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Fed In a Tight Spot After CPI Numbers Show Inflationary Pressure Is Still Broad-based

FS Insight Team

The May consumer price index report came in hotter than feared, with prices rising 8.6% year over year, the highest level since 1981. The increase marks a re-acceleration of inflation that makes it more difficult for consumers to afford everyday purchases at the grocery store and gas pump. It also poses a challenge for the Federal Reserve as it tries to secure a strong economy. CPI was 6% when excluding food and surging energy prices. Economists were looking for 8.3% for the main index and 5.9% for the core. There is plenty of debate on why inflation is occurring. Is it undisciplined monetary and fiscal policy? Is it supply chain disruptions? Is it the Russia-Ukraine conflict? The economy is a complex machine, and each situation plays a role.

The Consumer Price Index climbed 1 percent from April – far more quickly than in the previous month – and by 0.6 percent after stripping out food and fuel prices. The headline inflation rate was the fastest since late 1981, nearly 41 years ago, as items such as rents, gas, used cars, and food have become sharply more expensive. The cost of eating food at home has increased 11.9% over the last 12 months. Gasoline is up nearly 50% in the same time frame.

Thus, central bankers are raising interest rates to make borrowing more expensive, hoping to cool off demand and give supply a chance to catch up. This would moderate inflation.

"I said last month that we needed to see headline CPI drop below 8%," KPMG senior economist Tim Mahedy wrote in a note. "This makes another 50 bps hike in September increasingly likely... and the Fed pushing rates above neutral in the fourth quarter. We're running out of time, and there are a lot of reasons to think that inflation will ease, but it will be more gradual than the Fed would like."

On deck is the FOMC rate-setting meeting next week (June 14-15) and Federal Reserve Chairman Jay Powell’s press conference afterward. Economists like to say interest rates take the elevator down and the staircase back up, and the May 3-4 policy meeting ended with a half-percentage-point rate increase. There’s a general sense that policymakers would continue with similar moves in June and July. Whether the rate hikes continue beyond that, into the fall, remains to be seen.

Inflation is still well above the central bank’s 2% target. As a result, sentiment on Wall Street is mostly bearish, and analysts are raising their risks of recession.

It would be wise to brace for the fastest rate hikes since 1994: The Fed is also set to update its Summary of Economic Projections, which will show where policymakers see inflation, unemployment, growth and borrowing costs heading over the next two years. Baked into those insights will be what Powell and Co. have already foreshadowed: Officials see a third consecutive half-point hike on the table for the next gathering in July to lower inflation.

“Right now, it’s very hard to see the case for a pause. We’ve still got a lot of work to do to get inflation down to our 2 percent target,” said Fed Vice Chair Lael Brainard in a June 2 interview on CNBC. “If we don’t see the kind of deceleration in monthly inflation prints, if we don’t see some of that really hot demand starting to cool a little bit, then it might well be appropriate to have another meeting where we proceed at the same pace.”

If all goes as expected, that means the Fed’s key interest rate benchmark will have risen 1.5 percentage points in just a three-month span. Your wallet is sure to feel it, whether it’s noticeable in mortgage rates and auto loans or volatile stock prices. But even then, the Fed’s benchmark will just barely be back at 2019 levels, and the path forward isn’t clear. After that, the Fed looks like it has three possible policy paths: it can either keep raising rates by half a percentage point, shift down to hiking rates in more traditional quarter-point increments, or opt for a pause in the tightening cycle altogether.

All told, the Fed’s balance sheet and rate hike plans are going to be crucial because the continued expansion of the world’s largest economy is at stake.

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