Key Takeaways
As inflation spiked in the first quarter, some market participants questioned whether monetary policy was tight enough to contain price pressures. Since then, economic data has suggested that the Federal Reserve's higher interest rates, aimed at taming inflation, appear to be having the desired effect. That's important, because the central bank has stuck to the idea that its future monetary policy efforts will be data-driven.
With inflation subsiding and the economy slowing, the Federal Reserve's monetary policy appears to be working exactly as it was originally intended.
The Federal Reserve has raised influential interest rates to their highest in 23 years, raising borrowing costs and curbing spending to fight inflation, but inflation rose in the first quarter, surprising economists and raising concerns that upward price pressures may not abate.
The resurgence of inflation has led some market participants to question whether the Federal Reserve's monetary policy is tight enough, particularly the influential federal funds rate, and whether it is high enough. Earlier this year, one central bank official argued that interest rates may need to rise further to hit the Fed's annual target of 2% inflation.
Easing price pressures
But economic data since then has shown that pricing pressures have eased and spending has cooled across the sector.
“It's really distressing when no matter where you look, monetary policy isn't working,” San Francisco Federal Reserve Bank President Mary Daly said in an interview with CNBC last Friday after the release of the Fed's preferred inflation measure.
Prices, as measured by the personal consumption expenditures index, changed only slightly in May, marking the lowest monthly inflation rate since November. The index also showed that prices had risen 2.6% compared with the same period last year, bringing the annual rate closer to the Fed's 2% target.
“Economic growth is slowing, spending is slowing, the labor market is slowing, inflation is falling. That's how policy works,” Daly said. “Obviously, it's taking longer than we'd like, but that doesn't mean the policy isn't working.”
High interest rates have far-reaching effects
The effects of the Federal Reserve's anti-inflation measures are finally starting to be felt across the economy, as consumer and business spending that has endured high interest rates is slowing.
Companies are cutting back on building, a sign that companies are putting the brakes on capital spending, while manufacturers are seeing a drop in orders due to weaker demand.
Consumer spending has fueled the economy during the pandemic recovery, but it has started to slow in recent months, leading economists to predict shoppers will cut back on spending for the rest of the year.
“The latest snapshot of consumer behavior suggests the economy is gliding toward a much-anticipated soft landing,” wrote Bob Schwartz, senior economist at Oxford Economics.
So when will the Fed cut interest rates?
Fed officials have acknowledged progress in fighting inflation but said they need to see more data before starting to cut rates.
“We want to have greater confidence that inflation is declining sustainably toward 2 percent before we begin the process of tapering monetary policy,” Fed Chairman Powell said Tuesday during a panel discussion at a European Central Bank meeting in Portugal.
If the Federal Reserve cuts rates too soon, inflation could rise again and force the central bank to reverse course and raise rates again, but if it waits too long, unemployment could rise.
“We need to balance the two, but we can do so cautiously given the strength of the economy,” Powell said.
Chicago Fed President Austan Goolsby said the Fed should be prepared to move to cut interest rates if the job market weakens. “There are dangers in waiting and there are dangers in doing the wrong thing,” Goolsby said in an interview on Bloomberg TV on Tuesday.
The comments came ahead of Friday's release of June's jobs report, when officials will be watching closely to see whether the labor market continues to beat expectations.