Raphael Bostic - President and Chief Executive OfficerBy Raphael Bostic, President and Chief Executive Officer

June 27, 2024

Since my last essay in March, the economy and labor markets have continued to expand in healthy fashion. But the outlook concerning the most pressing issue of the day—inflation—has taken a subtle turn.

First, let me offer a quick recap.

During 2023, the inflation rate fell by more than half—from well above 5 percent to below 3 percent, per the personal consumption expenditures (PCE) price index, the Federal Open Market Committee's (FOMC) preferred gauge. That was a much steeper decline than my staff and I and most observers expected.

However, that progress slowed considerably early this year, with some suggesting that the decline may have stalled out entirely.

Well, the most recent inflation reports offer signals that push against the "stalling out" narrative. The April reports for the consumer and PCE price indexes presented a picture of inflation that was more consistent with the data received in the second half of 2023 than what we saw in the first months of 2024. In April, the headline year-over-year PCE reading of 2.7 percent was the same as the November 2023 reading.

Though the April PCE inflation reading was unchanged from five months earlier, mining the details of the inflation reports reveals a few promising signals. One I pay close attention to is the breadth of price changes—specifically, the percentage of individual goods and services prices in the consumer price index that rose more than 5 percent. That portion came in at 18 percent in May, and the three-month average has dipped to 35 percent, a level not seen since the summer of 2023, when overall inflation was steeply declining.

Still, that 35 percent figure is higher than a level that is consistent with price stability. But the salient point is that it's moving in the right direction. Consider that two years ago, in May 2022, 70 percent of prices rose by 5 percent or more. So, price pressures appear to be narrowing.

Progress will continue, but patience is in order

Despite those hopeful recent glimmers, the stubbornness of inflation early this year indicates that progress toward the FOMC's 2 percent objective will likely come more slowly than I and others had previously hoped. That said, I have long maintained that the path to 2 percent would take considerable time; it just might take a little longer than one might have expected given how fast inflation was falling as we exited 2023.

If conditions unfold as I expect—orderly slowing in the labor market and in economic activity—then inflation should fall all the way to 2 percent in 2025 or perhaps a bit later.

Even as 2 percent is the unquestioned target, it is important to note that inflation need not get all the way to target for me to favor reducing restrictiveness in monetary policy. If the Committee waits that long, it risks sapping too much momentum from the economy and labor market and creating unnecessary and harsh disruptions.

Rather than holding the federal funds rate steady until we are at the target, I would favor reducing the policy rate once I gain additional confidence that we are clearly on the path to the 2 percent objective.

What would provide that confidence? I am looking in particular for progress in shelter prices and services prices more broadly. Prices of services—air fares, restaurant meals, hotel rooms, haircuts, oil changes—tend to move far less quickly than goods prices because the largest cost input into services prices is usually labor, and wages do not tend to move as quickly as prices of raw materials do. But of late, contacts in service industries are telling my staff and me that their pricing power is eroding a bit, meaning they are finding it harder to raise prices without scaring off customers.

Housing prices and rents, meanwhile, have decreased more slowly than most anticipated in the midst of the Committee's moves to take the federal funds rate from effectively zero to above 5 percent over 16 months. My research team tells me declines in market rents will eventually show up in the official price data, but that development has been slow in coming.

Like many economic dynamics in the wake of the pandemic, shelter prices have behaved differently in this inflationary episode than history suggests they would. Economists at our Bank and elsewhere are working to untangle the reasons why.

I will also be looking beyond the headline numbers. On inflation, I'd like to see a narrowing of the breadth of price changes that I mentioned above. To use a labor market example, we will be tracking the extent to which strong top-line employment growth numbers continue to be a function of strength in a small number of sectors—healthcare and government, in particular—or represent strength across a broader set of sectors that suggests a slowdown might not be forthcoming. Overall, as a general matter, I want to make sure we achieve a price stability that will persist beyond an initial attainment of a 2-percent numerical headline.

Pandemic still a major economic influence

One reason I will be looking beyond the headlines is that it is clear to me that, despite a return to normalcy in many areas of our lives, today's economy is still heavily influenced by the global pandemic. I think the effects of policy responses to the pandemic bolstered the labor market and broader economy even in the face of aggressive monetary policy tightening.

Monetary policy affects economic sectors most sensitive to interest rates first, as one would expect. Prominent among those sectors is housing. And mortgage banking executives tell me they have essentially been in recession for a year because prevailing mortgage rates quickly doubled or tripled to levels above 7 percent.

Yet across the economy, activity has soldiered on despite higher interest rates. For many months during lockdowns, most of us were limited in what we could spend money on. Financial supports also left many households in a stronger financial position than they had been in entering the pandemic.

All the while, in the years immediately before the pandemic, interest rates had been low by historical standards. As a result, many consumers and firms locked in low rates on longer-term credit, and then more did so when the Fed slashed rates early in the pandemic lockdowns to support economic activity. Those dynamics, in my view, have softened the impact of higher interest rates.

Other changes could also be shifting how restrictive policy affects the economy. Looking ahead, business contacts tell my staff and me that a major emerging category of capital spending is software as a service. Essentially, instead of buying software packages, firms pay an ongoing monthly or annual fee to use apps housed in the cloud. This kind of transaction typically does not entail borrowing, and so is likely to be undeterred by higher interest rates.

The upshot of these and other factors is that it might well be taking longer for tighter policy to drive business decisions in a material way.

But we see signs of it starting to happen. Gross domestic product (GDP) growth in the first quarter slowed to just above 1 percent after topping 3 percent in the third and fourth quarters of 2023. And, though the 272,000 new jobs in May was an upside surprise, reports I'm hearing from Sixth District business contacts give me confidence that slowing is occurring in labor markets as well. Hiring is easier, turnover is down, and broader measures of the labor market, such as the Kansas City Fed's Labor Market Conditions Indicators, report that market activity has fallen significantly since the beginning of the year. One might think of labor markets today as "loosening but not loose."

On balance, I believe the most recent GDP and employment numbers describe an orderly deceleration in activity that will restore balance between demand and supply in the economy. That realignment should, in turn, put downward pressure on prices. After all, excess demand above supply sparked the inflation surge starting in 2021.

It's really Econ 101: the meshing of the demand for a good or service and its supply determines the price. That holds not only for cars or carpenters but also for the economy writ large.

Taking all the circumstances into account, I continue to believe conditions will likely call for a cut in the federal funds rate in the fourth quarter of this year. Still, the pandemic years have brought many surprises, and so I'm not locked in to any particular policy path. There are plausible scenarios in which more cuts, no cuts, or even a raise could be appropriate. I will let the data and conditions on the ground be my guide.

Be assured, we will bring inflation to 2 percent. That is the Committee's definition of price stability, a condition necessary for broad prosperity, sound decision-making for families and firms, and an economy that works for everyone.

When we get inflation to 2 percent, that does not mean prices across the board will be lower than they were before 2021. What it does mean is that we should have an economy in which inflation no longer dominates the psychology of consumers and producers, and that is the state the Committee and I aim to achieve.