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It’s time to stop believing in immaculate disinflation

August’s inflation numbers shattered that faith and suggest the Fed will now have to pay the price for waiting too long.

The Federal Reserve Board Building in Washington, D.C. The Federal Open Market Committee is set to hold its two-day meeting on interest rates starting on Sept. 20.Kevin Dietsch/Getty

It’s been more than nine months since Federal Reserve Chairman Jerome Powell suggested it was time to retire the word “transitory” with respect to inflation. Yet, until last week, financial investors clung to their faith that inflation could be tamed without the tough medicine of further economy-cooling interest rate hikes from the Fed. August’s inflation numbers shattered that faith and suggest the Fed will now have to pay the price for waiting too long.

The latest Consumer Price Index report made for sobering reading. Though the overall index rose by a modest 0.1 percent over the previous month — weighed down in part by a 10.6 percent decline in the cost of gas — the less volatile components of CPI, such as rent and services showed an inflation problem that is increasingly broad and entrenched.


Throughout 2021, economists and pundits who claimed that inflation was transitory and would subside on its own liked to point to alternative core measures that suggested that though headline numbers were eye-popping, the underlying inflationary pressure in the economy was still modest.

However, the most commonly cited measures of underlying inflation — core CPI, the Atlanta Fed’s “sticky” CPI, and the Cleveland Fed’s trimmed-mean and weighted-median CPI — now point to inflation rising at a more rapid pace in August than over the past three, six, and 12 months. Indeed, the average of these measures suggests that core inflation rose at an annual pace of 7.9 percent in August, well above its year-to-date average of 7 percent. Median CPI, which measures inflation for the typical product, rose at an annual pace of 9.2 percent, well above the headline number.

A few months ago, when higher energy prices were pushing up overall inflation, still-adamant defenders of the transitory hypothesis suggested that temporarily higher energy costs were likely passing through to other prices (for example, airfares). But if higher energy costs were temporarily inflating other prices a couple months ago, then by the same logic lower energy costs since June were temporarily deflating other prices last month. This would suggest that underlying inflationary pressure in August was actually higher, not lower, than implied by the official measures.


Part of the problem is that after 18 months of high inflation, people now expect higher inflation. Surveys show that while consumers’ expectations of inflation over the next year have eased since June, they are still more than double what they were on the eve of the pandemic. My own research indicates that once consumers do start paying attention to inflation, they quickly incorporate it into their daily decision-making, which means expectations of higher inflation can become self-fulfilling.

It seems the last to wake up to the inflation reality were financial markets, perhaps lulled by the Fed’s own sluggishness. As recently as a month ago, investors were betting that the Fed’s interest rate target would max out this December at 3.5 to 4 percent, with the Fed then proceeding to cut rates in the first half of 2023. After last week’s CPI report, markets are now expecting additional rate hikes to take their target interest rate above 4 percent, with scant possibility of easing in early 2023. That realization prompted the S&P 500 to tumble 6 percent by the end of the week, with last Wednesday marking the steepest daily decline since June 2020.


On one hand, this isn’t surprising — my analysis finds that unlike consumers, so-called experts were terrible at predicting inflation during the 1960s and 1970s, as well as the disinflation of the 1980s under former Fed chair Paul Volcker. Unfortunately, wishful thinking that the economy will autonomously disinflate without a sustained period of much higher interest rates make the Fed’s job harder — financial conditions actually eased throughout most of August as credit markets anticipated immaculate disinflation and a swift return to monetary easing.

Just over a month ago, markets were expecting the Fed to hike rates by 50 basis points at its meeting this week. Now, the question is whether it’ll hike by 75 or 100 basis points. My own view is that the Fed’s aversion to surprises will lead it to hike by 75 basis points, though there is a strong case for 100 basis points when inflation expectations are at 5 percent and underlying inflation is at 8 percent.

If the Fed does hike by 75 basis points this week, it will be all the more important that it speak forthrightly, as Powell did at the annual Jackson Hole Symposium in August, about the scale of the inflation challenge and the Fed’s willingness to endure interest rates higher for longer than markets expected just last week. It’s a long way from 8 percent inflation to 2 percent inflation, and barring some miraculous surge in supply, an economy doesn’t get there without a decline in demand. Premature celebrations only make the Fed’s task harder.


Tyler Goodspeed is a fellow at the Hoover Institution at Stanford University and US director at Greenmantle LLC. He served as acting chairman of the White House Council of Economic Advisers, 2020-21.