Observations: Inflation's final mile

The journey back to target is unlikely to be steady or easy

Given the exuberance with which markets greeted a single month’s CPI, I thought it appropriate to pen a quick note on inflation prospects – in the US and elsewhere – and what it means for the interest rate outlook before returning to the Global entropy series I began earlier this month.  Don’t worry, Part II of that series is just around the corner.

One of my favorite bike rides is the 51.6 miles from my parents’ house in Tracy, California to the top of Mount Diablo, the highest peak in the coastal mountain range surrounding San Francisco.  It is an immensely beautiful but gruelling ride.  The final 10 miles are a non-stop climb of nearly 3,200 feet that steepens from a 4-7% grade to a 7-10% grade in the last three miles, and then, just when you think it can’t get worse, steepens to a 16-19% grade for the final ascent.  The last time I made that final climb – Christmas 2020, during Covid, when I took the above photo – I was sure that my quads would burst before I made it to the top.  But I did make it and the sense of accomplishment at 50 was unbeatable.

I suspect that Chairman Powell and the rest of the FOMC will feel the same when they finally bring inflation back to target, sustainably.  But like Mt. Diablo, the final stretch is likely to be harder than the path so far.  On Fed policy, since even before my last ride up Mt. Diablo, I have had three consequential differences with the consensus: (1) inflation is being driven as much or more by Being is believing effects – expectations – as cost pressures, hence restrictive policy rates would be needed to bring inflation back to target; (2) neutral real interest rates are significantly higher than the consensus estimate of 0-0.5%, raising the hurdle for restrictive policy; and (3) that, despite starting late, the Fed would not hesitate to act as decisively to return both expectations and inflation back to target.  The last three years have vindicated those views.

And I expect 2024 will, too.  Now is not yet the time to bet on either near-term rate cuts or below-target inflation.  Nor is the risk of further hikes eliminated, in the US or other major economies.