.) The BEA estimates that real GDP increased by 4.9 percent at an annual rate in the third quarter—July through September. That was more than double the 2.1 percent increase in real GDP in the second quarter, and slightly higher than the 4.7 percent that economists surveyed by the Wall Street Journal last week had expected. The following figure shows the rates of GDP growth each quarter beginning in 2021.

Note that the BEA’s most recent estimates of real GDP during the first two quarters of 2022 still show a decline. The Federal Reserve’s Federal Open Market Committee only switched from a strongly expansionary monetary policy, with a target for the federal funds of effectively zero, to a contractionary monetary policy following its March 16, 2022 meeting. That real GDP was declining even before the Fed had pivoted to a contractionary monetary policy helps explain why, despite strong increases employment during this period, most economists were expecting that the U.S. economy would experience a recession at some point during 2022 or 2023. This expectation was reinforced when inflation soared during the summer of 2022 and it became clear that the FOMC would have to substantially raise its target for the federal funds rate.

Clearly, today’s data on real GDP growth, along with the strong September employment report (which we discuss in this blog post), indicates that the chances of the U.S. economy avoiding a recession in the future have increased and are much better than they seemed at this time last year.

Consumer spending was the largest contributor to third quarter GDP growth. The following figure shows growth rates of real personal consumption expenditures and the subcategories of expenditures on durable goods, nondurable goods, and services. There was strong growth in each component of consumption spending. The 7.6 percent increase in expenditures on durables was particularly strong, particularly given that spending on durables had fallen by 0.3 percent in the second quarter.

Investment spending and its components were a more mixed bag, as shown in the following figure. Overall, gross private domestic investment increased at a very strong rate of 8.4 percent—the highest rate since the fourth quarter of 2021. Residential investment increased 3.9 percent, which was particularly notable following nine consecutive quarters of decline and during a period of soaring mortgage interest rates. But business fixed investment was noticeably weak, falling by 0.1 percent. Spending on structures—such as factories and office buildings—increased by only 1.6 percent, while spending on equipment fell by 3.8 percent.

Today’s real GDP report also contained data on the private consumption expenditure (PCE) price index, which the FOMC uses tp determine whether it is achieving its goal of a 2 percent inflation rate. The following figure shows inflation as measured using the PCE and the core PCE—which excludes food and energy prices—since the beginning of 2015. (Note that these inflation rates are measured using quarterly data and as compound annual rates of change.) Despite the strong growth in real GDP and employment, inflation as measured by PCE increased only from 2.5 percent in the second quarter to 2.9 percent in the third quarter. Core PCE, which may be a better indicator of the likely course of inflation in the future, continued the long decline that began in first quarter of 2022 by failling from 3.7 percent to 2.9 percent.

The combination of strong growth in real GDP and declining inflation indicates that the Fed appears well on its way to a soft landing—achieving a return to its 2 percent inflation target without pushing the economy into a recession. There are reasons to be cautious, however.

GDP, inflation, and employment data are all subject to—possibly substantial—revisions. So growth may have been significantly slower than today’s advance estimate of real GDP indicates. Even if the estimate of real GDP growth of 4.9 percent proves in the long run to have been accurate, there are reasons to doubt whether output growth can be maintained at near that level. Since 2000, annual growth in real GDP has average only 2.1 percent. For GDP to begin increasing at a rate substantially higher than that would require a significant expansion in the labor force and an increase in productivity. While either or both of those changes may occur, they don’t seem likely as of now.

In addition, the largest contributor to GDP growth in the third quarter was from consumption expenditures. As households continue to draw down the savings they built up as a result of the federal government’s response to the Covid recession of 2020, it seems unlikely that the current pace of consumer spending can be maintained. Finally, the lagged effects of monetary policy—particularly the effects of the interest rate on the 10-year Treasury note having risen to nearly 5 percent (which we discuss in our most recent podcast)—may substantially reduce growth in real GDP and employment in future quarters.

But those points shouldn’t distract from the fact that today’s GDP report was good news for the economy.

Inflation, Disinflation, Deflation, and Consumers’ Perceptions of Inflation

Inflation has declined, although many consumers are skeptical. What explains consumer skepticism? First we can look at what’s happened to inflation in the period since the beginning of 2015. The figure below shows inflation measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. We show both so-called headline inflation, which includes the prices of all goods and services in the index, and core inflation, which excludes energy and food prices. Because energy and food prices can be volatile, most economists believe that the core inflation provides a better indication of underlying inflation.

