Desmond Lachman is a senior fellow at the American Enterprise Institute. He was a deputy director in the International Monetary Fund’s policy development and review department and the chief emerging market economic strategist at Salomon Smith Barney
“When the facts change, I change my mind,” John Maynard Keynes is thought to have said. “What do you do, sir?”
Now that the inflation outlook facts are rapidly changing for the better, the Federal Reserve should heed this advice and change its mind about the need for further large interest rate increases to regain inflation control. It should do so to spare the US economy from an unnecessarily hard economic landing.
Among the more dramatic changes in the inflation outlook pertains to the housing market. This is of particular importance since overall housing costs account for almost 33% of the consumer price index. To date, housing has been an important driver in inflation’s surge.
Mortgage rates rose from 3% at the start of the year to around 7% at present. In response, the housing market has already gone into a deep slump. It has done so as housing affordability has hit an all-time low and builder confidence has plummeted.
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This is prompting the Dallas Federal Reserve to forecast that next year, housing prices could decline by as much as 20%.
Even if home prices were to decline next year by half that amount, more than three percentage points would be shaved off headline consumer price inflation. In other words, prospective rent declines are likely to provide considerable inflation relief next year, instead of adding to inflationary pressures.
The US inflation outlook has also benefitted from a greater than expected slowing in the Chinese economy due to its zero-Covid policy and its property-market bust. China‘s economic difficulties are bringing in their wake a sharp reduction in international commodity prices, particularly in oil prices.
Oil prices have declined from around $120 to less than $75 a barrel since the start of the year. Chinese producer prices are also falling, and the Chinese currency is depreciating. The cheapening of the currency in turns lowers the US cost of Chinese imports along with the more general decline in US import costs as a result of this year’s more than 10% dollar appreciation.
Used-car prices are yet another area where we can expect considerable inflation relief. Last year, those prices shot up by more than 40% due to supply-chain disruptions. Now that supply-chain issues are being resolved and high interest rates are making car purchases less affordable, used-car prices have already declined by some 15% from their peak.
As these prices return to a more normal level, we can expect at least another two percentage points to be shaved off the headline inflation rate.
Over and above all of these downward inflationary pressures, it is now widely expected that the US economy will experience a recession next year. It will do so as a result of the most rapid pace of interest-rate increases in the past 40 years as illustrated by the four 75-basis-point interest rate increases so far this year.
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If that indeed turns out to be the case, we must expect that the current rapid pace of wage inflation will slow as the labour market becomes very much less tight than it is at present.
In 2020, when inflation was running well below the Fed’s 2% inflation target, the Fed deliberately maintained an ultra-easy monetary policy in the hope of getting inflation to increase towards its target. However, by keeping interest rates too low for too long and by engaging in excessive money printing, the Fed contributed importantly to inflation’s surge to more than 9%, a 40-year high.
Regrettably, the Fed now seems to be making the same policy mistake but in the opposite direction. In its zeal to correct its past inflation monetary-policy mistake, the Fed is slamming on the brakes hard. It is doing so even at a time when the economy appears headed towards a recession and the inflation outlook is improving for the better for a whole variety of reasons.
In the process, the Fed appears to be setting up the economy for an unnecessarily hard economic landing.
This article was published by Barron’s, a fellow Dow Jones Group