By Jonathan Levin
US inflation has finally surprised markets in a positive way and traders are understandably excited that the worst of the upward price pressures may finally be behind us. However, the real turn to better days will come when inflation ceases to be generally shocking – positively or negatively – and can recede into the background again.
The U.S. consumer price index rose 8.5 percent in July from a year earlier, the Labor Department said Wednesday, less than the median estimate of 8.7 percent in a Bloomberg survey.
Of the 46 forecasts, only two achieved the percentage (Credit Suisse and High Frequency Economics). The consensus has now scored hits in just four of the previous 17 CPI forecasts, with Wall Street economists underestimating inflation 12 times over that period. Even if the outlook appears to be improving, the US Federal Reserve and financial markets are still flying roughly blind, meaning the potential for monetary policy mistakes remains high.
Inflation is not inherently bad because it is high, but because it has been unpredictable, although prolonged high inflation would indeed be harmful. If everyone knew that prices would rise by, say, 6%, businesses could adjust wages and consumer prices accordingly, and most people would be more or less okay.
It is unexpected inflation that makes it difficult for businesses and households to make prudent investment decisions, making real earnings volatile and hampering the economy. Windfall deflation is certainly better than the opposite alternative at this juncture, but it wouldn’t be great either. Predictability is the best option.
The fact that the figures are still surprising – albeit on the downside – means that economists still don’t have a firm grasp of what’s going on. How fast will inflation fall from here? Will it settle to a level acceptable to the Fed? Or will it be stuck around 4% amid strong upward wage pressures?
Without much visibility even for next month’s inflation report, it’s hard to answer these questions with certainty, meaning Fed Chairman Jerome Powell will still struggle to adjust the “needle” of a monetary policy that it does enough to crush inflation without causing a recession at the same time.
Last summer, economists seemed to have the situation pretty well diagnosed, with one completely accurate forecast and a few near misses that indicated inflationary pressures appeared to be subsiding. Then inflation accelerated and almost no one saw it coming.
Again around the transition from 2021 to 2022, there was a string of successful forecasts as many experts saw peak inflation on the horizon. Once again, the idea that economists had inflation figured out disappeared in the months that followed as big misses became common again. Until now, the bias has been consistently towards underestimating the problem. The last time Wall Street economists overestimated inflation was for the February 10, 2021 report.
The problem is multifaceted and requires a lot of introspection. Despite all the research and real-time data available, there are still many blind spots and many models are still based on past trends and statistical relationships. This can make them prone to underwriting in a changing economy, especially at key inflection points.
Furthermore, the inflation of 2021 and 2022 was partly driven by the Covid-19 pandemic and the war in Ukraine, and one cannot really blame economists for the inadequacies of epidemiologists and geopolitical analysts. What is less forgivable was the initial reluctance of economists to see that many of these developments were not simply “special factors” that would soon disappear on their own, thus failing to recognize soon enough that inflation was spreading and becoming embedded in the economy.
Undoubtedly, Wednesday’s US report had plenty of positives beyond its pro-fall energy price implications: underlying price pressures in both core goods and services eased in July, and there are reasons to expect more may be coming good news.
Fewer small businesses are reporting plans to raise prices, and manufacturing is paying lower prices for its material inputs. On the other hand, wages remain well above the level that would be consistent with the Fed’s long-term inflation targets. And the big question remains: is this the end of inflationary fear altogether, or is it just the peak of a single wave in a longer and harder-to-beat inflationary regime like the period from the late 1960s to the early 1980s , which was characterized by large fluctuations and cycles of inflationary crises?
It’s hard to say with much certainty given that experts are so consistently off target, including the Fed itself. Policymakers risk doing too little and allowing inflation to run wild, or doing too much and causing an unnecessary recession.
This lingering uncertainty makes it difficult for the Fed to adjust interest rates precisely enough to cool the economy without tipping it into recession. A soft landing for the economy certainly looks more likely today than it did yesterday, but it would be much more likely if businesses and policymakers had some visibility into the foggy runway.