Both measures show inflation following a similar path. The inflation rate begins increasing rapidly in the spring of 2021, reaches a peak in the summer of 2022, and declines from there. Headline CPI peaks at 8.9 percent in June 2022 and declines to 3.7 percent in August 2023. Core inflation reaches a peak of 6.6 percent in September 2022 and declines to 4.4 percent in August 2022.

As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5, and Essentials of Economics, Chapter 17, Section 17.5), the Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The PCE includes the prices of all the goods and services included in the consumption component of GDP. Because the PCE includes the prices of more goods and services than does the CPI, it’s a broader measure of inflation. The following figure shows inflation as measured by the PCE and by the core PCE, which excludes energy and food prices.

Inflation measured using the PCE or the core PCE shows the same pattern as inflation measured using the CPI: A sharp increase in inflation in the spring of 2021, a peak in the summer of 2022, and a decline thereafter.

Although it has yet to return to the Fed’s 2 percent target, the inflation rate has clearly fallen substantially during the past year. Yet surveys of consumers show that majorities are unconvinced that inflation has been declining. A Pew Research Center poll from June found that 65 percent of respondents believe that inflation is “a very big problem,” with another 27 percent believing that inflation is “a moderately big problem.” A Gallup poll from earlier in the year found that 67 percent of respondents thought that inflation would go up, while only 29 percent thought it would go down. Perhaps not too surprisingly, another Gallup poll found that only 4 percent of respondents had a “great deal” of confidence in Federal Reserve Chair Jerome Powell, with another 32 percent having a “fair amount” of confidence. Fifty-four percent had either “only a little” confidence in Powell or “almost none.”

There are a couple of reasons why most consumers might believe that the Fed is doing worse in its fight against inflation than the data indicate. First, few people follow the data releases as carefully as economists do. As a result, there can be a lag between developments in the economy—such as declining inflation—and when most people realize that the development has occurred.

Probably more important, though, is the fact that most people think of inflation as meaning “high prices” rather than “increasing prices.” Over the past year the U.S. economy has experienced disinflation—a decline in the inflation rate. But as long as the inflation rate is positive, the price level continues to increase. Only deflation—a declining price level—would lead to prices actually falling. And an inflation rate of 3 percent to 4 percent, although considerably lower than the rates in mid-2022, is still significantly higher than the inflation rates of 2 percent or below that prevailed during most of the time since 2008.

Although, core CPI and core PCE exclude energy and food prices, many consumers judge the state of inflation by what’s happening to gasoline prices and the price of food in supermarkets. These are products that consumers buy frequently, so they are particularly aware of their prices. The figure below shows the component of the CPI that represents the prices of food consumers buy in groceries or supermarkets and prepare at home. The price of food rose rapidly beginning in the spring of 2021. Althought increases in food prices leveled off beginning in early 2023, they were still about 24 percent higher than before the pandemic.

There is a similar story with respect to gasoline prices. Although the average price of gasoline in August 2023 at $3.84 per gallon is well below its peak of nearly $5.00 per gallon in June 2022, it is still well above average gasoline prices in the years leading up to the pandemic.

Finally, the figure below shows that while percentage increases in rent are below their peak, they are still well above the increases before and immediately after the recession of 2020. (Note that rents as included in the CPI include all rents, not just rental agreements that were entered into that month. Because many rental agreements, particularly for apartments in urban areas, are for one year or more, in any given month, rents as measured in the CPI may not accurately reflect what is currently happening in rental housing markets.)

Because consumers continue to pay prices that are much higher than the prices they were paying prior to the pandemic, many consider inflation to still be a problem. Which is to say, consumers appear to frequently equate inflation with high prices, even when the inflation rate has markedly declined and prices are increasing more slowly than they were.

Is the U.S. Economy Coming in for a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from Bloomberg News via the Wall Street Journal.)

The key macroeconomic question of the past two years is whether the Federal Reserve could bring down the high inflation rate without triggering a recession. In this blog post from back in February, we described the three likely macroeconomic outcomes as:

A soft landing—inflation returns to the Fed’s 2 percent target without a recession occurring.
A hard landing—inflation returns to the Fed’s 2 percent target with a recession occurring.
No landing—inflation remains above the Fed’s 2 percent target but no recession occurs.

