We’re on track to whip inflation, so the Fed should leave interest rates alone

Don’t be fooled by rising energy prices: Inflation is headed in the right direction. The Federal Reserve was right not to raise its interest rate target last month — and it shouldn’t raise rates at its next meeting, either.

The Personal Consumption Expenditures Price Index (PCEPI), which the Bureau of Economic Analysis tracks, rose last month at an annualized rate of 4.72 percent. This seems fast at the outset — after all, the Fed is supposed to target 2 percent inflation. But the headline number is misleading, as it doesn’t filter out hyper-volatile food and energy prices.

We all know energy in particular is getting more expensive. Just from July to August, measured prices for gasoline and other energy products rose a whopping 10.21 percent. This reflects economic fundamentals (supply and demand) in petroleum and related markets. It’s a mistake to include these price effects in our inflation analysis.

Let’s look at the “core” PCEPI, which excludes food and energy. This was only 1.74 percent annualized — significantly below the Fed’s target, and the slowest since autumn 2020. Broad-based price pressures are almost certainly easing. This is a good sign for workers and families, whose wages have been stretched thin by inflation.

To fight dollar depreciation, the Fed has rapidly raised its interest rate target to between 5.25 and 5.50 percent. Using the core PCEPI, the implied real (inflation-adjusted) rate is between 3.51 and 3.76 percent. Does this mean monetary policy is appropriately tight? Before advocating higher rates, we should compare this to what economists call the “natural” rate of interest: the inflation-adjusted rate that helps the economy reach its maximum potential. The New York Fed estimates this rate is somewhere between 0.57 and 1.14 percent. Since market rates are significantly higher than the natural rate, we can be confident the Fed is appropriately positioned to lower inflation without further tightening.

Money supply data confirms this picture. The most widely cited measure of the money supply is 3.67 percent lower today than it was a year ago. Broader liquidity measures are falling between 1.92 and 2.69 percent per year. We haven’t seen contractions like this in decades. 

The likely cause is the pressure higher interest rates puts on banks. Financial intermediation gets more costly when rates are high, which constricts the money creation process. Although we don’t want this to go too far, since it could dampen investment and capital accumulation, it’s acceptable for the time being to help bring inflation down.

All the data we have says inflation is falling and monetary policy is already tight enough. Some Fed officials are hinting they want rates to go still higher. They ought to reconsider. When the Fed’s decision-making body meets at the end of October, they shouldn’t hike interest rates. Fighting inflation is good, but causing needless economic pain isn’t.

Alexander William Salter is an economics professor in the business school at Texas Tech University, a research fellow at TTU’s Free Market Institute, and a senior contributor with Young Voices.