Fed Speak – Why it is OK to be optimistic about Inflation

20 Jun 2024 , 03:39 PM

TIME TO BE OPTIMISTIC ABOUT INFLATION

The one common strand that comes out of the recent Fed policy statement and the quarterly long term projections is that inflation is likely to be sticky for longer than expected. Clearly, the Fed is yet to commence rate cuts and it is expected to start in September 2024. Also, the Fed is likely to restrict itself to just 1 rate cut in 2024 and be a lot more aggressive in 2025. However, the assumption is that inflation does come down meaningfully to give the Fed confidence to cut rates. On that front, there is still no clear answer. The Fed wants to cut rates subject to supportive inflation data. But nobody is willing to commit on when such a supportive data is likely to come in.

Now, there is some reason for hope, going by the recent speech delivered by Fed Governor, Adriana Kugler. Speaking at the Peterson Institute for International Economics, in Washington, Dr Kugler underlined that she was optimistic about inflation easing and she also had a strong justification for this perception. According to Kugler, the reason she is optimistic is a combination of how the data is manifesting itself, the way consumption is playing out and, above all, the way the Fed tightness in the last 30 months has helped tame inflation. According to Kugler, it may have taken much longer than anticipated, but there is room for optimism. Inflation may be finally moving decisively towards the 2% mark.

CURRENT ECONOMIC SITUATION IN THE US CHARACTERIZED

To paraphrase Kugler, the gist of the story today is that inflation still remains too high, although the Fed can feel proud about the progress in containing inflation and the trajectory of am encouraged by the overall progress and trajectory. Some of the data points in the US surely give room for optimism. From the peak of 7.1% in 2022, the PCE (personal consumption expenditure) inflation has fallen to the current level of 2.7%, showing good traction. More importantly, the core PCE inflation (excluding food and energy) is also down from a high of 5.6% to the current level of 2.8%. It is a signal that lower inflation is not just an outcome of cyclical factors, but also structural factors. Core inflation had risen in 2022 due to the supply chain constraints in the aftermath of the pandemic. Now that is clearly and rapidly unwinding.

However, as Kugler puts it, all is not hunky dory. For instance, housing services inflation and rentals continue to be very high. This is despite the recent cooling. Also, the current consumer inflation at 3.3% is still a good 130 bps away from the target of 2%. The experience of the last few months has been that incremental reductions in inflation is gradual. While food inflation and core inflation may have done their bit, energy inflation continues to remain elevated due to the Red Sea crisis and the geopolitical risks in the Middle East and West Asia. However, there are several reasons why Adriana Kugler continue to remain optimistic on the inflation front.

OPTIMISM DRIVER 1: CONSUMERS ARE GETTING MORE PRICE SENSITIVE

According to Dr  Kugler, the one silent shift that is happening in the US economy is that the average US consumer is becoming a lot more price sensitive. What exactly does that mean; and how is this kind of price sensitivity measured? One of the outcomes of the Fed being obsessed with inflation control is that it has helped to reduce inflation expectations and has also been instrumental in anchoring long run inflation expectations. Even the price setting by US companies are in tandem with the lower inflation expectations. In addition, the mark-ups of prices over labour costs are also coming down, which is again a positive for reducing inflation. The recent Biege Book released by the Fed has made an interesting observation. Pricing of products by companies today, is taking care of the reality that consumers are likely to push back against price hikes, and are avoiding that temptation.

This trend, according to Kugler, is more pronounced in the lower income groups. For instance, such groups are even pulling back from their purchases and companies are going that extra mile by actually cutting prices. An interesting trend in consumer behaviour in recent months has been the tendency to trade down. What does that mean? Consumers are willing to look for products that offer value for money and they are even OK to reconcile to smaller sizes and combinations to reduce the cost. That is also serving to keep inflation under control and will be a key factor in bringing the level of inflation eventually to 2%.

OPTIMISM DRIVER 2: INPUT COSTS ARE FINALLY COMING DOWN

Input costs are coming down for US businesses and they are coming down appreciably. One of the key factors driving costs lower is the tapering of nominal wages. While wages are higher in absolute terms, the rate of growth is slowing as the labour market is moving more into balance. One reason for the rapid fall in wage growth has also been that inflation has been coming down rapidly and that has expanded the real wages of persons and hence their purchasing power, even when the overall nominal wage growth is slow. Hence the slower rate of growth in wages is not pinching in purchasing power terms. In reality, it is not just the labour costs, but even the input costs are coming down sharply and that is also helping. Cost of funds continue to be low and despite the spike in interest rates, the companies are able to secure funding at competitive and attractive rates of interest.

OPTIMISM DRIVER 3: PRODUCTIVITY GROWTH COULD BE THE X-FACTOR

While productivity growth is being talked about in hushed tones, nobody is willing to stick their neck out and say that productivity growth is reducing costs. But that is exactly what is happening in the US. The post pandemic period saw a phenomenal surge in new business creation. In addition, IT innovations like artificial intelligence (AI) and machine learning (ML) are likely to redefine the productivity matrix of companies and make them supremely more efficient with the same level of resources. The interest fact is that the post-pandemic business creation surge was very strong in high-tech sectors, such as computer systems design and research and development services. The surge in business entities is normally a precursor to productivity growth. When that happens, supply goes up even with the same resources and keeps prices in check. This argument is still open to debate, but is a key factor nevertheless.

Of course, no discussion on productivity would be complete without giving adequate coverage to the power of AI. One only has to look at how NVIDIA (a company with near monopoly over AI chips in the market) has grown to become the most valuable company in the world, even beating Microsoft and Apple on their turf. There is no gainsaying the fact that AI technology has the potential to make workers and businesses more productive. That is an immediate boost to supply and a reason to temper prices in the market. That impact has been playing out for some time now.

OPTIMISM DRIVER 4 – YES, CENTRAL BANK POLICY HAS WORKED

Contrary to what the critics may say about the Fed starting too early or starting too late; the fact remains that inflation control through monetary measures has worked. While the 2% target may still be elusive, the inflation in the US economy is on track. The persistent hawkishness in action and language by the Fed has not only managed to tame consumption but has also managed to tame the labour market and bring it more into balance. That gives the confidence that the current Fed policy of higher for longer, may be good enough to eventually move the rate of inflation towards the 2% mark. The real impact of the restrictive policies of the US Fed are visible in the rate-sensitive sectors. To an extent the effects of restrictive financial conditions are also evident in the labour markets.

The good news is that the Fed members may have concerns over the current level of inflation but are surely optimistic about the future trajectory of inflation. If the rates being higher for longer is able to tame inflation quicker, then it is worth the effort!