Below are the inflation readings through the end of June, 2023. The blue line represents the year-over-year change in consumer prices while the red line represents the change in producer prices (commodities). One can see progress has been made on the inflationary front since the Fed began its tightening campaign in March of 2022 designed to bring down inflation.

While the progress on inflation has been highly constructive, the Fed has nonetheless maintained a hawkish tone in its inflation policy rhetoric in recent weeks. The reason for this hawkish tone can be found in a history lesson. Below is a chart of the CPI over the period 1970 to 1990. One can see in the decade of the 1970’s, after inflation dropped, it then resurged. A resurgence of inflation was caused by the Fed declaring victory on inflation and lowering rates too soon. It then had to clean up the mess with a massive rate increase managed by the gutsy then Fed Chairman Paul Volcker.

Below is a picture of the effective Fed Funds rate over the same period as represented in the inflation data above. One can see the Fed moved rates down rapidly as inflation came down, which then triggered a resurgence in inflation. The Fed has stated this time it will “stay higher for longer.” This is clearly an effort not to repeat the policy errors of the 1970’s with respect to inflation.

This week’s inflation data will tell us whether continued progress is being made. But don’t expect the Fed to change its hawkish stance until inflation has reached its 2.0% target. This is a high stakes game and an important time. So far, current Fed Chairman Jerome Powell is proving to be a student of history and is playing it correctly.

 

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