August 26, 2022

There are many different measures of inflation, but the one that the Federal Reserve considers to be most important is the personal consumption expenditures deflator, in particular the PCE deflator excluding the volatile food and energy components.

The PCE deflator fell 0.1% in July after having jumped 1.0% in June.  The year-over-year increase now stands at 6.3%.

Excluding the volatile food and energy components the PCE deflator rose 0.1% in July after climbing 0.6% in June.  The year-over-year increase is now 4.6%.  This is the inflation measure that the Fed would like to see rise by 2.0%.   For the longest time the Fed believed the run-up in inflation was temporary, but it has now changed its mind and is prepared to aggressively raise interest rates in 2022 to slow down the rate of increase in inflation.  We believe inflation will stay elevated for some time to come.

The  purchases of Treasury securities by the Fed in 2020 and 2021 caused money supply growth to surge.  We all learned back in our basic economic classes that money growth is the cause of inflation.  However, the length of time between a pickup in money growth and an increase in inflation is both long and variable.  Thus, the recent increase in  money growth has caused the inflation rate to climb well above the Fed’s 2.0% target for a protracted period of time.  Money growth has slowed in recent months and its Its current year-over-year growth rate of 5.3% is slightly slower than the 6.0% pace it had risen on average in the past decade.  That problem is that the earlier rapid growth pushed the level of M-2 far higher than its trend path would suggest.  At the moment that difference is $3.6 trillion which represents surplus liquidity slopping around in the economy.  Slow growth in the money supply will eliminate some of that surplus liquidity over time, but it currently seems likely to remain about $0.5 trillion above its trend path by the end of next year.  That will make it difficult for inflation to subside any time soon.

The core PCE deflator rose 4.9% in 2021 and we expect it to climb 4.5% in 2022. As a result, we expect the Fed to boost the funds rate from 2.3% currently to which would raise the funds rate to 3.5% by yearend. The Fed believes its policy is neutral when the funds rate is 2.5%.  However, if the core PCE deflator rises 4.5% for the year, the inflation-adjusted or real funds rate would be negative by 1.0% at the end of this year.  Thus, policy will still be accommodative at the end of this year which will do little to slow the pace of economic activity and reduce the inflation rate.

After declining in the first two quarters of this year we expect 2,9% GDP growth in the second half which would produce 0.3% GDP growth for the year as a whole.    We anticipate 2.0% GDP growth in 2023 as wages continue to climb, real interest rates remain negative, and supply constraints diminish and provide a tailwind to growth.

Stephen Slifer


Charleston, SC