Earlier this week, Treasury Secretary Janet Yellen made headlines when she expressed optimism that the Federal Reserve Board’s long hoped-for 2 percent inflation target might be achieved by 2025. The attention was understandable.
For one thing, when inflation reaches the target, we can expect lower interest rates and more economic normalcy. For another, at the time, the most recent readings on the all-item Consumer Price Index still showed May year-over-year inflation running 3.3 percent, and the index without food and energy hitting 3.4 percent. Since then, the Fed’s preferred inflation metric for May, the Personal Consumption Expenditure Index, showed 2.6 percent growth, unchanged for two months and running.
Still, the distance between 3.3 percent or 2.6 percent today and 2.0 percent just six months from now is large. Given Yellen’s many years of experience in the higher reaches of government and her strong reputation as an economic scholar, one has to wonder what’s going on.
A quick check of three other forecast groups I follow closely — The Wall Street Journal’s panel of 50 economists, the Philadelphia Fed’s panel of 37 and Wells Fargo Economics — offers a far less optimistic outlook.
The Wall Street Journal April panel predicted the all-item CPI would show 2.3 percent growth for 2025 and 2026. The Philadelphia Fed’s forecast for 2024’s second quarter showed CPI growth averaging 2.3 percent over the next 10 years. The estimate by Wells Fargo Economics for June 26 showed the all-item CPI growing 3.1 percent in 2024 and 2.6 percent in 2025.
It may turn out that Secretary Yellen is correct. Let’s hope so, but right now she is definitely an outlier.
So why might CPI inflation, which speaks to a top concern of U.S. voters, resist all of the Fed’s persistent efforts to hit a 2 percent target? And since achieving the goal has proved to be so difficult, why doesn’t the Fed just call off the chase and admit that inflation can’t be bottled up at the moment?
There are at least two parts to this problem. First off, the more the Fed does to control inflation by way of interest rate hikes, all else being equal, the greater will be inflation in the very short run. Why? It’s rather simple: The cost of shelter, both renter- and owner-occupied, included in the CPI rises when mortgage rates go up.
Since the Fed started hitting the brakes, the interest rate on a 30-year, fixed-rate mortgage rose from high-2 percent territory in 2020 to the high-6 percent range in 2022’s third quarter. By May 2024, these mortgages were fetching more than 7 percent.
Sure, there’s more to it than just the cost of mortgages. But consider this: As noted recently by the Bureau of Labor Statistics, “The index for all items less food and energy rose 3.4 percent over the past 12 months. The shelter index increased 5.4 percent over the last year, accounting for over two thirds of the total 12-month increase in the all items less food and energy index.”
Second, the Fed has no way to control government deficit spending, which, when the Treasury borrows to fund it, can be a direct source of inflation. It turns out that, just a few days before Yellen spoke about inflation, the Congressional Budget Office released an update to its 10-year budget projections and boosted its fiscal-year 2024 U.S. budget deficit estimate to $1.9 trillion, up from $1.5 trillion in its February projections.
Put another way, while the Fed was hitting the brakes, the White House and Congress were putting the gas pedal to the metal.
So, should the Fed just call off the chase and forget about hitting a 2 percent target? Hardly. But in fairness to the Fed’s past efforts, and in contrast to Secretary Yellen’s optimism, it’s hard to bail out our leaky boat when a passenger is drilling new holes.
Bruce Yandle is a distinguished adjunct fellow with the Mercatus Center at George Mason University and dean emeritus of the Clemson University’s College of Business and Behavioral Sciences.