Fed’s tricky balancing act: Navigating inflation and public confidence

For over a year now, we have been writing about the risk of a recession. Over that same period, Federal Reserve Chair Jerome Powell warned us that bringing down inflation would require “some pain to households and businesses.” 

Yet so far in 2023, we’ve seen inflation subside while job growth and other economic indicators remain strong. This trend continues this month, with a solid employment report and the slowest pace of inflation in over two years. 

Could this mean we avoid the “pain” Chair Powell warned us about? And what does this mean for the Fed’s July 26 meeting? 

Here are our thoughts.

Sustainable pace of growth can bring down inflation

Inflation is fundamentally caused by spending outpacing the economy’s ability to supply goods and services. The recent bout of inflation stemmed from a surge in demand that overwhelmed supply. For inflation to subside, all that needs to happen is for the growth in demand to equilibrate with the growth of supply. 

This gets to the concept of a sustainable pace of growth. This is the idea that various elements of the economy can only grow so fast before causing inflation. 

Think of it like cooking a sauce. If the heat on the stove is too hot, the sauce will boil over and make a mess. On the other hand, if you turn the heat off entirely, the sauce never thickens up properly. The goal is to find the right temperature to produce a consistent simmer. 

Historically, the simmer rate for job growth appears to be somewhere between 1% and 3%. The chart below shows employment growth on a rolling six-month basis. We used six months to remove some of the month-by-month noise and translated it to an annual pace for easier comparison. 

Source: Bureau of Labor Statistics

The red line is at 1% growth, and the green line is at 3%. What we see is that in almost all positive growth periods, job gains were within this 1-3% range. When employment growth fell below this range, it almost always headed negative, meaning we were in a recession.

If we zoom into the last couple of years, we see that job growth ran consistently above the typical range. In fact, using this methodology, 2021 was the best year for job gains of all time, and 2022 was the second-best year.

Source: Bureau of Labor Statistics

But was the 2021-2022 pace of job gains sustainable? History suggests it was not. So does the fact that inflation surged during this period. It sure seems like our pot was boiling over.

On the chart, we see that in recent months the pace of job gains has eased back into the 1-3% range, which has been more typical of expansionary periods in the past. 

Today the 1-3% range translates to between 130,000 and 385,000 job gains per month.

In the Labor Department’s June employment report, job gains were estimated at 209,000, right in the middle of that range. 

Inflation is also easing, albeit slowly

With job growth going from a rolling boil to a low simmer, it stands to reason that inflation should be subsiding as well. Based on the overall Consumer Price Index (CPI), inflation is declining rapidly. 

The June CPI showed prices have increased by 3.0% over the last year, which is the slowest pace since early 2021. Unfortunately much of this improvement has come from energy prices, which have declined 17% over the last year, according to the Labor Department’s estimations. The so-called Core CPI measure, which strips out food and energy, rose by 4.8%. On this measure inflation is slowing at a much slower pace.

Source: Bureau of Labor Statistics

That being said, the evidence is building that inflation pressure is generally easing and that the official statistics just aren’t keeping up. 

For example, consider three key categories within the CPI home prices, apartment rents, and used cars. Because of how the CPI measures these prices, many economists argue that the official estimate could adjust slower than real-life prices. 

Looking at private estimates of all three of those categories, it appears prices are actually falling significantly in all three categories. 

The chart below compares the official inflation estimate for each category with private estimates for home prices, rents, and used cars. 

Source: Bureau of Labor Statistics, S&P Case Shiller, Rent.com, Manheim

To illustrate how impactful these categories are for overall CPI, we estimated what the CPI would have been had the official estimates been equal to the private price estimates from the chart above. Had that been the case, CPI would have been a mere 0.4% over the last year.

Source: Bureau of Labor Statistics, S&P Case Shiller, Rent.com, Manheim

This is not to say that we think inflation was actually 0.4% over the last year. Rather, given the wide gap between the CPI’s measurement and more real-time estimates for prices, there is good reason to believe that CPI will continue to decline purely for this reason.

Our optimism over inflation goes beyond this measurement issue. There have been a number of business surveys recently indicating that inflation pressures are subsiding. 

The ISM Report on Business, a survey of business sentiment, asks a question about prices paid for parts, raw materials, and other items used as inputs in production. 

For manufacturing, corporate managers report that input prices are falling. For services, the rate of price increases is at its lowest since March 2020. 

Separately, the National Federation of Independent Businesses runs a small business sentiment survey. This survey includes a question about plans to raise prices for customers. 

The June survey indicated only 29% of firms plan on raising prices, the lowest response since March 2021.

All the data seems to point to inflation cooling. If we add in the fact that employment gains are now running at a more sustainable pace, that gives us a lot of reason for optimism.

What does this mean for the Fed?

The Federal Reserve meets on July 26, and several Fed officials have indicated a rate hike is highly likely for that meeting. Given all the data we’ve discussed above, you might wonder why the Fed feels the need to keep hiking. 

The answer is that the Fed has a tricky communications job. Economists generally believe that the Fed’s reputation on inflation makes fighting high inflation easier. If everyone believes the Fed will bring inflation down, firms and consumers act like future inflation will be low.

It is widely believed that the public losing confidence in the Fed was part of why inflation got so out of control in the 1970s, and restoring that confidence required extraordinary effort by the Fed at the time. 

Chair Powell has referenced the painful 1970s experience in several speeches recently. He argued that if the Fed does not do enough to arrest inflation now, it will only be more difficult to deal with later.

That being said, the Fed is very much aware of the data we outlined previously. They are just worried that the public could misinterpret inaction on its part as complacency about today’s relatively high level of inflation.

So the Fed is trying a middle ground. They paused rate hikes in June but suggested they would likely hike in July. In effect, they didn’t hike in the short term but made it very clear they weren’t satisfied with today’s level of inflation. 

What happens after July is very much up in the air. The Fed’s next meeting isn’t until September 20. If job gains remain in the “simmer” zone we described before, and if inflation continues to show more and more progress, the Fed could be done hiking for 2023. But if inflation doesn’t decline quickly enough, they will do whatever it takes to restore price stability.