More good news on the inflation front: the Consumer Price Index (CPI) grew by only 0.2 percent in June. That corresponds to a 2.2 percent continuously compounded annual inflation rate, which is less than the 3.0 percent average rate over the last 12 months.
Core CPI, which excludes food and energy prices, grew 0.2 percent in June and 4.8 percent over the last 12 months.
Although the Federal Reserve uses the Personal Consumption Expenditures Price Index (PCEPI) to measure inflation, the CPI is typically a good predictor of the PCEPI, which will come out later this month.
Importantly, much of the disinflation seems to be explained by falling energy prices. The CPI shows a 12-month decline in energy prices of 16.7 percent. Housing tells a similar story in the opposite direction. The price of shelter is growing much faster than the index average. This suggests supply-and-demand dynamics in particular markets are significantly affecting the topline numbers. Core inflation, which includes shelter but excludes food and energy, likely gives us a better perspective on continued inflationary pressures.(It’s worth noting that housing estimates tend to lag, which results in initial overestimates during inflationary episodes.)
What does this mean for monetary policy? The federal funds rate target range is currently 5.00 to 5.25 percent. If we project forward the new CPI data, the inflation-adjusted policy rate is 2.8 to 3.1 percent. Real interest rates were negative for a long time, but absent a policy reversal, those days seem to be behind us.
We should compare inflation-adjusted rates to the natural rate of interest. Economists believe this is the rate consistent with supply-and-demand equilibrium in short-term capital markets. Current estimates place it somewhere between 0.5 and 1.5 percent. Provided the recent monthly inflation figures give us an accurate forecast, the real federal funds rate is significantly above the natural rate. This indicates monetary policy is restrictive.
Data on the money supply provide supporting evidence for the tightness of monetary policy, as well. M2 is shrinking at 4.6 percent per year. Divisia monetary aggregates, which weight components of the money supply by their liquidity, are falling at 2.5 to 2.75 percent per year. This isn’t surprising. When market interest rates rise above the natural rate, significant financial disintermediation can occur.
The Federal Open Market Committee should seriously consider keeping rates at 5.25 percent at their next meeting. Further hikes are likely unnecessary. To be clear, aggregate demand remains significantly above its pre-pandemic trend and core inflation is still 1.5 to 2.5 times the Fed’s target. But the data strongly suggest price pressures are ebbing, and further tightening can burden production by upsetting market expectations.