Inflation is cooling off. Will the Federal Reserve ease up on rate hikes?

There’s little doubt inflation is ebbing.

© Joe Raedle
A customer shops at at a grocery store in Miami.

Home prices and apartment rents are losing altitude. A gallon of gas is cheaper than it was before Russia invaded Ukraine. Shortages that made everything from two-by-fours to Toyotas more expensive are largely a thing of the past.

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And that’s welcome relief after the Federal Reserve rapidly raised interest rates last year to rein in runaway consumer prices.

It’s enough progress, some economists say, that the Fed should now wait to see whether inflation continues to retreat before boosting rates further and putting millions of workers in danger of losing their jobs.

The mostly progressive analysts urging the Fed to err on the side of workers argue that the price spikes of the past two years weren’t the result of higher labor costs tied to worker shortages — a primary target, along with home prices, of the central bank’s rate hikes.

Instead, they say inflation was largely caused by the shocks of the pandemic on labor and supply chains, and the war in Ukraine on food and energy prices.

What the Fed should do now is pause to allow last year’s rate increases to fully work their way through the economy.

“There is no compelling case that American families would be better off if the Fed damaged the job market in the name of fighting inflation,” Josh Bevins, director of research at the left-leaning Economic Policy Institute, wrote in a recent opinion piece for Barron’s.

The link between wage growth and inflation was unclear before COVID, according to economic consultant Claudia Sahm, who previously worked for the Fed and Congress. That hasn’t changed.

“There is no proof that wage growth is inconsistent with stable prices,” she said. Higher pay would bring more people into the workforce, easing the worker shortage that has vexed many employers in the lower-wage service sector.

Most economists don’t see it that way. Neither does the Fed.

The Fed’s preferred inflation measure — the Personal Consumption Expenditures price index excluding volatile food and energy — rose 4.7 percent in November, the latest month available. While that’s down from a post-pandemic peak of 5.4 percent earlier in the year, it remains well above the central bank’s 2 percent target.

Moreover, the job market is too hot for the Fed’s comfort, a view that was reinforced on Friday when the Labor Department reported that unemployment in December fell back to its pre-COVID low of 3.5 percent.

Fed officials argue that consumer demand, especially for services, exceeds supply. The mismatch has pushed wages — the largest cost for service providers — up at an inflationary pace as businesses try to attract workers.

The central bank’s solution is to drive rates higher. Jobs would be lost as sales decline, they concede, but runaway prices fueled by wage inflation would be more painful over the longer term.

“Without price stability, the economy doesn’t work for anyone,” Fed chair Jerome Powell said last month after officials announced their seventh straight rate hike since March, bringing the benchmark federal funds rate from near zero to a range of 4.25 to 4.5 percent, the highest since 2007.

The Fed’s latest projections, released in December, call for the benchmark rate to breach 5 percent this year. The forecasts see unemployment climbing to 4.6 percent, an increase that would mean about 1.8 million workers losing their jobs, based on the current labor force.

Such a spike in the jobless rate — which many forecasters believe is likely, and perhaps too rosy — would almost certainly trigger a recession, either this year or next. Powell has acknowledged that avoiding a painful recession may not be possible.

While the job market has started to soften and workers’ wage gains are moderating, the Fed says it’s too early to stand down. It has given no indication a pause is in the offing.

Employers added an average of 247,000 jobs a month in the fourth quarter, compared with an average of 366,000 jobs a month in previous quarter. Average hourly earnings rose 4.6 percent in December over a year earlier, down from 5.1 percent in November.

Job growth would have to decline below 100,000 a month, and wage gains to dip below 4 percent a year, for inflation to return to 2 percent, Powell has indicated.

Fed leaders, who waited too long to take inflation seriously, have since been hammering home a simple message: We will do whatever it takes to get prices under control and stopping too soon would be a mistake.

But while the central bank has taken a hard line, it has not been inflexible.

The Fed’s most recent rate increase, in December, was one-half percentage point. That followed four straight three-quarter-point hikes, an unusually large increment. And most investors are betting that policy makers will approve a quarter-point increase when they wrap up their next two-day meeting on Feb. 1.

Mary Daly, president of the Federal Reserve Bank of San Francisco, said on Monday that slowing the pace of rate increases rather than stopping altogether has its advantages.

“When you’re being seriously data dependent, doing it in more gradual steps does give you the ability to respond to incoming information,” she said at an event sponsored by The Wall Street Journal.

Economist Sahm said that if inflation continued its downward trend, the Fed would boost rates by a quarter point one more time, maybe two, then hold steady for the rest of the year.

“The Fed will do the right thing,” she said.

Powell & Co. would be heroes if they beat inflation without a job-killing recession.

But there’s plenty of doubt that they can pull it off.

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