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By Joseph Purtell
The most recent U.S. inflation print is good news, but the Federal Reserve’s inflation fight is far from over.
As the U.S. endures its highest inflation in 40 years and digests 375 basis points of policy-rate increases since January, the question of how far and how long this monetary tightening cycle must continue remains open. At various points throughout the year, the expectation from markets has been an optimistic quick return to target inflation accompanied by a Fed policy pivot. While we subscribe to the view that peak inflation is likely behind us, we expect the path back to 2% inflation to be either longer or more economically costly than most appreciate. This will ultimately force the Fed to keep policy rates elevated for longer than the market is currently pricing. In making this case, we highlight two recent research papers:
First, the degree of demand imbalances in the economy is likely far larger than conventional measures would imply. While the current unemployment rate is near late 2019 levels (a period of low and stable inflation), Blanchard, Domash and Summers (2022)1 find that the labor market, when considering the level of job openings relative to the unemployed, is substantially tighter. They estimate that, in this so-called Beveridge Curve Space, the natural rate of unemployment the economy can support in equilibrium is much higher than the current unemployment rate. Moreover, they believe that the Fed’s intention to lower job vacancies without inducing large increases in unemployment is not feasible.
Second, Ball, Leigh and Mishra (2022)2 use similar labor market metrics coupled with long-term inflation expectations to project various paths of inflation. They find that in only the most optimistic model specifications does inflation return to near the Fed’s target over two years’ time without substantial weakening of the labor market, as the central bank’s latest Summary of Economic Projections anticipates. In contrast, less optimistic assumptions generate elevated inflation two years out even with large increases in the unemployment rate.
While a small subset of research within the large debate around inflation, these two papers represent themes we expect to continue into 2023: Cooling such a historically tight labor market is easier said than done, and inflation will not leave as quickly as it arrived. We find the market’s enthusiasm in pricing lower terminal rates and a quicker Fed pivot now that peak inflation appears behind us as reason for caution, and we expect that the Fed will hold rates higher for longer as it awaits a slow return of underlying inflation to target.
- Blanchard, Olivier, Alex Domash and Lawrence H. Summers, 2022, “Bad News for the Fed from the Beveridge Space,” Peterson Institute for International Economics Policy Brief 22 – 7.
- Ball, Laurence, Daniel Leigh and Prachi Mishra, 2022, “Understanding U.S. Inflation During the COVID Era,” NBER Working Paper, 30613.
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