The Federal Reserve decided on Wednesday that it needed more information before deciding whether to raise interest rates again, voting 10 to 2 to hold its target range for the federal funds rate at 3.75 to 4 percent. The Fed explained that “the accumulation of more information” would help it determine the appropriate stance of monetary policy. It did not have to wait long. Data released Thursday morning show that inflation accelerated in September and that overall spending in the economy is still growing too fast for inflation to return to the Fed’s 2-percent target.
At his post-meeting press conference, Chairman Kevin Warsh described an economy “expanding at a strong pace” and acknowledged that inflation “has been running above the Committee’s objective for close to 6 years.” He said financial conditions have tightened since September, but added, “I’m unwilling and unable to call them tight.” In other words, by Warsh’s own account, inflation is still too high and financial conditions are not tight. That makes the decision to wait hard to justify, unless September’s rate increase is doing more to restrain borrowing and spending than Warsh himself suggests.
Not everyone at the Fed wanted to wait. Two officials dissented in favor of another quarter-point increase. One was Beth Hammack, president of the Federal Reserve Bank of Cleveland, who also dissented in July and warned earlier this month that inflation pressures look “relatively broad-based.” A retailer in her district, she said, plans to raise prices by more than its costs have risen: “They know there’ll be more inflation coming, they just don’t know from where.” The other, more surprising, was Fed Governor Lisa Cook, who voted to hold in July and argued in August that disinflationary forces could bring inflation down “without a rate increase.” On Wednesday, she stopped waiting.
The Bureau of Economic Analysis (BEA) reported on Thursday that the Personal Consumption Expenditures Price Index (PCEPI), the Fed’s preferred measure of inflation, rose 0.5 percent in September, up from 0.3 percent in August. Prices are now 3.6 percent higher than a year ago, up from 3.4 percent in August.
Energy prices were the primary driver of September’s increase, rising 5.4 percent from August. Although higher fuel prices certainly squeeze household budgets, they do not necessarily tell us that inflation is accelerating. Energy prices often reflect supply conditions outside the Fed’s control such as the conflict with Iran. Warsh acknowledged this distinction, describing the Fed’s job as ensuring that “relative price changes in some sectors do not broaden out across the economy.”
But looking through higher energy prices offers little reassurance. Core PCEPI, which excludes volatile food and energy prices, rose 0.3 percent in September, the same as in August, and is 3.1 percent higher than a year ago, up from 3.0 percent. At 0.3 percent a month for two consecutive months, core inflation is running at an annualized rate of roughly 3.7 percent, well above the Fed’s 2-percent target. The problem is not confined to energy.
The best guide to where inflation is headed, however, is nominal spending, the dollar value of all final goods and services produced in the economy. The BEA’s advance estimate of third-quarter GDP, also released Thursday, shows that nominal spending grew 5.9 percent over the past year. Spending growth slowed in the third quarter, to an annualized rate of 5.6 percent from 8.5 percent in the second quarter, but not because the economy slowed. Real output grew faster, at 3.4 percent compared with 2.2 percent the prior quarter. The slowdown came from prices, which rose at an annualized rate of 2.2 percent, down from 6.1 percent, as energy prices leveled off after surging in the spring. Nonetheless, nominal spending remains well above the pace consistent with the Fed’s target.
The Fed’s latest Summary of Economic Projections (SEP) shows what that pace is. Fed officials put longer-run real output growth at 2 percent per year. Add the 2-percent inflation target, and nominal spending should grow about 4 percent per year. Over the past year, it has grown nearly 2 percentage points faster than that. In short, as long as spending grows faster than about 4 percent annually, inflation will tend to run above the Fed’s 2-percent target.
Warsh doesn’t see it that way. Asked whether strong demand was adding to inflation, he said most Fed officials do not think the economy is running too hot. He credited faster growth in part to rising productivity, adding that while “economic growth is higher,” that “doesn’t tell me that economic growth is somehow causing inflation.”
To be sure, faster productivity growth is good news. The faster the economy’s productive capacity grows, the more spending can occur without raising prices. But real growth would have to run near 4 percent a year, twice the SEP’s longer-run estimate, to make today’s (year-over-year) spending growth consistent with 2 percent inflation. Fed officials’ own projections put real growth at 2.3 percent this year.
There has been some progress. Financial conditions have tightened since September, as Warsh noted, and because monetary policy works with a lag, the full effects of September’s rate increase have yet to show up in the data. But the Fed paused to see which way inflation and spending were heading. Thursday’s data show inflation moving the wrong way and spending still growing well above the roughly 4 percent pace consistent with the Fed’s target, so the fight to get inflation down to the Fed’s target is far from over.
The Fed meets again in December. By then, policymakers will have more information, but Thursday’s data already make the case for another rate increase. Inflation is still running above the Fed’s target, as it has for the better part of six years, nominal spending continues to grow too quickly, and financial conditions are not yet meaningfully restrictive. The Fed wanted more information, and now that it has it, the next move is clear: raise rates again.
