Moderate inflation returns in July

By Alexander William Salter

After a slight deflation in June, prices rose again in July. The Bureau of Labor Statistics reported that the consumer price index (CPI) rose 0.2 percent last month, for a year-over-year increase of 2.9 percent. Core The CPI, which excludes volatile food and energy prices, also rose 0.2 percent on the month and rose 3.2 percent year-on-year.

The annual rate of monthly inflation was 1.9 percent in July. The annualized monthly core inflation rate was 2.0 percent. Taken together, inflation appears to be in line with the Federal Reserve’s official 2% target.

Shelter prices saw the biggest increase. They rose 0.4% for the month, “accounting for nearly 90% of the monthly increase in the all-items index.” However, the expected increase in the shelter component of the CPI likely reflects price pressure from a year or more ago. That Treh Manhertz at Zillow shows“annualised changes in housing CPI may remain high long after rent price growth cools”.

Using the latest inflation data, we can determine the stance of monetary policy. The Fed’s target range for its main policy rate is 5.25-5.50%. If market participants expect inflation of 1.9 percent, in line with July’s headline inflation rate, the implied target range for the real interest rate is 3.35 to 3.6 percent. If inflation is expected to be 2.0 percent, in line with July’s core inflation rate, it is 3.45 to 3.7.

Is the Fed’s interest rate target too high, too low or just right? We need to compare our estimates of the implied target range of the real interest rate with the natural rate of interest, which is the price of capital that balances supply and demand in short-term capital markets. We cannot observe this rate directly; the best we can do is estimate it. The New York Fed’s latest estimates put it somewhere between 0.70 and 1.18 percent. Therefore, the Fed’s interest rate target range appears to be much higher than natural rates. Unless estimates are completely divorced from reality, interest rates suggest that money is pretty tight.

We also need to consider monetary data. The M2 money supply, which is the most frequently cited monetary aggregate, has grown by 0.87 percent over the past year. It grew at an average annual rate of 5.4% in the five-year period just before the pandemic. The Divisia aggregates, which weight the components of the money supply based on their relative liquidity, rose more. The M3 division grew by 1.30% in the past year, compared to an average of 4.5% in the five years before the pandemic. The M4 division (including Treasury) grew by 2.10%, compared to 4.7% in the previous period. Therefore, both the simple sum monetary aggregates and the Divisia monetary aggregates are growing at historically low rates.

To judge whether monetary policy is loose, it is not enough to show that monetary aggregates are growing at historically low rates. What matters is whether the money supply is growing faster than the demand for money. As with the natural rate of interest, we do not directly observe the demand for money. However, we can create a proxy for money demand by adding real GDP growth (3.1 percent) and population growth (0.5 percent). This indicator suggests that the demand for money is plausibly growing at about 3.5 – 4.0 percent per year, which is much faster than all of the above money supply figures. Therefore, monetary data says that money is also tight.

The Federal Open Market Committee (FOMC) will meet in September. It should seriously consider reducing the interest rate target. Although inflation was higher in July than in June, it was still in line with the Fed’s target – and probably below target once lagged housing prices are taken into account. However, while inflation has declined over the past year, monetary policy has been passively tightening: the Fed’s fixed nominal interest rate target over this period corresponds to an implicit real interest rate increase target. If monetary policy remains tight, it could lead to a significant economic contraction. To avoid a recession, the Fed should admit that it has finally (albeit belatedly) accelerated inflation and bring monetary policy back in line with economic fundamentals.

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Editor’s note: The abstracts for this article were chosen by the editors of Seeking Alpha.