Did inflation peak? Doesn’t matter to the Fed

The Federal Reserve is not going to abandon its plan to aggressively remove monetary policy accommodation even if inflation has peaked. The CPI increased 0.3% in April, in line with our forecast and a touch stronger than the consensus expectation.

Energy prices dropped 2.7% in April after jumping 11% in March. Excluding energy, the CPI was up 0.6% in April, stronger than the 0.4% gain in March.

The CPI for food/beverages continued to post solid gains, as it was up 0.8% after rising 1% in each of the prior two months.

Excluding food and energy, the CPI rose more than anticipated, adding 0.6% in April compared with 0.3% in March. On a year-ago basis, the headline and core CPIs were up 8.3% and 6.2%, respectively, not seasonally adjusted.

Though the gain was in line with our forecast, there was a little more uncertainty in the forecast because the Bureau of Labor Statistics altered how it measures new-vehicle prices. Previously, it surveyed dealerships, but it will now use transaction data.

Turning back to monetary policy, the odds of the Fed engineering a soft landing are declining. The Fed is behind the curve on inflation and the labour market is extremely tight. Therefore, tightening monetary policy to tame inflation without causing the unemployment rate to increase will be extremely difficult.

There has never been an increase in the unemployment rate of more than 30 basis points on a three-month moving average basis that wasn’t associated with a recession.

Once the labour market overshoots full employment, it is extremely difficult for the Fed to pull off a soft landing. Also, inflation expectations are climbing; inflation at a seasonally adjusted 8.2% on a year-ago basis, compared with the 2.1% average growth in 2018 and 2019, is costing the average household an extra $311.78 per month to purchase the same basket of goods and services as last year. This is a little less than last month but still a noticeable burden on households.

The Fed could face a situation where higher consumer prices begin to weigh on consumer spending, reducing GDP growth. The pandemic has not repealed the law of demand, which states that, all else equal, a higher price of a good or service reduces the quantity demanded.

The Fed could be faced with a Hobson’s choice: Push the economy into a mild recession, similar to our scenario, to tame inflation or wait and possibly cause a more significant recession, since a stagflation scenario is possible next year if the Fed isn’t aggressive enough.