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Economic Report: Inflation appears to be slowing, but the Fed isn’t turning down the heat

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Even as the U.S. economy gets squeezed by rising interest rates and the threat of recession, mounting evidence suggests inflation is easing just as the Federal Reserve ratchets up the pressure.

The yearly rate of inflation slowed to 7.1% in November, from 7.7% in the prior month and from a 40-year peak of 9.1% last summer, based on the consumer price index.

What’s more, the increase in the cost of many goods that drove the spike in inflation last year, such as used cars, has decelerated, in some cases quite rapidly.

Used-vehicle prices have fallen 3.3% in the past 12 months, compared with a 41% yearly increase as recently as February.

Soaring rents, another big driver of inflation, are also coming back down to earth. The cost of housing is the single biggest influence on the consumer price index.

Yet senior officials at the Fed still aren’t persuaded that the rate of inflation is on a clear trajectory to their 2% goal — the rate they think is optimal for the economy. They don’t expect inflation to return to prepandemic levels at least until 2026, based on their most recent forecast.

“It will take substantially more evidence to give confidence that inflation is on a sustained downward path,” Fed Chair Jerome Powell said last week after the bank raised interest rates for the eighth time this year. Other top Fed officials backed him up.

The Fed lifted a key short-term rate to a top end of 4.5% — the highest in 15 years — and signaled it won’t stop until it hits around 5.25% or so. The rate was near zero just nine months ago.

Senior Fed officials also made it clear in interviews after their meeting that they intend to keep the rate above 5% for all of 2023 — a more aggressive strategy than Wall Street had expected.

“Despite the increasingly compelling evidence that core inflation will fall sharply next year, the Fed simply doubled down on its recent hawkishness,” said Paul Ashworth, chief North America economist at Capital Economics.

The Fed’s tough talk sent stocks plunging and intensified worries that its actions are likely to capsize the economy in 2023. Higher borrowing costs depress the economy by reducing consumer spending and business investment.

Some Wall Street
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economists warn the Fed is downplaying the slowdown in inflation and needs to shift its stance to avert a recession.

Also read: ‘The recession debate is not a parlor game’, says Moody’s Zandi 

Fed officials are mindful of the damaging consequences of rising rates. But after failing to spot the initial surge in inflation last year, they don’t want to compound their error by allowing price pressures to remain high.

In past episodes such as the 1970s, they point out, high inflation required more punitive measures to come under control the longer it was allowed to persist — to the long-term detriment to the economy.

“The worst pain would come from a failure to raise rates high enough and from us allowing inflation to become entrenched in the economy,” Powell said.

What particularly worries the Fed is the fastest increase in wages in four decades, a result of perhaps the tightest labor market on record. Compensation is rising more than 5% a year, double the annual amount in the decade before the pandemic.

Businesses have to offer sharply higher pay to attract new workers and retain existing ones at a time when good help is hard to find.

Wages are the single biggest cost for most companies, especially in the service-oriented sectors that now dominate the modern U.S. economy, such as banking, retail, restaurants, recreation, travel, medical treatment and personal care.

The yearly rate of service inflation (minus energy) nudged up to a 40-year high of 6.8% in November, compared with less than 3% a year before the pandemic. Much of that increase reflects rising labor costs.

“I haven’t seen a lot of evidence service inflation is coming down,” said Loretta Mester, president of the Cleveland Federal Reserve bank.

The evidence could come soon, though.

For one thing, rent increases are expected to slow sharply in 2023 as the economy weakens and people balk at paying more. The cost of new and existing homes is also rising at a slower pace.

“Take out shelter, and the inflation cooling looks far more dramatic,” said senior economist Bob Schwartz of Oxford Economics.

Inflation in goods, meanwhile, is also expected to keep slowing.

Tangled global supply chains that limited the flow of goods during the pandemic are loosening, eliminating an original source of high inflation.

Consumers are also cutting back on purchases of goods such as cars and computers and shifting their spending to services like travel, unraveling another major source of inflation.

The cost of goods minus food and energy is up just 3.7% in the past year, for example, compared with an annual rate of 12.4% in February.

But the Fed needs to see clear proof of slower wage growth and more slack in the labor market before it throttles back its fight against inflation — even it it means that several million people lose their jobs.

“I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way,” Powell said.

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