Powell’s path to 2% inflation needs luck or, failing that, pain

VIRGINIA (BLOOMBERG) – Federal Reserve Chair Jerome Powell sees two possible paths for the economy and monetary policy over the next year: With some luck, inflation will cool with the help of more supply. And if that fails, the Fed won’t hesitate to impose a more painful solution.

In the best-case scenario, the Fed’s front-loaded interest-rate hikes slow demand for rate-sensitive sectors like housing, cars and other durable goods bought on credit. Plus – over time – supply disruptions ease and come back into better balance with demand.

In Powell’s view, there is a chance that price growth can slow quite quickly, helping the Fed reduce inflation toward its 2 per cent target.

“If demand can move back down, then inflation could move to back along that path just as quickly as it went up,” Powell told the Senate Banking Committee last Wednesday during his semi-annual testimony before Congress.

Powell said the Fed had misjudged inflation’s momentum in late 2021. Inflation, according to the central bank’s preferred measure, is running at 6.3 per cent. The central bank is now trying to front-load policy restraint. Officials raised interest rates by 75 basis points earlier this month – lifting the target range for their main benchmark to 1.5 per cent to 1.75 per cent.

Powell said that a similar move, or one of 50 basis points, was on the table when they meet late next month. Investors have almost fully priced another 75 basis-point move in July.

Collectively, Fed officials in their June projections saw inflation gliding back down to near 2 per cent by 2024 with growth hardly dipping much below 2 per cent, while unemployment rises modestly.

Michael Pond, the top inflation strategist at Barclays Plc in New York, says the Fed’s outlook could work out. He points to falling freight rates and well-stocked retail inventories as signs that “supply-chain constraints are starting to ease up.”

“In our base-case forecast, we do have quite a bit of disinflation as we get into next year,” Pond says. “But there is still significant uncertainty.”

Add something else to that list: Fed officials worry rolling price shocks -most recently to food and energy after Russia’s invasion of Ukraine – could dislodge public expectations about trend prices going forward.

Survey measures of such expectations for future inflation, for example, are notoriously correlated to the level of gas prices today. Fed officials are concerned that rising expectations now could harden into a reset of the way the public considers the average rate of inflation going forward, though they got some good news on that front on Friday.

A preliminary reading of the University of Michigan’s June measure of expected inflation 5 to 10 years ahead jumped to 3.3 per cent – the highest reading since 2008 – and Powell and other Fed officials have pointed to that June 10 data release as one of the factors in their last-minute decision to raise by 75 basis points five days later.

Final results from the Michigan survey, published Friday, showed a smaller increase, however, to 3.1 per cent.

Chicago Fed President Charles Evans told reporters Thursday that “we can’t afford to be fooled again on this, or else it’s going to get beyond us.”

“We’re all kind of counting on these real factors improving to bring down inflation,” he said. “If we’re counting on monetary policy restraint only, then a Phillips curve which is pretty flat, and inflation expectations – I mean, you would need a much higher increase in the unemployment rate to provide inflation restraint.”