May 27, 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 rose 0.2% in April after having jumped 0.9% in March after rising 0.5% in December, January and February.  The year-over-year increase now stands at 6.3%.

Excluding the volatile food and energy components the PCE deflator rose 0.3% in February, March, and April after climbing 0.4% in January.  The year-over-year increase is now 4.9%.  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 appears to have recently changed its mind and is now 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 has 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 should cause the inflation rate to climb well above the Fed’s 2.0% target for a protracted period of time.  Its current year-over-year growth rate of 8.0% is still faster than the 6.0% pace it had risen on average in the past decade.

The core PCE deflator rose 4.9% in 2021 and we expect it to climb 4.7% in 2022. As a result, we expect the Fed to boost the funds rate seven times this year which would raise the funds rate to 2.5% by yearend. The Fed believes its policy is neutral when the funds rate is 2.5%.  However, if the core PCE deflator rises 4.7% for the year, the inflation-adjusted or real funds rate would be negative by 2.2%.  Thus, policy will still be accommodative at the end of this year which will do little to slow the pace of economic activity.

After 5.5% GDP growth last year we expect 2.0% GDP growth this year as supply constraints continue to bite and the Fed steadily tightens throughout the year.  We anticipate 2.5% GDP growth in 2023 as those supply constraints diminish and provide a tailwind to growth.

Stephen Slifer


Charleston, SC