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Inflation and Fed Policy
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John O'Trakoun offers an update on where inflation stands, how it is affecting the economy, and what steps the Federal Reserve is taking to bring it down. O'Trakoun is a senior policy economist at the Richmond Fed and primary author of the Bank's Macro Minute blog.
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Tim Sablik: Hello, and welcome to Speaking of the Economy. I'm your host, Tim Sablik, an economics writer at the Richmond Fed. My guest today is John O'Trakoun. John is a senior policy economist in the Richmond Fed's Research Department and previously served as an economist for the Ford Motor Company. John, thanks for being here.
John O'Trakoun: Thanks, Tim. It's great to be back.
Sablik: Our topic today is inflation and the Fed's efforts to re-establish price stability. John, you're involved in helping keep our researchers and Bank President Tom Barkin up to date on everything that's going on in the economy. What is the latest story on inflation and how has the picture evolved over the first half of this year?
O'Trakoun: Tim, inflation started off the year too high and now, halfway into the year, it still remains too high. In January, the Personal Consumption Expenditures Price Index — that's the Fed's preferred measure of the cost of living — came in about 6 percent year over year. In May, which as of today is the latest month of inflation data that we have, that measure has risen to 6.4 percent year over year. That's over three times higher than our preferred 2 percent average inflation target.
But it's not all bad news. Today's 6.4 percent actually has come down a bit from 6.6 in March. Core inflation, which strips out volatile food and energy prices, looks like it could be coming down some. But overall inflation is too front of mind these days for the Fed to have any degree of comfort. That's why we've been lifting rates at our most recent meetings.
Sablik: Yeah, a big part of the inflation story this year has been the actions that the Fed is taking to try and rein it in. Maybe you can describe for our listeners what steps the Fed has taken, what it hopes to accomplish, and what effects these policies are having on the economy so far.
O'Trakoun: Our main policy tool is setting the benchmark interest rate of the economy. It's called the federal funds rate. This year, we've raised it in three meetings. In March, the Federal Open Market Committee, the FOMC, lifted the fed funds rate by 25 basis points. Then in May, we increased it again by 50 basis points. Then in the most recent June meeting, we lifted rates by 75 basis points for a total of one and a half percentage points this year … so far. At the moment, it looks like further increases are probably still needed because inflation is still too high for comfort.
But in the background of all this, the Fed is also reducing its asset holdings on its balance sheet. During the pandemic, we purchased assets like Treasury securities and mortgage-backed securities to help support the economy and lower interest rates, especially those interest rates that are out into the future — long-term interest rates. The value of our asset holdings grew from around $4 trillion just before the pandemic to around $9 trillion today. These purchases helped to support economic activity during the crisis. But now we don't need the same levels of crisis support, so the Fed is starting to gradually run off these asset holdings and get back to something that looks more like normal.
By these moves, what we're hoping to do is to cool off the elevated level of demand in the economy and slow down those bidding wars that are lifting up prices in various markets and contributing to today's elevated level of inflation. The challenge in adjusting policy right now is that we're doing it in a way that's responsive to the real problems we're seeing with inflation numbers at close to 40-year highs, but we're also trying to get a smooth adjustment in the process.
Sablik: There's also been a lot of talk that the Fed's actions could put the economy into a recession. Do you see any warning signs of that in the data that you're watching?
O'Trakoun: The official body that determines whether or not we're in a recession is the National Bureau of Economic Research, the NBER. They'll look at a number of criteria to determine whether the economy is in or close to a recession.
Some people out there try to use a rule of thumb like two consecutive quarters of negative real GDP growth as a kind of benchmark for recession. But when it comes to the NBER's actual policy, there's no hard and fast rule that they follow. For example in the COVID recession, they said that that only lasted for two months in March and April of 2020. So, it's really hard to pick out any one or two data points and say, well, that definitely indicates that we're in recession territory.
That said, the New York Fed has an economic model that was updated in June. That [model] predicts that within the next 10 quarters, the probability of fourth quarter GDP growth dipping below −1 percent is pretty elevated — about 80 percent. The Atlanta Fed has a forecast for GDP growth in the second quarter of this year that, as of July 1, is at −2.1 percent. So, some signs are emerging that real activity is starting to cool. I wouldn't necessarily call that a warning sign yet because it's also partly what we'd expect to see in an environment of monetary tightening.
Sablik: Right.
O'Trakoun: In May, we saw inflation-adjusted household spending fall for the first time this year, and that's a sign that consumption is slowing. Real orders and shipments of manufactured goods also fell in May, and that suggests less business investment is happening. In the most interest-rate sensitive sectors — which are housing and autos — we're seeing sales fall, but low inventories are part of the picture there. The pace of new and existing homes is down from the beginning of the year. The pace of light vehicle sales is down to a 12.7 million seasonally adjusted annual rate in May, and that's down from 15 million from the beginning of the year.
Sablik: Right. As you mentioned, some of this slowdown is intentional on the Fed's part.
Some of our listeners may have also heard some talk about the Fed trying to engineer a "soft landing" from inflation. What do you think are the chances that the Fed can bring inflation down without causing a serious economic contraction?
O'Trakoun: Okay, the key word in that question is "serious." I think the chances that we can bring down inflation without experiencing what I think you're describing are pretty good.
