How distant is the Fed from its inflation objective?

Federal Reserve Chairman, Jerome Powell, has signalled that although the disinflation process has begun, inflation is still high (see Chart 1a) and interest rates must rise further to return it to the 2% target. Powell has highlighted differences between the main groups within the core PCE deflator: housing, other services ex-housing, and core goods, i.e. excluding energy and food (see Chart 1b).

Chart 1a. PCE deflators (year-on-year)

Chart 1b. Core PCE components (year-on-year)

Source: Refinitiv and EFGAM calculations.

He has noted that the recent decline in annual core PCE inflation was almost entirely due to goods prices. In contrast, housing PCE grew strongly but Powell expressed confidence that the decline in new rents and house prices seen in recent months will soon be reflected in the PCE deflator. Overall, the Fed considers that monetary policy has achieved its intended effect on these two spending items.

Conversely, the Fed sees little progress in the rate of change of prices of services ex-housing, which represents almost 60% of the core PCE and includes healthcare, transportation, and leisure services. According to Powell, prices in these areas show no signs of moderation and, therefore, call for tighter monetary policy.

Powell also stressed the risks stemming from high wage inflation. Labour is the main productive input in services and rising wages are likely to encourage firms to raise prices, keeping overall inflation high.

However, the latest data are more encouraging than the Fed's comments suggest. Charts 2a and b show the six-month annualised changes in the main components of the PCE deflator. Chart 2a shows that after peaking at 6% in late 2021, core inflation fell below 4% in 2022H2.

Chart 2a. PCE deflators (6-month annualised)

Chart 2b. Core PCE components (6-month annualised)

Source: Refinitiv and EFGAM calculations.

Furthermore, the core PCE deflator ex-housing only rose at an annualised pace of around 2.5% in the second half of 2022, not far from the Fed's 2% target. The slowdown of housing prices from the 9% pace reached in December is expected to start no later than 2023Q2. This could cause the core PCE deflator to decline on a monthly basis and push the annual inflation rate below 2%.

Goods prices are exerting a deflationary effect again, as they did before Covid. Chart 2b shows the anomaly in the period between mid-2020 and mid-2022 related to the surge in goods demand and the disruption of global supply chains seems to have ended.

Finally, Chart 2b shows that prices of services ex-housing have also moderated. After peaking near 6% in mid-2021, price increases fell to 3.8% in 2022H2. If this trend continues, the increase in the prices of services ex-housing will converge towards its pre-Covid trend rate, pushing overall inflation close to 2%.

It is also notable that in 2022H2 the prices of services ex-housing fell faster than average hourly earnings (see Charts 3a and b). Historically, the correlation between hourly wages and the prices of services ex-housing is unstable and, if anything, it seems to have weakened after 2015.

Chart 3a. Wages and services (year-on-year)

Chart 3b. Wages and services (6-month annualised)

Source: Refinitiv and EFGAM calculations.

In conclusion, Chairman Powell's latest statements indicate that the Fed links the need for tighter monetary policy to the prices of services ex-housing and it is therefore encouraging that the latest data show they are slowing. To confirm that the peak in US interest rates is drawing closer, it is crucial that this moderation continues in the upcoming data, starting with the January CPI released on 14 February.