Why Inflation Is Stuck in a Moment

Authored By:
The MBS Highway Team
John Smith
January 1, 2023
5 min read

In March 2022, the Fed began aggressively hiking its benchmark Federal Funds Rate (the overnight borrowing rate for banks) to try to slow the economy and curb runaway inflation. These hikes were designed to make borrowing more expensive so the demand for goods would decrease, thereby reducing pricing pressure and inflation.    

After their eleventh hike in July 2023, the Fed paused further hikes as signs of cooling inflation grew. The two main reports that measure inflation at the consumer level, the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), have shown that inflation has fallen significantly from the highs seen in 2022.

Headline CPI is now at 3.5% year-over-year as of March, which is down from its 9.1% peak in June 2022. Core CPI, which removes volatile food and energy prices, is now 3.8% versus the 6.6% peak. PCE has also made great strides lower, with the annual headline reading for February at 2.5% (down from 7.1%) and the core reading at 2.8% (down from 5.6%).  

After their March meeting, the Fed reiterated that they are “fully committed to returning inflation to our 2 percent goal.” They have also stressed that they don’t expect to begin cutting the Fed Funds Rate this year until they have “gained greater confidence that inflation is moving sustainably toward 2 percent.” 

While the Fed cares about both the CPI and PCE inflation measures, members focus on Core PCE when it comes to their 2% inflation target. And while the latest 2.8% Core PCE reading is much lower than the 2022 peak of 5.6%, progress has been slowing.  

So, what’s ahead for Core PCE? Could this progress lower pick-up steam? 

As you can see in the chart below, the current annual Core PCE is at 2.784%, which we rounded above to 2.8%. Remember that this year-over-year reading is calculated on a rolling 12-month basis, which means that the total of the past 12 monthly inflation readings gives us the year-over-year rate of inflation. 

When March’s data is released on April 26, it will replace the reading from March 2023, which was 0.336%. If we substitute the estimated reading for this March, which is 0.23%, Core PCE would fall to 2.678%. While this is a move lower in the right direction, it’s still not significant progress closer to the Fed’s 2% target.  

Looking further ahead, the chart below breaks down the trajectory of Core PCE if the monthly readings through September all equal 0.2%. While these estimates show Core PCE lower than it is currently, we still haven’t reached the Fed’s 2% target.

The Fed has indicated they won’t “wait to get to 2% to cut rates,” though the question remains. When will the Fed think inflation has progressed low enough for them to start cutting the Fed Funds Rate later this year?

Another factor that could impact their timing is the unemployment rate, which has been in a narrow range between 3.7% and 3.9% since August. While the Fed’s latest forecasts showed that seventeen of nineteen Fed members don’t see the unemployment rate rising above 4.1%, an increase over this level could pressure the Fed to cut rates, given their dual mandate of price stability and maximum employment.

However, the overall strength of March’s Jobs Report, which featured job growth well above estimates and a declining unemployment rate, will likely not add any pressure to their timeline.

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By The MBS Highway Team

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