Inflation remained high in September. The Consumer Price Index increased 0.4 percent overall during the month of September, and 0.3 percent excluding food and energy, the latest release from the Bureau of Labor Statistics shows. This corresponds to (continuously compounded) annualized rates of 4.74 percent and 3.87 percent, respectively. Many commentators are worried this may impel the Federal Open Market Committee to raise its interest rate target when it meets at the end of the month.
I still maintain the FOMC should hold its rate target steady. The recent uptick in inflation is not severe enough to change the underlying reality that monetary policy is appropriately restrictive. We shouldn’t expect continuous disinflation every month. It will take time to get back to normal. Barring several more months of elevated inflation, we likely don’t need to tighten further to get there.
The current federal funds rate target range is 5.25 to 5.50 percent. Adjusting for inflation using the core inflation rate yields a real interest rate between 1.38 and 1.63 percent. As always, we need to compare this to the natural rate of interest. The natural rate of interest is the inflation-adjusted rate consistent with full resource use across the economy. The quantity of capital supplied equals the quantity of capital demanded at the natural rate of interest, keeping investment at its highest sustainable level.
We can’t observe the natural interest rate directly, but we can estimate it. The New York Fed has the most widely-cited measures, which put it somewhere between 0.57 percent and 1.14 percent. The inflation-adjusted federal funds rate range is above the natural rate, implying money is tight.
Liquidity conditions reinforce this assessment. The M2 money supply is 3.67 percent lower today than it was a year ago—the fastest decrease during the history of the current measure dating back to 1960. The broader divisia monetary aggregates, which weight components of the money supply based on their liquidity, are falling between 2.23 and 2.97 percent per year. This is faster than the August decreases, reflecting a reduction in financial intermediation.
We’ll know more when the Bureau of Economic Analysis releases updated Personal Consumption Expenditures (PCE) data at the end of the month. But even if new PCE figures confirm a bump in the disinflationary road, it’s still likely best for the FOMC to hold off on further rate hikes. The Fed gravely erred when it allowed inflation to spike in the first place. But overreacting to a previous overreaction isn’t sensible. As Luwig von Mises memorably put it, if you’ve run a man over with a car, you can’t make him better by putting it in reverse and running him over again.
The solution to inflation isn’t deflation. Rather, the solution is restoring a credible and predictable growth path for the dollar’s purchasing power. Steady as she goes, Mr. Chairman.