On the longest day of the year, the U.S. House Committee on Financial Services welcomed Federal Reserve Chairman Jerome Powell to address its concerns around inflation and weakness in the U.S. economy. Powell warned Congress that the fight against inflation is far from over, that the battle will be a long, hard slog, and that the U.S. economy and labor markets will likely be negatively impacted before victory—price stability defined as two percent inflation—can be declared.
Powell commented that “inflation pressures continue to run high, and the process of getting inflation back down to two percent has a long way to go.” He also noted that “longer-term inflation expectations appear to remain well anchored,” meaning that businesses, households, and financial markets are behaving as if they believe inflation is here to stay. High inflationary expectations can be dangerous because they can become self-fulfilling prophecies. Market participants seek to outrun inflation by proactively raising prices (producers) or buying more and earlier than normal (producers and consumers) to avoid price hikes later. Both behaviors tend to be pro-inflationary.
Chairman Powell also confirmed that the Federal Reserve is almost certainly going to raise interest rates again this year. He noted, “nearly all FOMC [Federal Open Market Committee] participants expect that it will be appropriate to raise interest rates somewhat further by the end of the year.” By how much and when was left to the market’s imagination.
Powell’s comments came hard on the news of the most recent U.S. Consumer Price Index (CPI) data, which showed that while May’s headline CPI fell to 4.0 percent (from 4.9 percent in April), continuing the downward trend from June 2022’s peak of 9.1 percent, Core CPI (i.e., excluding food and energy) was up 5.3 percent. The still too high headline CPI result was driven by rising shelter (up 8 percent), food (up 6.7 percent), and transportation (up 10.2 percent) costs, offset by energy prices, with gas and fuel oils both down substantially (19.7 percent and 37 percent, respectively).
To make matters worse, the Personal Consumption Index (PCE), known as the Fed’s favorite metric for measuring inflation, actually increased in the latest period from 4.2 percent to 4.4 percent, while core CPE (excluding food and energy) increased from 4.6 percent to 4.7 percent.
Persistently high inflation matters because of inflation’s pernicious compounding effect. To illustrate the issue, consider that the difference between two and five percent inflation over ten years is approximately twenty percent. In other words, a dollar today will be worth only 64 cents in purchasing power under five percent inflation compared with (a still depreciated) 84 cents under two percent inflation. Neither is great, but higher inflation makes us poorer faster.
The markets reacted negatively to Powell’s comments on the likelihood of additional rate increases later this year. The fact that three of the four largest U.S. bank failures of all time occurred in the last three months is an indication that interest rates were raised too high too quickly. Further increases are likely to put additional pressure on a banking system already under strain. More bank failures may result, despite Powell’s comments that the “U.S. banking system is sound and resilient.” Additional interest rate increases will also pressure the economy and labor markets, as Chairman Powell himself acknowledged: “Reducing inflation is likely to require a period of below-trend growth and some softening of labor market conditions.”
The U.S. is not alone in struggling to slay the inflationary dragon. In the United Kingdom, the UK Consumer Prices Index (CPIH) increased by 7.9 percent in May 2023, up from 7.8 percent in April. Consequently, the Bank of England surprised the markets on June 22 with a bigger than expected 50 basis point increase in the central bank’s interest rate to 5 percent, the highest since 2008. European inflation remained both sticky and high at 6.1 percent for May, with analysts now expecting headline inflation of 5.4 percent for the full year 2023. This led to the European Central Bank’s decision in June to raise interest rates by an additional 25 basis points, bringing the headline borrowing rate to 4.25 percent.
In the U.S. the market is expecting that inflation will continue to slow, with estimates for June headline CPI of 3.2 percent. While near-term inflation appears to be trending down, there in risk of a reversal in the coming months. One possible driver of a reversion to high single digit inflation would be a strengthening of energy markets. The risk is in a surprise output reduction from the consortium of oil producing nations (OPEC+, which includes Saudi Arabia, Iran, Russia, Venezuela, and others) in a bid to tighten the global oil market and increase their profitability. Crude oil prices have fallen some thirty percent since the beginning of the year, to below $70 per barrel, a situation that is not likely to last. Saudi Arabia’s Prince Abdulaziz bin Salman recently warned that OPEC+ actions could tighten the market such that prices could rise to above $80 per barrel, and even $90 and $100, toward the end of the year. Chairman Powell’s prepared testimony gave no indication of this risk, but it is significant.
The U.S.’s best defense against such future energy driven inflation is to take steps to reestablish American energy independence and the strength of its domestic oil and gas industries. But so long as a strong domestic energy policy remains anathema to the Biden administration, the U.S. will continue to be at the mercy of adversarial nations, and of persistently high inflation.
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