For the Fed, inflation doesn’t matter … for now

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As for the Federal Reserve’s interest rate policy, what inflation does now matters a lot less than what it does next spring.

What inflation is doing now is pretty high. The Labor Department said on Tuesday that its seasonally adjusted consumer price index rose 0.3% in August compared with July, placing it 5.3% above its level a year earlier. Basic prices, which exclude food and energy products to better capture the trend of inflation, rose 4% from the previous year.

A separate Commerce Department measure of inflation the Fed prefers tends to be a bit cooler, but Tuesday’s report suggests it was well above the central bank’s target of 2%.

Still, the August inflation rate at this point has little bearing on the Fed’s short-term plans. The central bank appears to have decided to start cutting back on its monthly bond purchases at its November meeting, ending them completely by the middle of next year. Inflation metrics are unlikely to show a massive cooling or massive acceleration by November, so the only thing that could really delay the start of the cut is a really lousy jobs report.

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One of the reasons Fed officials want to start tapering is because they don’t want to keep buying assets when they start to raise rates. So the sooner they stop buying central bank bonds, the sooner they have a tightening option.

Whether they will start raising rates once they finish their cut seems to depend largely on how inflation develops at that time. This is where the question comes in to what extent recent increases in consumer prices are transient.

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Tuesday’s report showed that some of the pandemic-related issues that drove prices up are in fact starting to fade away. Prices for used cars and trucks were down 1.4% in August from July, for example, and it looks like they will see further declines. Car rental prices fell 8.5% on the month.

Other prices could cool down by next spring, when the debate over what the Fed should do about rates becomes more pressing. The global chip shortage that has held back the production of cars and other items should have eased by then. The same is true for other bottlenecks in the supply chain that affect prices.

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But even if the world is better off with Covid-19, some frictions linked to the pandemic could persist. In addition, the persistent difficulties employers face in filling positions appear likely to continue to push up wages, and these higher labor costs could be passed on to prices.

Once the tapering is complete, the risk is that the Fed will no longer consider whether to start raising rates, but how much to raise them.

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