Inflation is becoming a real problem for consumers, investors and policymakers, and the surge in oil prices is only part of the equation the Federal Reserve must consider for future rate policy.
The odds are overwhelmingly in favor of policymakers keeping the benchmark interest rate at the target range of 3.50% to 3.75% at the conclusion of the June 16-17 policy meeting.
But several officials, including voting members of the Federal Open Market Committee like the Cleveland Fed's Beth Hammack and Dallas Fed's Lorie Logan, as well as Kansas City Fed's Jeff Schmid, have warned the central bank may have to raise interest rates to get inflation back to its 2% target.
The question facing Fed officials is whether the current drivers of inflation -- such as higher oil costs, effects of higher tariffs on goods prices, and rising demand for materials linked to the buildout of artificial intelligence -- will lead to entrenched price growth that requires intervention to fix. Evidence is mounting that there are broad-based pressures that can't be ignored.
It is now widely believed that Fed policymakers waited too long to raise rates to combat the surge in inflation in 2021 and 2022. When the Federal Reserve initiated its rate-hiking cycle in March 2022, the consumer price index measured 7.9% for the 12 months ended in February.
Today the U.S. may already be well on its way to another bout of higher inflation. The annual inflation rate is expected to hit 4.3% in May, according to economists surveyed by FactSet. That's up from the 3.8% year over year pace in April. The Bureau of Labor Statistics is set to publish the May data on June 10.
Much of the recent headline inflation has been driven by higher energy costs in the wake of the Iran war. Fed officials would typically look through this oil shock because, presumably, when the latest conflict in the Middle East subsides, the inflationary surge will abate as well.
But the latest pressure from higher oil prices comes at a point when inflation has already been running above the Fed's 2% target for more than five years. Moreover, oil prices are unlikely to drop quickly, with many energy analysts and executives noting that not only has the conflict blocked transport through the Strait of Hormuz, oil wells and production facilities throughout the region have been damaged and will need time and resources to get back online.
In the interim, there's evidence that the effects of higher fuel costs are broadening beyond energy costs. April's producer price index, for example, showed that perishable food prices were already bearing the brunt of higher transportation costs. Wholesale prices for fresh fruit were up 4.3% month over month, while fresh vegetable prices were up 5.7% on the month. The May PPI data will be released on June 11.
Beyond the oil shock, there are other inflationary pressures at play. Higher tariffs, for example, have also weighed on inflation in recent months, particularly for goods prices. Oxford Economics estimates that tariff pass-through to consumer prices added more than 0.5 percentage points to inflation. But the effects vary dramatically sector to sector and some industries are still processing the changes -- and reacting to new levies.
The new Section 301 tariffs are expected to lift the average tariff rate to 9.7% from roughly 9.3%, Oxford estimates. That will likely only have a small effect on inflation throughout the remainder of the year.
Yet it's unlikely that goods inflation will slow anytime soon. In recent months, wholesale costs for a variety of inputs, including metals like steel, aluminum and copper, and industrial chemicals have been on the rise.
The Institute for Supply Management's Purchasing Managers' Index for both manufacturing and services showed input costs continued to rise in May. Among manufacturers, 16 of 18 industries surveyed reported paying higher prices in May, while none reported getting a break on costs.
Additionally, the buildout of AI technology is playing a role in price growth. Demand for semiconductor chips used for memory storage is now so high that it's causing shortages and price spikes -- and that is affecting producer costs. Wholesale electronics component prices have risen sharply as a result in recent months.
The fact that some of the long-term inflation expectations have remained well-anchored, as Fed officials like to tout, shouldn't be a comfort at this point. When the Fed was forced to hike rates in March 2022, the New York Fed's long-term inflation expectations were still only at 3% over a five-year time horizon. They were registering the same 3% rate in April.
In fact, research published and presented by experts at the Brookings Institution on Tuesday contended that one of the key lessons from former Chair Jerome Powell's leadership of the Fed is that inflation is harmful, even if inflation expectations do not become unanchored.
"Policymakers should focus less on inflation expectations and more on the inflation itself, and so be more willing to respond," researchers noted.
As the U.S. learned in 2021 and 2022, there are financial and even political consequences when policymakers fail to act in response to inflation. Some are already beating the drum, so to speak.
"These forces that create higher prices are something that we're going to have to react to as policymakers," Schmid said Thursday, adding that he views inflation as an "economic thief."
But until the entire rate-setting committee is convinced, the Fed will continue to wait, or perhaps make minor tweaks to interest rates, in hopes that they will not have to inflict a more damaging cure for inflation that results in job losses, or worse, a recession.
Comments