After dipping well below the Federal Reserve’s 2-percent target in August, inflation now appears to be back on track. The Bureau of Economic Analysis (BEA) reports that the Personal Consumption Expenditures Price Index (PCEPI), which is the Fed’s preferred measure of inflation, grew at a continuously compounding annual rate of 2.1 percent in September 2024, up from 1.4 percent in the prior month. PCEPI inflation has averaged 1.8 percent over the last three months and 2.1 percent over the last year .
Core inflation, which excludes volatile food and energy prices, remains elevated. Core PCEPI grew at a continuously compounding annual rate of 3.0 percent in September 2024. It has averaged 2.3 percent over the last three months and 2.6 percent over the last year.
Figure 1. Headline and Core Personal Consumption Expenditures Price Index Inflation, January 2020 – September 2024
High core inflation is partly due to housing services prices, which grew at a continuously compounding annual rate of 3.8 percent in September 2024. Prices for housing services, which accounts for nearly 20 percent of the core PCEPI basket, tend to adjust with a considerable lag. Rental prices (+3.3 percent) are typically fixed for the duration of the rental agreement. Owner equivalent rents (+4.0 percent) are not directly observed; they are imputed using data from rental markets. Consequently, core PCEPI tended to underestimate future headline inflation in 2021 and is likely overestimating future headline inflation now.
The latest inflation data is unlikely to affect the Federal Open Market Committee’s decision next week. In September, the median FOMC member projected an additional 50 basis points worth of policy rate cuts this year. By showing that inflation is back on track, the latest data bolsters the case for neutralizing the policy rate.
The CME Group currently puts the odds of a 25 basis point rate cut in November at 96.7 percent, with a subsequent 25 basis point cut expected in December (73.3 percent). That would bring the federal funds rate target range to 4.25 to 4.5 percent by the end of the year, just as FOMC members projected.
Looking somewhat further ahead, there are two big questions:
1. What is the neutral federal funds rate?
2. How long will the FOMC take to get there?
In September, the median FOMC member projected the midpoint of the longer run federal funds rate target rate range at 2.9 percent. Twelve of the nineteen members said it was at or below 3.0 percent. Of course, members may revise their estimates as they get closer to the terminal rate, depending on how the macroeconomic data evolve.
As it stands, FOMC members intend to take some time reducing the policy rate to neutral. The median FOMC member projected a 3.25 to 3.5 percent federal funds rate target range by the end of 2025, with policy returning to neutral sometime in 2026. Again, their projections are contingent on the incoming data. They might move more quickly if the economy shows signs of contraction, or reduce the pace of rate cuts if they become concerned that inflation will pick back up.
The good news is that the period of high inflation appears to be in the rearview mirror. The bad news is that prices remain permanently elevated. The PCEPI is around 9.0 percentage points higher today than it would have been had inflation averaged 2.0 percent since January 2020. This unexpected burst of inflation transferred wealth from savers and employees to borrowers and employers.
The recent period of high inflation also illustrates a problem with the Fed’s asymmetric average inflation target. Had the Fed adhered to a symmetric average inflation target, it would have brought prices back down to the pre-pandemic growth path. A symmetric average inflation target limits unexpected wealth transfers and reduces the need for costly renegotiations. It also facilitates long term contracting, by making the price level easier to predict. Fed officials should think carefully about this period — and the advantages of a symmetric average inflation target — when considering whether to revise the monetary policy framework.