The following figure shows inflation measured as the percentage change in the personal consumption expenditures (PCE) price index and in the core PCE, which excludes food and energy prices. Recall that the Fed uses inflation as measured by the PCE to determine whether it is hitting its inflation target of 2 percent. Because food and energy prices tend to be volatile, many economists inside and outside of the Fed use the core PCE to better judge the underlying rate of inflation—in other words, the inflation rate likely to persist in at least the near future.

The figure shows that inflation first began to rise above the Fed’s target in March 2021. Most members of the Federal Open Market Committee (FOMC) believed that the inflation was caused by temporary disruptions to supply chains caused by the effects of the Covid–19 pandemic. Accordingly, the FOMC didn’t raise its target for the federal funds from 0 to 0.25 percent until March 2022. Since March 2022, the FOMC has raised its target for the federal funds rate in a series of steps until the target range reached 5.25 to 5.50 percent following the FOMC’s July 26, 2023 meeting.

PCE inflation peaked at 7.0 percent in June 2022 and had fallen to 2.9 percent in June 2023. Core PCE had a lower and earlier peak of 5.4 percent in February 2023, but had experienced a smaller decline—to 4.1 percent in June 2023. Inflation as measured by the consumer price index (CPI) followed a similar pattern, as shown in the following figure. Inflation measured by core CPI reached a lower peak than did inflation measured by the CPI and declined by less through June 2023.

As inflation has been falling since mid-2022, , the unemployment rate has remained low and the employment-population ratio for prime-age workers (workers aged 25 to 54) has risen above its 2019 pre-pandemic peak, as the following two figures show.

So, the Fed seems to be well on its way to achieving a soft landing. But in the press conference following the July 26 FOMC meeting Chair Jerome Powell was cautious in summarizing the inflation situation:

“Inflation has moderated somewhat since the middle of last year. Nonetheless, the process of getting inflation back down to 2 percent has a long way to go. Despite elevated inflation, longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.”

By “longer-term expectations appear to remain well anchored,” Powell was referring to the fact that households, firms, and investors appear to be expecting that the inflation rate will decline over the following year to the Fed’s 2 percent target.

Those economists who still believe that there is a good chance of a recession occuring during the next year have tended to focus on the following three points:

1. As shown in the following two figures, the labor market remains tight, with wage increases remaining high—although slowing in recent months—and the ratio of job openings to the number of unemployed workers remaining at historic levels—although that ratio has also been declining in recent months. If the labor market remains very tight, wages may continue to rise at a rate that isn’t consistent with 2 percent inflation. In that case, the FOMC may have to persist in raising its target for the federal funds rate, increasing the chances for a recession.

2. The lagged effect of the Fed’s contractionary monetary policy over the past year—increases in the target for the federal funds rate and quantitative tightening (allowing the Fed’s holdings of Treasury securites and mortgage-backed securities to decline; a process of quantitative tightening (QT))—may have a significant negative effect on the growth of aggegate demand in the coming months. Economists disagree on the extent to which monetary policy has lagged effects on the economy. Some economists believe that lags in policy have been significantly reduced in recent years, while other economists believe the lags are still substantial. The lagged effects of monetary policy, if sufficiently large, may be enough to push the economy into a recession.

3. The economies of key trading partners, including the European Union, the United Kingdom, China, and Japan are either growing more slowly than in the previous year or are in recession. The result could be a decline in net exports, which have been contributing to the growth of aggregate demand since early 2021.

In summary, we can say that in early August 2023, the probability of the Fed bringing off a soft landing has increased compared with the situation in mid-2022 or even at the beginning of 2023. But problems can still arise before the plane is safely on the ground.

Is a Soft Landing More Likely Now?

Photo from the Wall Street Journal.

The Federal Reserve’s goal has been to end the current period of high inflation by bringing the economy in for a soft landing—reducing the inflation rate to closer to the Fed’s 2 percent target while avoiding a recession. Although Fed Chair Jerome Powell has said repeatedly during the last year that he expected the Fed would achieve a soft landing, many economists have been much more doubtful.

It’s possible to read recent economic data as indicating that it’s more likely that the economy is approaching a soft landing, but there is clearly still a great deal of uncertainty. On April 12, the Bureau of Labor Statistics released the latest CPI data. The figure below shows the inflation rate as measured by the CPI (blue line) and by core CPI—which excludes the prices of food and fuel (red line). In both cases the inflation rate is the percentage change from the same month in the previous year.

