Inflation Eases — But Problems Lie Ahead

The Bureau of Labor Statistics just released the Consumer Price Index (CPI) number for October. The CPI increased by 0.4% which means inflation for the last 12 months is 7.7%. That’s lower than last month’s annual number and lower than economists expected.

While that’s good news, going forward it looks like inflation will worsen.

The core inflation rate, which removes volatile food and energy prices fell to 6.3%, which was also lower than the prior month. That’s good news, although that too is likely to rise in the coming months.

Energy prices at the end of October and into early November were rising. As the cold weather arrives, demand for energy will increase, likely pushing prices up. Food prices will also rise, mostly because U.S. farmers are facing continuing high costs for fertilizers, labor, and diesel fuel which powers nearly all of their equipment.

Food prices will rise worldwide since about 25% of the world’s wheat supply and 10% of other grains come from Russia and Ukraine. Whether those food shipments reach the market is in question as Russia seems undecided about allowing the food to leave the harbor.

The Federal Reserve’s monetary policy will also impact future inflation. The Fed has been very aggressive with interest rate increases since last June. The Federal funds rate has been increased from near zero to 3.75%. The Fed is being pressured to slow rate increases because, at current interest rate levels, economic activity is slowing.

In 2021, the Fed did absolutely nothing to slow the rising inflation. Even with the economy growing at a 6% rate and unemployment falling so rapidly, labor shortages developed and the federal government continued to massively deficit spend. Perhaps more notably, the Fed did nothing to control inflation, dismissing it as transitory.

This shockingly irresponsible monetary policy not only permitted but encouraged inflation to increase. When the Fed finally confronted the inflation problem seriously in June of this year, inflation had reached 9.1% and a wage/price spiral was developing.

What will the Fed do going forward?

Fed officials should keep raising interest rates to ensure that inflation continues to go down. That means another 75-basis point rate increase in December and even more rate increases in 2023. It is likely that the Federal Funds rate will have to be increased to about 6% before the economy sees meaningful decreases in the inflation rate.

There will be continued pressure on the Fed to slow the interest rate increases. While third-quarter GDP grew at a healthy 2.6% annual rate, the first half of this year saw negative GDP growth. The consensus view for fourth-quarter growth is between -1% to plus 1%. That means for 2022, GDP growth will be near zero and possibly negative.

That will put even more pressure on the Fed to slow the interest rate hikes. If they give in, inflation will worsen. If they continue, a deeper recession will follow. Some economists are starting to talk about a “double dip.”

That means we had two successive quarters of negative growth in GDP in the first half of this year. By the widely accepted definition, that was a mild recession. Then the third quarter was positive. But if the fourth quarter is negative and the first quarter of next year is negative, that’s another recession.

While we welcome this month’s lower inflation, it looks like this is temporary. The CPI increased zero percent in July, 0.1% in August, 0.4% in September and 0.4% in October. The CPI will be higher than those numbers in November and December. That means the Fed must continue to be aggressive with rate increases.

Inflation will be a serious problem at least for the next year. Let’s hope the Fed acts appropriately even if their policy brings on another recession.

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