Inflation was the big story in 2022, but what will inflation be in 2023? More of the same high inflation or something different?
Something slightly unexpected has been happening with inflation. Since July of 2022, inflation appears to have abruptly returned to “normal.” What is normal? If inflation continues as it has for the last six months, the 12-month inflation rate will end up close to 2%. Interestingly, this happens to be the Fed’s stated inflation target.
Monthly Inflation in 2022
Source: US Bureau of Labor Statistics
Inflation can fall faster than most people think – Inflation in the 1970s
This might seem a surprise to many, but it is not unprecedented. In the 1970s, the last time we had similar inflation levels, inflation broke rapidly following Fed tightening campaigns.
Where does this leave the Fed? Inflation vs. Fed Funds Rate
Source: YCharts. Data as of November 30, 2022. Unemployment data through December 30, 2022. Inflation data through December 31, 2022. https://www.cnbc.com/2022/10/04/jolts-august-2022.html
Currently, the Fed Funds Target Rate is 4.25% to 4.50%. Given the expected 0.25% increase in February, this would leave the Fed Funds Rate at least 4.5%. However, inflation is already on a 2% trajectory. This would cause the Fed Funds Rate to be 2% above inflation.
The Fed has historically kept the Fed Funds Rate above inflation – 1980 – 2000
In the post Financial Crisis environment of 2009-2020, the Fed had intentionally kept the Fed Funds Rate below inflation. While many of us think of this state of expansionary Fed Policy as the “norm”, historically, this has not been the case. Before 2008, the Fed Funds Rate was consistently targeted to be above inflation. This is because the Fed’s primary goal is to fight inflation and moderate it to a target of 2%.
- Inflation can fall quickly.
- Inflation may approach 2% in 2023.
- The Fed does not have to lower rates to meet falling inflation.
- A Fed Funds Rate greater than inflation is normal, based on history.
- The Fed will likely raise rates as expected by 0.25% in February, but maybe they shouldn’t.
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