How the Fed Reserve should talk about inflation

Consumer prices actually fell last month, by 0.1%, compared with the month before, thanks mainly to lower energy costs. On a 12-month basis, inflation slowed from 7.1% in November to 6.5%. Core inflation, excluding food and energy, fell to 5.7%, the lowest in more than a year. Most notably, the prices of so-called core services, which the Fed is known to watch closely as a measure of underlying inflation, are also rising more slowly than before.

None of this should come as a great surprise. A sharp decline from earlier peaks in 12-month inflation rates was baked into the numbers because of the sudden acceleration of prices early last year, and there’s likely more to come. The question is whether, without further increases in interest rates, this trend would eventually push inflation all the way back down to the Fed’s target of 2%.

As things stand, that still looks unlikely. With unemployment at just 3.5% and employers struggling to fill vacancies, the labor market is still exceptionally tight. Wage inflation appears to be slowing but is still substantially higher than before the pandemic. Reconciling a red-hot labor market and strong consumer demand with 2% inflation would be quite a feat. It certainly isn’t to be counted on.

Granted, slowing inflation tightens monetary policy in its own right by raising real (inflation-adjusted) interest rates. The Fed will need to take this into account. Nonetheless, recent statements by Chair Jerome Powell and other officials affirming the need to raise the policy rate by at least another half point seem warranted. Growth in wages has to subside more convincingly before tightening can safely stop and go into reverse. The new data do support a slower pace of rate increases – many forecasters expect the next one to be 25 basis points, not 50 – but it’s still too soon to declare this battle won.

In the meantime, the Fed faces a communications dilemma. Despite the central bank’s messaging to the contrary, many investors still expect it to start lowering rates before the end of this year. Perhaps the Fed agrees, but if this became its declared intention, yields would likely subside, asset prices would rise, and financial conditions would ease – all serving to lessen the downward pressure on inflation more than the central bank might wish. Investors understand that the Fed therefore has an incentive to mislead them about its true intentions. Merely by promising to keep policy tight in the future, the Fed keeps policy tighter now – and improves the chances that it will indeed be able to relax sooner.

This paradox of “forward guidance” is all too familiar to central bankers, and not easily resolved. The more the central bank relies on seeming to make promises about the future, the more often it will find itself tempted to mislead. This, in turn, risks causing investors to pay less attention to its supposed commitments – including its most important commitment, which is to get inflation back on target.The best remedy is straightforward. The central bank should focus attention on current data and how its policymakers understand it, and less on how policy might change months from now. With conditions as disrupted and unfamiliar as they are today, that’s something neither the Fed nor those who pore over its every announcement can know.