The first price index release of the year brings some less-than-welcome news: Inflation has ticked up once again. The Bureau of Labor Statistics (BLS) announced the Consumer Price Index (CPI) increased 0.3 percent in December. Core inflation, which excludes volatile food and energy prices, increased the same amount. Over the last year, headline inflation was 3.4 percent while core inflation was 3.9 percent.
Shelter accounted for the largest price hikes, “contributing over half of the monthly all items increase,” the BLS reported. This might be the silver lining. When a large fraction of the CPI increase is localized in one or a few categories, it indicates pricing pressures are not affecting the whole economy. Indeed, the monthly core CPI increase for December was the same as for November. We can take some consolation, then, that market- and industry-specific factors are so prominent. But not too much—shelter accounts for a large share of households’ budget expenditures, so the immediate welfare effects are still undesirable.
On a continuously compounded basis, headline and core inflation are 3.63 and 3.70 percent, respectively. Let’s use these figures to see whether Fed policy is loose or tight. The target range for the Fed’s key policy interest rate is 5.25 to 5.50 percent. If the nominal interest rate is adjusted for inflation using the latest headline rate, the real interest rate range is 1.62 to 1.87 percent. Using core inflation, the real interest rate range is 1.55 to 1.80 percent. This tells us, roughly, that short-term loans are yielding somewhere between one and a half to two percent in terms of purchasing power.
We need to compare the current real rate to the natural rate of interest. There exists a price for short-term capital that balances its quantity supplied against its quantity demanded. When this price prevails, the economy will invest as much as sustainably possible, and hence produce as much as sustainably possible. Unfortunately, we cannot directly observe the natural rate of interest. But we can estimate it. According to the New York Fed, it’s somewhere between 0.88 and 1.19 percent. Those estimates imply that market rates are somewhere between 30 and 112.5 (!) percentage points higher than the natural rate. That means the price of capital is significantly higher than the economic fundamentals would support, as best as we can tell. Monetary policy remains tight despite the increase in inflation.
The monetary aggregates support the hypothesis of restrictive policy. M2, the most commonly cited measure of the money supply, is nearly 3.0 percent lower today than it was a year ago. Its rate of growth has picked up slightly over the past two months, but not much. The Divisa monetary aggregates tell a similar story. These indexes weight the money supply components based on how liquid they are, giving us an even better picture. All of the measures have decreased year-over-year between 0.98 and 1.93 percent. While it is not abnormal for money growth to fall, it is highly unusual for it to turn negative. You would need to make extraordinary assumptions about money demand for this to look like anything other than tight money.
After a rough couple of rounds, inflation has come out swinging. It doesn’t have the legs for a knockout punch, but it remains a troublesome opponent. The Fed must not let up. Until we get several data releases across multiple sources confirming we’re back in the neighborhood of 2-percent inflation, monetary policymakers must keep their guard up.
