For President Biden, there is some good news and bad news in today’s inflation numbers. The good news is that inflation is finally beginning to decline from its four-decade high, albeit very modestly. The bad news is that inflation still remains too high for the Federal Reserve to back off from its proposed course of aggressive monetary policy tightening to bring inflation back under control. This raises the real prospect that in the run-up to this November’s election we could have the economy experiencing the unfortunate combination of both inflation and recession. We could also still have the stock market on the back foot.
Today’s Labor Department numbers show that headline consumer inflation only moderated from 8.5 percent to 8.3 percent. This was the first such moderation in eight months but was less than the markets anticipated. More disappointing yet was the fact that excluding volatile food and energy prices, so-called core inflation remained as high as 6.2 percent, or around three times the Federal Reserve’s 2 percent inflation target.
Earlier this month at its policy meeting, the Fed adopted a decidedly more hawkish monetary policy stance to slay the inflation beast. It raised interest rates by 50 basis points rather than by the more normal 25 basis points and it indicated that it expected to raise interest rates again by 50 basis points at each of its next two policy meetings. At the same time, it announced that it planned to aggressively reduce the size of its balance sheet by $45 billion a month over the next three months and beginning in August by $95 billion a month. It proposed to do so by not rolling over its bond holdings at maturity
The shift in the Fed’s policy stance has caused the sharpest rise in long-term interest rates since 1994. The all-important 10-year Treasury bond rate has approximately doubled since the start of the year to around 3 percent. Meanwhile the 30-year mortgage rate has jumped from around 3 percent at the start of the year to 5 ½ percent at present.
The Fed’s plan to keep raising interest rates and draining large amounts of liquidity from the markets has sent the stock market into a tailspin. Since the start of the year, the S&P 500 has now lost around 16 percent in value while the NASDAQ has lost more than 25 percent. These large declines mean that since the start of the year as much as 33 percent of GDP in wealth has evaporated.
Even prior to the Fed’s anti-inflation measures, the economy was expected to slow significantly as consumers had to contend with high food and energy prices and as the government’s fiscal stimulus would begin to fade. Now with the Fed causing mortgage rates to spike and the stock market to swoon, there is every prospect that the economy will again succumb to recession by the end of the year.
As a result of higher mortgage rates, households can now afford to buy a home that has only around 75 percent of the value of a home that they could afford to buy at the start of the year. Meanwhile, according to the Fed’s economic model, if the loss of wealth as a result of the stock market’s decline is sustained, consumers could cut back spending by around 1 ¼ percent of GDP.
Today’s inflation numbers, which show that core inflation is still running at some three times the Fed’s 2 percent inflation target, do not give the Fed cover to back off from its aggressive policy stance. This would seem to be especially the case at a time that Russia’s war could result in further food and energy price increases at the same time that China’s zero-tolerance Covid policy could result in further damage to the global supply chain.
In the run up to the November elections, President Biden could with some justification blame Fed Chairman Jerome Powell for having got us into this stagflation mess by having been too slow to raise interest rates last year. However, this is unlikely to cut much ice with voters. After all, earlier this year Mr. Powell was renominated for a second term by Mr. Biden and Mr. Powell is not running in the mid-term elections.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.