Inflation Won’t Hit the Fed’s Target in 2025. Interest Rates Will Drop Anyway.

Article originally posted on HERE on November 26, 2024

there’s little chance that U.S. inflation will descend to the Federal Reserve’s 2% annual target in 2025, but that isn’t likely to knock the central bank from its current interest-rate-cutting trajectory.

Inflation—the Fed’s primary bugbear for most of the past four years—has come a long way. The year-over-year increase in the personal-consumption expenditures price index, which is policymakers’ preferred inflation gauge, peaked at above 7% in June 2022. That was not long after officials began to increase interest rates from near zero, after dropping them rapidly early in the Covid-19 economic freeze.

Things improved rapidly at first: A year later, in June 2023, the annual rise in the PCE price index was down to just 3.3%. The federal-funds rate hit its highest level in two decades a month later, at a target range of 5.25% to 5.5%.

Inflation has come in waves since then, slowing further in late 2023 before picking up again early this year. After more disinflation over the summer, late 2024 brought another stalling in progress. The core PCE price index, which excludes volatile food and energy components, has been stuck around 2.7% for the past six months.

“I expect inflation to continue to come down toward our 2% objective, albeit on a sometimes bumpy path,” said Fed Chair Jerome Powell on Nov. 14.

What explains policymakers’ willingness to seemingly declare “mission accomplished” on inflation while it’s still notably above their target? That requires looking beneath the surface of the inflation indexes.

For starters, 2% headline inflation doesn’t mean that all prices across the entire economy are increasing at 2% all at once. The consumer price index’s basket includes some 80,000 items, with many of their prices rising faster than 2% and many slower.

You can think of three broad price categories in the inflation indexes: goods, housing, and nonhousing services. During the peak of the postpandemic inflation spike in 2022, all three experienced rapid price increases. Goods were hit with supply-chain disruptions and the stay-at-home online-shopping binge. Rents and home prices surged in many areas as Americans reconsidered their needs in a work-from-home era. And services prices, which are closely tied to wages, jumped during a period of labor shortages.

Today, goods inflation has been tamed, while services inflation is easing alongside a cooling labor market. It’s housing-price inflation that remains problematic.

The category includes rents paid to landlords plus so-called owners’ equivalent rent, essentially the estimated cost that it would take owners to rent their homes. It can also include utilities prices. Housing makes up roughly a third of the CPI and about a 16% weight in the PCE price index.

Housing and utilities costs in the PCE price index were up 5% from a year earlier in September, versus a peak above 8% in mid 2022. Meanwhile, prices of nonhousing services were up 3.3% year over year in September and goods were down 1.2%.

Housing, by definition, is a slow-moving category the Fed can’t do much to speed up with its primary policy tool of changing interest rates. Rental leases tend to renew only once a year, while home sales are less frequent. Central bankers can’t go out and build more homes to boost housing supply, nor can they get people to renew their leases sooner.

Instead, Fed officials are focusing on only new rental leases—rather than existing leases—and how they compare to the prior month. And the progress there is more encouraging, even if it will take significantly longer to flow through to the inflation indexes.

“Shelter inflation is high because rents for existing tenants are still catching up to the past surge,” said Federal Reserve Bank of Boston President Susan Collins on Nov. 20. “While this catch-up process may continue to be slow and uneven, it does not raise concerns for me about the durability of inflation’s trajectory back to 2%—as long as new tenant rent inflation remains subdued and overall inflation expectations stay well-anchored.”

A recent study by researchers at the Cleveland Fed found there’s plenty of catching up left to do. Their model calculates that rent inflation won’t fall below its pre-2020 average of 3.5% annually until around the middle of 2026.

That’s all before any new growth policies of the new Congress and administration take effect. Such moves could lift goods inflation via tariffs, services inflation via labor shortages, and overall demand via tax cuts.

The October PCE price index will be published on Wednesday, and economists’ consensus is calling for a 0.2% increase in the headline index and 0.3% in the core during the month, both matching September’s pace. That would bring the headline and core year-over-year rates to 2.3% and 2.8%, respectively.

“Two consecutive 0.3% [month over month] prints will certainly lead Fed participants to reassess their inflation and policy outlook,” wrote BofA Securities economists. “That said, we still expect the Fed to cut rates by 25 basis points in December, but the risk appears to be tilting toward a shallower cutting cycle, given resilient activity and stubborn inflation.”

None of this will matter for the Fed’s Dec. 17-18 meeting. There are just two additional data points coming between now and then: the November jobs report on Dec. 6 and the November CPI on Dec. 11. A hotter-than-expected inflation report could nudge the FOMC to support a pause in rate cuts at the meeting, while another dud of a jobs report may make the case for continuing to lower rates. Futures market pricing on Thursday had the odds as close to a coin flip.

Officials are confident that the current level of rates is restrictive, and they want to get closer to neutral before damaging the economy. They’re willing to look past slightly above-target inflation readings as long as they’re confined to housing prices and there continues to be progress in new rent inflation.

Faced with the perhaps uncomfortable choice of living with above-target inflation for an extended period or needing to slow the economy more drastically to achieve their inflation goal, Fed officials seem to have accepted the fact that they won’t get to 2% in 2025.