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  • Writer's pictureThomas Hayes

Why the Fed is Always Late to the Party

Updated: Apr 30

In late 2021 as inflation moved higher, Chairman of the Federal Reserve Jerome Powell wanted to wait “to see the whites of the eyes” of inflation prior to raising interest rates.  Fearing rate hikes would derail the economy as it recovered from the COVID-19 pandemic, the Fed failed to move rates in the face of rising inflation data.  By March of 2022, when the Fed finally reacted, inflation was already at 8.5% on a year over year basis, hitting a high of 9.1% in June of that year.[1]  While runaway inflation wasn’t necessarily the result of low interest rates, it demonstrates another instance of the Fed being slow to react, with policy changes always seemingly behind the curve. But why does the Fed always seem to be one step behind, and are they likely to make the same mistake again soon?


The lag in Fed policy can largely be attributed to the way that they calculate inflation data. There are two different ways to measure inflation. Year over year, where current prices are compared to the same prices one year ago; and month over month, which measures the change in prices relative to the previous month, which is then multiplied by 12 to produce an estimated annual inflation rate. The year over year method is backward-looking, whereas the month over month calculation is more indicative of the current rate of inflation.  When inflation is rising or falling rapidly, the year over year calculation is slow to react, showing a rate of inflation that is lower than the month over month figure on the way up, and higher than the month over month figure on the way down.  The chart below shows how year over year figures can distort the true direction of inflation.




The Fed relies on the year over year figure to decrease volatility in the inflation measure caused by using month to month figures. The problem is that this method also makes them much slower to react to current changes in the economy.  As you can see in the chart above, extrapolating out the monthly figure has it’s own shortfalls, as monthly changes tend to be too volatile to measure the annual inflation rate accurately. For now, the year over year measure is likely to continue to result in the Fed reacting slowly to economic changes.


As of February 2024, year over year inflation had come down to 3.2%, a level approaching the Fed’s 2% target. In January, the market was pricing in roughly 7 rate cuts this year, assuming with the inflation largely vanquished, the Fed would ease off.  Recent comments by the Fed have called those cuts into question, with only 3 rate cuts now projected for 2024. Given the way the Fed measures inflation, by the time their preferred year over year measure shows 2%, the economy may already be experiencing problems that could have been avoided by cutting rates earlier.  In short, they may be to be late to the party as usual.

 


Disclaimer: The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.


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