Will Core Inflation Come Down Any Time Soon?

Rich Cervisi

The answer is probably not based on the five episodes of rate increases since 1993.

One of the tools the Federal Reserve uses to control inflation is the Federal Funds Target Rate

(FFTR), which is the overnight rate commercial banks charge each other. For the five most

recent periods of FFTR increases, the chart shows 12-month core inflation (blue bar excluding

food and energy) prior to the start of FFTR increases. The chart then shows what happened to

12-month average core inflation (orange bar) after the Federal Reserve started raising the FFTR.

The first takeaway is that inflation increased or stayed the same following the start of FFTR increases.  At whatever level of core inflation over the prior year, core inflation wants to be at that level or higher for many months once the Federal Reserve decides to raise rates.  

Of course, arresting the growth in inflation is one of the reasons the Federal Reserve starts increasing FFTR.  It just historically takes a while, and sometimes recessions soon follow.  Recessions followed periods #2, #3 and #4 in the figure.  The FFTR increases may have contributed to these recessions, but the Internet Stock Bubble bursting (period #2), the Real Estate Crash (period #3) and COVID (period #4) were very disruptive events that surely contributed.

The Federal Reserve used increases in FFTR during the periods #1, #2 and #3 to control inflation.  They allowed their assets like government bonds to increase during these periods.  Starting in period #4 and in addition to raising FFTR, they reduced their assets and started paying banks interest on the reserves the banks kept in the Federal Reserve.  This move has the effect of motivating banks to maintain large reserves instead of lending out the money, which also reduces the money supply.

Will the Federal Reserve’s ongoing actions more rapidly reduce inflation this time around?  The Federal Reserve is certainly taking a more aggressive approach.  Over the last 4 months they raised FFTR by 2.3%.  This is the same increase that was realized over 36 months the last time around, and substantially more aggressive than in the first three episodes.  They are also reducing assets by limiting reinvest of bond payments in new bonds.  This step has the effect of moderating the growth in the money supply, which in theory should bring down inflation.  The asset reduction through 7/27/22 is just 0.7%, but their plan going forward is significantly more aggressive at several percent per month than the last time.  Lastly, they are paying 2.4% interest on all bank reserves held at the Federal Reserve.  

There is debate around the relationship between the money supply and inflation.  I’ll provide a perspective on that in the next post.