I think part of the problem is that the last two recessions we've gone through have been really strange ones, because they've been the most recent and they're shaping people's fears about what a recession might feel like and what an economic downturn looks like. The 2008-2009 Great Recession was a once-in-a-generation, worldwide financial crisis. The 2020 COVID recession was a once-in-a-century global pandemic. After having lived through these two episodes, I feel like it may be tempting to think they're representative of all economic downturns and to have a knee-jerk reaction to the word "recession" and think it means we're about to fall off a cliff.
I think the best description of what the economy might go through comes from a former colleague of mine in the auto industry, Charlie Chesbrough at Cox Automotive. He said something like, "We're not about to fall off a cliff, we're falling off a curb." In that moment [when] you're walking, carrying groceries, and you step off a curb you didn't know is there. For an instant, you feel like, oh, you're in freefall. But a second later, you catch yourself. You realize it was just another step that happened to be a little deeper than you thought.
The reason we're falling off a curb and not a cliff is that, for all the fearful talk going on right now, in some respects our economy is actually doing really well. As of May, the unemployment rate is at 3.6 percent, and that's just barely off of its all-time record low. There [are] 1.9 jobs available for every unemployed person out there. The ISM manufacturing survey is indicating that manufacturing activity is still growing. Real spending is basically at its pre-COVID trendline. And, household balance sheets are really healthy — net worth is up for all households as of the first quarter of this year. Even in the bottom 20 percent of households by income, net worth is about 24 percent higher than the pre-pandemic level. So, there are these economic tailwinds that the Fed is leaning into as it tries to tighten monetary policy.
Sablik: I like that metaphor of falling off a curb versus falling off a cliff, although some of our listeners might naturally wonder, even if there's a chance of falling off that cliff — even if it's small — tightening monetary policy carries those risks. Why is it so important that the Fed take these actions now? What are the costs of allowing inflation to continue?
O'Trakoun: Well, we talked earlier about some of those emerging signs of softness in the economy. But I think some of the most troubling warning signs today are coming from survey data that are pointing to the awareness and pain of inflation really weighing into the psychology of households and businesses.
The Conference Board's index of consumer confidence is down in June. It fell to 98.7 from 103.2 in May. In that survey, the respondents are actually confident about the labor market, but their expectations for business conditions dropped to −14.8. That's the worst result since 2009.
It looks like the driver behind these expectations is high inflation. In the survey, the year-ahead inflation projection was up by half a percentage point to 8 percent. That's the highest reading ever in the history of this survey that goes back to 1987.
From the University of Michigan, we got another survey of consumers and that index of consumer sentiment fell to 50 in June. That's lower than levels that we saw during the global financial crisis and lower than during the Volcker inflation shock, which was the late '70s and early '80s when inflation was really high.
Sablik: Mm-hmm.
O'Trakoun: The previous low for this survey was around the middle of the 1980s, when it hit 51.7. In the most recent reading, 79 percent of consumers expected that there were going to be bad times in the year ahead for business conditions. That's the highest percentage we've seen since 2009.
Once again, it looks like inflation is the culprit. The respondents to the survey expect 5.3 percent inflation for the year ahead, and that's at a historic high. Forty-seven percent of those consumers blamed inflation for eating into their standard of living. That's just one percentage point off of its all-time record high.
During the COVID days, the Census Bureau began collecting a weekly Household Pulse Survey. Thirty-five percent of respondents to the survey said they had difficulty paying household bills. That's the highest we've seen since late 2020, back when the Delta variant was really wreaking havoc on the economy and on people's minds. A record 12 percent borrowed from friends or family to meet their spending needs. I think that's a sign that high prices are really causing some households to really struggle, and it's a problem that we need to tackle with urgency.
Most importantly, though, the Fed has to act before inflationary dynamics become entrenched. That could happen if inflation expectations become unanchored and people start believing that high past inflation means we're going to have high future inflation as well. Once that genie is out of the bottle, it can be really difficult to cram it back in without imposing significant constraints on economic activity.
Luckily, for now, measures of long-run inflation expectations are at levels that look like they're consistent with our target. But the point is that we want to act preemptively and early before we even start to see signs of unanchoring materialize.
Sablik: What will you be looking for over the next weeks and months in the data, either related to this unanchored question or other things that you're watching in the economy?
O'Trakoun: Well, when it comes to getting a grip on inflation, the proof is really in the pudding. So, I'll be watching for measures of actual inflation to go down. Because households' expectations of inflation tend to follow the headline measure – that's the one that includes food prices and energy prices – I'll closely be watching that along with the standard measure of core inflation that most economists follow. If demand is falling, we'd expect to see nominal spending slow down like it did last month, so I'll be closely tracking that measure. And, on the supply side, I'll be watching for further improvement in inventory to sales ratios, and things like month's supply of homes and autos.
Here at the Fed, we're tracking a whole variety of indicators to assess the health of the economy. For any listeners who are interested, I'd definitely recommend you stay tuned to get the latest updates.
Sablik: Yeah, absolutely. Anyone who wants to stay up to date on all the things that John is watching and working on, you can head over to Richmondfed.org or the show notes to check out a link to his blog, Macro Minute, where he blogs on these and other topics happening in the economy.
That's all we've got time for today. John, thanks very much for joining me to unpack the first half of this year and what to look for next.
O'Trakoun: Thanks a lot, Tim.