The inflation rate as measured by the CPI has been trending down since it hit a peak of 8.9 percent in June 2022. The inflation rate as measured by core CPI has been trending down more gradually since it reached a peak of 6.6 percent in September 2022. In March, it was up slightly to 5.6 percent from 5.5 percent in February.

As the following figure shows, payroll employment while still increasing, has been increasing more slowly during the past three months—bearing in mind that the payroll employment data are often subject to substantial revisions. The slowing growth in payroll employment is what we would expect with a slowing economy. The goal of the Fed in slowing the economy is, of course, to bring down the inflation rate. That payroll employment is still growing indicates that the economy is likely not yet in a recession.

The slowing in employment growth has been matched by slowing wage growth, as measured by the percentage change in average hourly earnings. As the following figure shows, the rate of increase in average hourly earnings has declined from 5.9 percent in March 2022 to 4.2 percent in March 2023. This decline indicates that businesses are experiencing somewhat lower increases in their labor costs, which may pass through to lower increases in prices.

Credit conditions also indicate a slowing economy As the following figure shows, bank lending to businesses and consumers has declined sharply, partly because banks have experienced an outflow of deposits following the failure of Silicon Valley and Signature Banks and partly because some banks have raised their requirements for households and firms to qualify for loans in anticipation of the economy slowing. In a slowing economy, households and firms are more likely to default on loans. To the extent that consumers and businesses also anticipate the possibility of a recession, they may have reduced their demand for loans.

But such a sharp decline in bank lending may also be an indication that the economy is not just slowing, on its way to a making a soft landing, but is on the verge of a recession. The minutes of the March meeting of the Federal Open Market Committee (FOMC) included the information that the FOMC’s staff economists forceast “at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.” (The minutes can be found here.) The increased chance of a recession was attributed largely to “banking and financial conditions.”

At its next meeting in May, the FOMC will have to decide whether to once more increase its target range for the federal funds rate. The target range is currently 4.75 percent to 5.00 percent. The FOMC will have to decide whether inflation is on a course to fall back to the Fed’s 2 percent target or whether the FOMC needs to further slow the economy by increasing its target range for the federal funds rate. One factor likely to be considered by the FOMC is, as the following figure shows, the sharp difference between the inflation rate in prices of goods (blue line) and the inflation rate in prices of services (red line).

During the period from January 2021 to November 2022, inflation in goods was higher—often much higher—than inflation in services. The high rates of inflation in goods were partly the result of disruptions to supply chains resulting from the Covid-19 pandemic and partly due to a surge in demand for goods as a result of very expansionary fiscal and monetary policies. Since November 2022, inflation in the prices of services has remained high, while inflation in the prices of goods has continued to decline. In March, goods inflation was only 1.6 percent, while services inflation was 7.2 percent. In his press conference following the last FOMC meeting, Fed Chair Jerome Powell stated that as long as services inflation remains high “it would be very premature to declare victory [over inflation] or to think that we’ve really got this.” (The transcript of Powell’s news conference can be found here.) This statement coupled with the latest data on service inflation would seem to indicate that Powell will be in favor of another 0.25 percentage point increase in the federal funds rate target range.

The Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The Bureau of Economic Analysis will release the March PCE on April 28, before the next FOMC meeting. If the Fed is as closely divided as it appears to be over whether additional increases in the federal funds rate target range are necessary, the latest PCE data may prove to have a significan effect on their decision.

So—as usual!—the macroeconomic picture is murky. The economy appears to be slowing and inflation seems to be declining but it’s still difficult to determine whether the Fed will be able to bring inflation back to its 2 percent target without causing a recession.

Soft Landing, Hard Landing … or No Landing?

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.

How Should We Measure Inflation?

In the textbook, we discuss several measures of inflation. In Macroeconomics, Chapter 8, Section 8.4 (Economics, Chapter 18, Section 18.4) we discuss the GDP deflator as a measure of the price level and the percentage change in the GDP deflator as a measure of inflation. In Chapter 9, Section 9.4, we discuss the consumer price index (CPI) as a measure of the price level and the percentage change in the CPI as the most widely used measure of inflation.

