Inflation Report: Critical for Fed Policy Direction | Economy Update 2023

The upcoming release of the consumer price index (CPI) report on Tuesday is anticipated to have significant implications for the Federal Reserve's policy direction. After months of grappling with soaring prices, this report is expected to reveal a slowdown in the rate of price increases, prompting policymakers to reassess the need for further interest rate hikes and allow the U.S. economy to regain its footing.




According to the Dow Jones consensus estimate, the CPI is projected to show a mere 0.1% increase in all-items inflation for the previous month, which translates to an annual rate of 4%. Excluding the volatile food and energy components, core inflation is forecasted to rise by 0.4% and 5.3%, respectively.




These figures may instill confidence among policymakers that inflation is indeed moving in the right direction, especially after its peak above 9% in June 2022. Mark Zandi, chief economist at Moody's Analytics, noted that the year-over-year growth rates are expected to decline significantly, providing encouraging signs that inflation is on a favorable trajectory.




The surge in inflation, which began in the spring of 2021, was largely driven by pandemic-related factors such as disrupted supply chains, elevated demand for goods over services, and substantial monetary and fiscal stimulus measures. In response, the Federal Reserve initiated a series of 10 interest rate hikes starting in March 2022, despite initially downplaying the longevity of inflationary pressures. Since then, inflation has been gradually receding but still remains well above the central bank's target of 2%.




The upcoming CPI report is likely to convince policymakers on the Federal Open Market Committee to forgo a rate hike during their meeting this week. Instead, they will await further data and carefully consider the longer-term policy trajectory. Zandi believes that if the report aligns with expectations, the Federal Reserve will find reassurance that inflation is moving in the right direction, reducing the urgency to raise rates again.




Several key variables in the May CPI report warrant close attention. Notably, core inflation is expected to appear stronger than headline inflation—an uncommon occurrence—due to the exclusion of food and energy components, which tend to be more volatile. This discrepancy is primarily a result of year-over-year comparisons, which include a period when gasoline prices surged to over $5 per gallon but have since subsided.




Additionally, analysts will closely monitor used vehicle prices, which experienced a 4.4% monthly increase in April and are anticipated to remain elevated in May. Shelter costs, which constitute a significant portion of the CPI, are expected to decline later this year, according to Federal Reserve officials. Economists are also keeping an eye on airfare and lodging costs, which are projected to rebound in May.




Dean Baker, co-founder of the Center for Economic and Policy Research, acknowledged that inflation has been trending downward over the past year. However, he raised the question of whether this downward trajectory will persist or if inflation has reached a plateau, as it still remains above the Federal Reserve's target of 2%. The upcoming CPI report and subsequent data leading up to the July meeting will play a crucial role in determining whether the market's expectation of the Fed skipping a rate hike is accurate or if policymakers deem further action necessary.




While market expectations indicate a pause in rate hikes after the upcoming meeting, there is a possibility of one final increase in July before an extended hiatus, potentially lasting into early 2024, as suggested by trading in the fed funds futures market. The CPI report, coupled with additional data in the following month, will heavily influence whether the market's projection aligns with the Federal Reserve's decisions or if policymakers believe further measures are required.




Bill English, a former Fed official and current finance professor at the Yale School




of Management, emphasized that achieving a soft landing depends largely on the path of inflation. If inflation remains high, it may necessitate additional rate hikes. English added that finding a balance between employment, output, and reducing inflation to 2% within a few years is crucial for the Federal Reserve's policymaking process.