Near the end of the business cycle the most important factor to consider is whether inflation is getting out of control. The Fed’s goal is to have 2% year over year core PCE. The Fed likes to raise rates ahead of the goal being reached because once inflation accelerates, it’s not an easy force to stop. Raising rates only after inflation hits 2% would be a huge policy mistake. However, raising rates excessively before inflation accelerates could slow the economy into a recession. The great news about inflation is that the Fed knows it can fight it through hawkish monetary policy. The out of hand inflation in the 1970s and early 1980s was partially caused by the fact that the Fed thought it couldn’t fight inflation. That’s like a firefighter not realizing he can put out a house fire with a hose.
The Fed’s goal is to focus on limiting inflation while allowing for economic growth to flourish. Out of control elevated inflation causes the Fed to get especially hawkish, ending all hope of a continued expansion. With the Fed nearing hawkish policy in mid-2018, some believe the Fed has gone too far with rate hikes. This has been the lowest decade of inflation since the 1930s, with annual inflation averaging 1.7%, but the Fed has been getting more aggressive as it has hiked rates 5 times in the past 18 months because it fears inflation won’t be able to be stopped if it accelerates. Plus, it doesn’t like the idea of facing a recession with the Fed funds rate near the zero bound. The higher the Fed funds rate going into a recession, the more tools the Fed has at its disposal to shorten the down cycle.
The May CPI Report
This sets the table for why the May CPI report is very important. The ultimate judge of inflation is the core PCE in the eyes of the Fed, but as you can see in the chart made by @takis2910 on Twitter, core CPI and core PCE are highly correlated.
Source:Â chart made by @takis2910
The latest CPI reading gives us a good idea of how the PCE report will look on June 29th. All the headline data met estimates as the month over month CPI was up 0.2% and the month over month core CPI was up 0.2%. The year over year CPI was up 2.8% and the year over year core CPI was up 2.2%. There was a slight uplift in the data as year over year CPI was up 2.5% last month and core CPI was up 2.1% last month.
