The Fed building
Those inside the Federal Reserve can almost celebrate the defeat of inflation © Reuters

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This is the second week of major central bank monetary policy meetings. There have been no moves so far and none expected from the Federal Reserve tomorrow or the Bank of England on Thursday. As the chart below on Tokyo’s inflation rate in January shows, central bankers’ words can age quickly and badly. I’d love to hear your thoughts on which statements from central bank officials have been undermined most rapidly by brutal reality. And don’t say “transitory inflation”, that took at least four months. Email me:

Almost there . . . 

In the US, officials must feel they are almost within touching distance of “immaculate disinflation”, the elimination of rapidly rising prices without an economic downturn or any meaningful rise in unemployment.

Over the past week, the inflation data has been encouraging and the US economy expanded at an annualised rate of 3.3 per cent in the fourth quarter of 2023 (for the benefit of most of the rest of the world and headline writers everywhere, this irritating American growth reporting convention translates to a quarterly growth rate of 0.8 per cent). Before Fed officials went into their “blackout period” you could sense the anticipation of good news with titles to speeches such as Fed governor, Chris Waller’s, “almost as good as it gets . . . but will it last?”

Depositors, borrowers and investors want to know where US official interest rates are heading. Last week, I said that you should trust the Federal Open Market Committee’s projection that there would be three rate cuts this year unless inflation was materially better than the FOMC’s December 2023 summary of economic projections or economic prospects were significantly worse. With only good news coming from the real side of the economy, this week I will take a closer look at the US inflation figures published on Friday.

The figures to watch are the personal consumption expenditure deflator figures (PCE) preferred by the FOMC to the consumer price index (CPI) measure because officials think they are more comprehensive, more consistent over long periods and reflect more timely household spending patterns.

So that we don’t commit bucket or time crime, below is a table of US annualised PCE inflation over different measures and time periods. The idea of putting a whole bunch of inflation measures in one table came from Professor Jason Furman of the Harvard Kennedy School, although I’ve made slightly different methodological choices. I’ve also added the weight of each inflation measure so you can see how much of the whole index is excluded. All errors are mine.

Look first at the 12-month figures — these are the normal year-on-year comparisons that tell you how much prices have changed in the past year. The Fed will be pleased that the core rate, excluding food and energy, has fallen below 3 per cent in December. But as Martin Sandbu explained last week, these 12-month figures often tell you as much about what was happening a year ago than more recently. It is therefore worthwhile to look at more recent periods, but annualising the change in prices so they are comparable with the 12-month numbers.

Look at the blue summary median of all other measures and on one-month, three-month and six-month annualised bases. PCE inflation is down to 2 per cent or below on each. For sure it is higher on a few underlying measures, especially the Dallas Fed trimmed mean measure and the Cleveland Fed median inflation measure (which both tend to be a bit laggy), but we can conclude that inflation has hit the Fed’s 2 per cent over the past six months at least.

The question for rates is how these figures compare with the FOMC’s summary of economic projections. The answer is very well indeed. Compared with the December forecasts (when most of the data was already available), a quarter of the FOMC thought headline inflation would have been higher in the fourth quarter of 2023 and none thought it would be lower. More than 40 per cent of the committee forecast a higher core rate of inflation over the same period and, again, none thought price pressures would be weaker.

The data for December, of course, tells us nothing about 2024, except that better than expected inflation performance at the end of 2023 might continue. The FOMC will therefore have seen evidence that is reassuring, but probably not enough yet to signal a March rate cut or a change in view in the appropriate number of rate cuts this year. That might be obvious by the March 20 meeting.

If you liked the table above, but thought, “I wonder how these figures have moved over the past year or so”, they are all in the chart below. But do look also at the shaded minimum and maximum values — these show the broad swath of US inflation measures all falling back to target.

With disinflation clearly a feature of the US economy, it is worth thinking what is preventing the Fed cutting the federal funds immediately. The four following reasons are likely to feature.

  1. Strong growth. With expansion at a year-on-year rate of 3.1 per cent in the fourth quarter, the US economy performed better than every FOMC member expected as recently as the December 2023 economic projections. The highest forecast on December 13 was 2.7 per cent. It would be a brave period to base monetary policy decisions on current growth rates since the link between economic performance and inflation has been catastrophic of late, but strong growth is a good excuse temporarily to do nothing.

  2. Uncertainty. As I wrote a few weeks back, the Fed thinks the world is unusually uncertain, so is likely to want to wait before taking a big decision.

  3. Reversal risk. Last week’s newsletter highlighted how central bankers hate a U-turn. This delays action.

  4. Low costs of waiting. Since there are few signs of pain in the US economy, it is reasonable for officials to say the cost of delay in cutting rates is low. This is entirely valid.

A dovish European Central Bank?

The ECB last week left its interest rates on hold with a statement almost identical to that in December. Christine Lagarde said: “The disinflation process is at work.” I am not going to engage in a lengthy textual analysis of her words (or those of the multiple national central bank governors who have spoken since the meeting) because it is pretty pointless.

Instead, the ECB emphasised data dependency, so it is clear that a reasonable central expectation would be that it starts to cut rates around June. Earlier action is not ruled out and would come if there was sufficiently good news on inflation, signs of more rapidly slowing wage growth or bad news on economic activity.

As the chart below shows, the ECB’s meeting itself was viewed in forward interest rate markets as a little dovish, but the much bigger move has been a realisation by market participants that they became too excited about quick and deep rate cuts over the Christmas period.

What I’ve been reading and watching

  • Your views on whether Christine Lagarde was correct and wise to have a pop at economists interested me all week. My summary of them is that you are quite evenly split on whether her comments were correct although the intensity of feeling among supporters was stronger. People were more reluctant to say whether her words were wise.

  • At the Peterson Institute, David Wilcox, former lead economic forecaster at the Fed, gives a candid assessment of what the US central bank got wrong recently (too rigid foreword guidance, mostly). But he said the pandemic period was so unusual, central banks should not rush into changing their forecasting or inflation-fighting frameworks.

  • The UK’s Bank of England and Treasury published responses to their consultation on a “digital pound”, the UK’s proposed central bank digital currency. There were more than 50,000 responses and privacy was one of the most often cited concerns. The authorities’ answer was a series of guarantees. Any digital pound would not be programmable to expire after a certain date or contain conditional contracts such as limiting what it could be used to purchase. It would be private (without being anonymous) and designed to ensure people would always have a trusted payment mechanism in future.

  • For the longevity of his reporting, the breadth of his canvas and comments on central bank policies, John Plender’s lessons from 55 years of investing is a must-read.

A chart that matters

Japan released figures for Tokyo’s inflation in January. These are an excellent predictor of the national figures coming later in February. Headline and core inflation (excluding fresh food) fell well below expectations in January and well below the Bank of Japan’s 2 per cent target. They came three days after the BoJ said it was more confident than it had been that inflation would be sustainable at its target level. Oh dear.

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