Great News on the Inflation Front

Underlying inflation has cooled

The kerfuffle on Twitter over Isabella Weber’s ideas (on greedflation see Matt Bruenig) made me want to revisit my estimator of underlying inflation. Based on that estimator, we argued in January 2023, a bit prematurely, that the Fed would pivot soon. The Fed did eventually pause the most rapid hiking cycle since 1980. But it is stuck in a ‘holding pattern’ — a moment of equipoise dictated by the radical uncertainly over the future path of inflation.

More recently, we argued that the Fed deserves credit for the disinflation. Even though the Phillips curve orthodoxy has been debunked yet again, monetary policy is working through the channels scholars have identified: Bank capital and reserves have contracted due to the Fed’s tight money policy, with the result that credit and deposit creation has slowed, tempering demand and inflation.

A lot of tightening is already baked-in. If underlying inflation is on its way to falling to the target level of 2 percent per annum and the Fed continues to tighten much further, then it could unnecessarily push the economy into recession. It is therefore extremely important to not overdo the tightening.

The Fed used to look at core inflation. But that has become less informative about the future path of inflation in this cycle. For a while, the FOMC paid great attention to services inflation—thought to have a good signal of demand-side inflation pressures. That’s fallen to 4.0% per annum. (We use 3-month annualized rates.) The fear is that this indicator is correct and the pace of inflation is settling down at twice the level of the target rate.

Another crucial demand-driven inflation signal is contained in rental inflation. Not only is housing a massive portion of the consumption bundle, because of the way rent contracts are structured, they contain an important signal of inflation expectations. The rental housing markets responds quickly, both to renters being flush and to fluctuations in expected inflation. Unfortunately, the shelter component of CPI and PCE lag far behind these fluctuations. Fortunately, we have an excellent replacement — Zillow’s rent index. This extremely important inflation series has collapsed to 0.0% per annum. This is excellent news.

But wither underlying inflation? And which may very well be the same thing: wither inflation expectations?

This is where our estimator comes in. We’ve argued before that, like landlords, the slowest moving price-setters must necessarily pay special attention to expected inflation: their pricing strategies reflect their expectations of the future path of inflation plus a markup if there is enough demand (they’re always greedy, of course). This signal is inversely proportional to the volatility of the specific inflation series. We can thus extract this signal by using inverse volatility weights.

This approach yields a robust estimate of the underlying rate of inflation. This measure peaked at 8.3% in March 2022. Since then, except for a blip in Feb 2023, it’s been falling steadily. The latest, for July, came in at 1.6% per annum; consistent with the Fed’s target. In fact, it has been below 2% per annum since May. According to our estimate then, we’re basically home.

We wager that the Fed will be satisfied very soon and call off the hiking cycle as our prediction is confirmed by the incoming data. Depending on how much tightening is already baked-in, it seems quite likely that the Fed will achieve a soft landing. To be sure, we expect the Fed to remain agnostic and wait for confirmation. But barring another major inflationary shock, there’s good reason to believe that this hiking cycle is over.