The last post where I attempted a macro prescription was in April 2022, when I said the Fed was still under-reacting to inflation. That turned out right; since then the Fed has raised rates a full 500 basis points (5 percentage points) to fight inflation. So I’ll try my luck again here.

Headline annual CPI inflation has fallen from its high of 9% at the peak last year to 3.7% today. Core PCE, the measure more closely watched by the Fed, is at a similar 3.9%. Way better than last year, but still well above the Fed’s target of 2%. Are these set to fall to 2% on the current policy path, or does the Fed still need to do more?

The Fed’s own projections suggest one more rate hike this year, followed by cuts next year. They expect inflation to remain a bit elevated next year (2.5%), and that it will take until 2026 to get all the way back to 2.0%. They expect steady GDP growth with no recession.

What do market-based indicators say? The yield curve is still inverted (usually a signal of recession), though long rates are rising rapidly. The TIPS spread suggests an average inflation rate of 2.18% of the next 5 years, indicating a belief the Fed will get inflation under control fairly quickly. Markets suggest the Fed might not raise rates any more this year, and that if they do it will only be once. All this suggests that the Fed is doing fine, and that a potential recession is a bigger worry than inflation.

Some of my other favorite indicators muddy this picture. The NGDP gap suggests things are running way too hot:

M2 shrank in the last month of data, but has mostly leveled off since May, whereas a year ago it seemed like it could be in for a major drop. I wonder if the Fed’s intervention to stop a banking crisis in the Spring caused this. Judging by the Fed’s balance sheet, their buying in March undid 6 months of tightening, and I think that underestimates its impact (banks will behave more aggressively knowing they could bring their long term Treasuries to the Fed at par, but for the most part they won’t have to actually take the Fed up on the offer).

The level of M2 is still well above its pre-Covid trend:

Before I started looking at all this data, I was getting worried about a recession. Financial markets are down, high rates might start causing more things to break, the UAW strike drags on, student loan repayments are starting, one government shutdown was averted but another one in November seems likely. After looking at the data though, I think inflation is still the bigger worry. People think that monetary policy is tight because interest rates have risen rapidly, but interest rates alone don’t tell you the stance of policy.

I’ll repeat the exercise with the Bernanke version of the Taylor Rule I did in April 2022. Back then, the Fed Funds rate was under 0.5% when the Taylor Rule suggested it should be at 9%- so policy was way too loose. Today, the Taylor Rule (using core PCE and the Fed’s estimate of the output gap) suggests:

3.9% + 0.5*(2.1%-1.8%) + 0.5%*(3.9%-2%) + 2% = 7%

This suggests the Fed is still over 1.5% below where they need to be. Much better than being 9% below like last April, but not good. The Taylor rule isn’t perfect- among other issues it is backward-looking- but it tends to be at least directionally right and I think that’s the case here. Monetary policy is still too easy. Fiscal policy is still way too easy. If current policy continues and we don’t get huge supply shocks, I think a mild “inflationary boom” is more likely than either stagflation or a deflationary recession.