Have We Crested The Inflation Wave?

By Alexander William Salter

Finally, some welcome news on the inflation front: Core PCEPI inflation is down to 4.6 percent year-over-year, and 0.3 percent month-over-month, which is 3.6 percent annualized. PCEPI growth has fallen in six of the past eight months. Inflation expectations over the five-year and ten-year horizon have ticked up slightly, but are comfortably below 2.5 percent per year.

Too many commentators celebrated prematurely when inflation slowed down in December 2022. Thankfully, things have improved since then. We can be cautiously optimistic that monetary policy has finally gotten ahead of dollar depreciation. It’s too soon for the Fed to declare “mission accomplished,” but the time is right to reconsider future tightening.

The current federal funds rate target range is 4.75 to 5.0 percent. Most economists think the real (inflation-adjusted) neutral fed funds rate - the Goldilocks point for monetary policy, neither too loose nor too tight - is between 0.25 and 0.5 percent. Since core PCEPI grew at an annualized rate of 4.8 percent over the previous three months and 3.6 percent over the previous month, the real federal funds rate is likely around 0.2 to 1.4 percent today. That monetary policy is near or slightly tighter than neutral is a good sign. We probably need a higher-than-neutral rate to get inflation down to 2.0 percent and restore the Fed’s credibility.

Aside from interest rates, monetary considerations (which matter more!) also suggest the Fed is erring on the side of tightness. The M2 money supply is shrinking - and has been for each month of 2023. More sophisticated measures of the money supply tell a similar story. The Divisia aggregates, which contain more money substitutes than M2 and weight each component by its moneyness (or, liquidity), have also fallen each month this year.

Economic theory suggests the money supply should grow to offset changes in money demand. As a rule of thumb, that means keeping up with population growth and real income growth. Steve Hanke and Manuel Hinds suggest 5 to 6 percent money growth per year. I’m inclined to agree. At this point, money is almost certainly tight compared to market actors’ expectations. That hasn’t yet caused nominal GDP (aggregate demand) to fall below its neutral level. But if the Fed continues tightening, it’s only a matter of time.

Analyzing monetary policy in real time is hard because different data can tell different stories. From what we’ve seen, monetary policy is now between appropriately tight and excessively so. The worst-case scenario would be a continual policy see-saw, as happened during the 1970s and early 1980s. But as long as central bank discretion (rather than strict rules) has the last word, this remains a troubling possibility.

My view is the Fed should pause its rate hikes in the short run. Disintermediation might be the cause of recent money supply trends. In the long run, the Fed should resume forward guidance, but not on interest rates. The ultimate goal is to stabilize markets’ inflation expectations by committing to a predictable growth path for aggregate demand.

Simple aggregates like the money supply and nominal GDP are out of favor with our current crop of would-be monetary policy sophisticates. So much the worse for them. These measures are still the most reliable indicators of monetary policy. Until central bankers rediscover their importance, we’ll always run the risk of fighting the previous war - and letting inflation slip through our fingers as a consequence.

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