The Federal Reserve often finds itself navigating the economy with a peculiar handicap, frequently accused of steering by the rearview mirror. This isn’t a casual observation but a critique rooted in its reliance on economic indicators that summarize past performance rather than reflecting the present or future trajectory. The consequence can be significant: monetary policy decisions made on stale data, potentially out of sync with real-time economic shifts.
Consider the Consumer Price Index, the widely-cited measure of inflation. The July CPI figure registered 3.4 percent, a slight dip from June’s 3.5 percent, yet still considerably above the Fed’s 2 percent target. On the surface, this suggests persistent inflationary pressure, a concern echoed by some within the Federal Open Market Committee. At their last meeting, the presidents of three regional Fed branches, including Beth Hammack of Cleveland, Neel Kashkari of Minneapolis, and Lorie Logan of Dallas, advocated for immediate interest rate increases. Hammack voiced apprehension that “The longer that high inflation persists, the more challenging and costly it can be to bring it back down,” noting broadening pricing pressures and consumer despair. Kashkari, similarly, worried about inflation becoming “entrenched,” while Logan remained pessimistic. Even Chairman Warsh, a prominent voice, has underscored the ongoing battle against high inflation and the commitment to reach the 2 percent goal.
However, a closer look at the underlying data reveals a different narrative, suggesting the headline numbers might be painting an incomplete picture. The 3.4 percent CPI reading is a year-over-year comparison, capturing price changes over the past 12 months. Yet, a more recent trend emerges when examining a shorter window. The annualized three-month average of the CPI since May stands at a mere 0.49 percent. This stark contrast suggests a potential shift in the inflation’s momentum that the longer-term metric struggles to capture. The Producer Price Index, also released recently, showed a 4.7 percent increase year-over-year, which could ordinarily signal future consumer price hikes. However, on a monthly basis, the PPI has been declining rapidly since April, even turning negative for June and July, with its three-month annualized rate at 1.6 percent.
Further evidence of moderating price pressures comes from inflation expectations themselves. Since May, both market-based measures, such as the 5-year Breakeven Inflation forecast, and the Cleveland Fed’s 1-year inflation expectation model, have eased significantly. Both now project inflation to hover around the 2.3 percent range, well below the headline CPI. This confluence of shorter-term data points suggests that inflation may be reversing course more quickly than the traditional year-over-year CPI can indicate. Indeed, some short-run measures suggest inflation might have already touched the Fed’s 2 percent target. Market reactions underscore this perception; the S&P 500 reached a new all-time record shortly after the CPI release, with “tame inflation data” cited as a key driver. The market consensus on a September rate hike also flipped, from an 80 percent likelihood last month to roughly 67 percent “No” today, with even The Wall Street Journal acknowledging a return of “disinflation.”
The idea that annualized quarterly measures of inflation offer a superior, more current view than year-over-year figures is not a fringe concept. Nobel laureate Paul Krugman has endorsed this approach, stating that in volatile economies, “many economists are now focusing on either three- or six-month changes” because a year is simply too long a lag. Jason Furman, former Chair of Obama’s Council of Economic Advisors, has similarly emphasized the importance of a shorter window to understand inflation trends. Even former Fed Chair Jerome Powell and Vice-Chair Lael Brainard have occasionally cited inflation figures based on shorter averaging periods. The Cleveland Fed’s “inflation nowcast,” for instance, presents an annualized quarterly CPI currently at 1.05 percent. Many academic economists and those within the Fed itself support the use of shorter averaging windows, recognizing that the past year’s measure is inherently slow and backward-looking.
The implications for monetary policy are substantial. A heavy reliance on lagging data risks obscuring critical turning points in economic trends and can exacerbate the delay in policy response, leading to potentially serious macroeconomic consequences. The inflation spike from 2021 to 2023 serves as a stark reminder. While the Fed was slow to act, the rate increases initiated in mid-2022 are often credited with bringing down inflation. However, the three-month annualized series tells a different story, showing a structural change in the inflation trend in mid-2022, plummeting from 10.1 percent to 1.9 percent in a single quarter. This suggests that by the time the Fed began raising rates, the inflationary surge was already subsiding. Milton Friedman’s famous observation about the “long and variable lag” of monetary policy, typically between 9 and 24 months, reinforces this. Chairman Powell himself referred to these lags numerous times in late 2022, indicating that the full impact of policy decisions might not be felt for years.
The current economic landscape presents another critical juncture. Despite the latent hawkishness at the Fed, the annualized three-month CPI suggests that the short-run inflation pace may be lower than headline figures indicate. The labor market has shown signs of weakening, with a negative July jobs report and downward revisions for May and June. Labor participation is declining, mortgage rates are climbing, and home sales are down. Retail spending saw its first drop in nine months in July. With elevated geopolitical uncertainty and economic uncertainty indices at pandemic levels, the question arises whether this is the appropriate moment to apply further economic brakes based on potentially flawed inflation measures. Kevin Warsh’s initiative to reevaluate how the Federal Reserve understands and responds to inflation drivers, and to improve the quality and timeliness of economic signals, is a laudable step. As Warsh articulated at the Jackson Hole Economic Symposium, “Yesterday’s news has a way of getting mistaken for what is happening right now… we must interrogate reality to make sure we are not setting forward-looking policy based on stale or inaccurate data.” The challenge for the Fed lies in recognizing these short-term trends to avoid policy missteps in a rapidly evolving economic environment.