In Chapter 15, Section 15.5 we examine the reasons that the Federal Reserve often looks at the core inflation rate—the inflation rate excluding the prices of food and energy—as a better measure of the underlying rate of inflation. Finally, in that section we note that the Fed uses the percentage change in the personal consumption expenditures (PCE) price index to assess of whether it’s achieving its goal of a 2 percent inflation rate.

In this blog post, we’ll discuss two other aspects of measuring inflation that we don’t cover in the textbook. First, the Bureau of Labor Statistics (BLS) publishes two versions of the CPI: (1) The familiar CPI for all urban consumers (or CPI–U), which includes prices of goods and services purchased by households in urban areas, and (2) the less familiar CPI for urban wage earners and clerical workers (or CPI–W), which includes the same prices included in the CPI–U. The two versions of the CPI give slightly different measures of the inflation rate—despite including the same prices—because each version applies different weights to the prices when constructing the index.

As we explain in Chapter 9, Section 9.4, the weights in the CPI–U (the only version of the CPI we discuss in the chapter) are determined by a survey of 36,000 households nationwide on their spending habits. The more the households surveyed spend on a good or service, the larger the weight the price of the good or service receives in the CPI–U. To calculate the weights in the CPI–W the BLS uses only expenditures by households in which at least half of the household’s income comes from a clerical or wage occupation and in which at least one member of the household has worked 37 or more weeks during the previous year. The BLS estimates that the sample of households used in calculating the CPI–U includes about 93 percent of the population of the United States, while the households included in the CPI–W include only about 29 percent of the population.

Because the percentage of the population covered by the CPI–U is so much larger than the percentage of the population covered by the CPI–W, it’s not surprising that most media coverage of inflation focuses on the CPI–U. As the following figure shows, the measures of inflation from the two versions of the CPI aren’t greatly different, although inflation as measured by the CPI–W—the red line—tends to be higher during economic expansions and lower during economic recessions than inflation measured by the CPI–U—the blue line.

One important use of the CPI–W is in calculating cost-of-living adjustments (COLAs) applied to Social Security payments retired and disabled people receive. Each year, the federal government’s Social Security Administration (SSA) calculates the average for the CPI–W during June, July, and August in the current year and in the previous year and then measures the inflation rate as the percentage increase between the two averages. The SSA then increases Social Security payments by that inflation rate. Because the increase in CPI–W is often—although not always—larger than the increase in CPI–U, using CPI–W to calculate Social Security COLAs increases the payments recipients of Social Security receive.

A second aspect of measuring inflation that we don’t mention in the textbook was the subject of discussion following the release of the July 2022 CPI data. In June 2022, the value for the CPI–U was 295.3. In July 2022, the value for the CPI–U was also 295.3. So, was there no inflation during July—an inflation rate of 0 percent? You can certainly make that argument, but typically, as we note in the textbook (for instance, see our display of the inflation rate in Chapter 10, Figure 10.7) we measure the inflation rate in a particular month as the percentage change in the CPI from the same month in the previous year. Using that approach to measuring inflation, the inflation rate in July 2022 was the percentage change in the CPI from its value in July 2021, or 8.5 percent. Note that you could calculate an annual inflation rate using the increase in the CPI from one month to the next by compounding that rate over 12 months. In this case, because the CPI was unchanged from June to July 2022, the inflation rate calculated as a compound annual rate would be 0 percent.

During periods of moderate inflation rates—which includes most of the decades prior to 2021—the difference between inflation calculated in these two ways was typically much smaller. Focusing on just the change in the CPI for one month has the advantage that you are using only the most recent data. But if the CPI in that month turns out to be untypical of what is happening to inflation over a longer period, then focusing on that month can be misleading. Note also that inflation rate calculated as the compound annual change in the CPI each month results in very large fluctuations in the inflation rate, as shown in the following figure.

Sources: Anne Tergesen, “Social Security Benefits Are Heading for the Biggest Increase in 40 Years,” Wall Street Journal, August 10, 2022; Neil Irwin, “Inflation Drops to Zero in July Due to Falling Gas Prices,” axios.com, August 10, 2022; “Consumer Price Index Frequently Asked Questions,” bls.gov, March 23, 2022; Stephen B. Reed and Kenneth J. Stewart, “Why Does BLS Provide Both the CPI–W and CPI–U?” U.S. Bureau of Labor Statistics, Beyond the Numbers, Vol. 3, No. 5, February 2014; “Latest Cost of Living Adjustment,” ssa.gov; and Federal Reserve Bank of St. Louis.