‘I like a good rally, but the stock market overreacted.’ Interest rates may need to go higher if the Fed wants inflation at 2%.

‘i like a good rally, but the stock market overreacted.’ interest rates may need to go higher if the fed wants inflation at 2%.

‘I like a good rally, but the stock market overreacted.’ Interest rates may need to go higher if the Fed wants inflation at 2%.

The Fed should not lower interest rates until inflation hits the 2% target for several months.

Investors are anxiously anticipating the May consumer-price index report and the Federal Reserve’s interest-rate decision, both due Wednesday, in hoping for signs that U.S. inflation has further eased and the Fed will soon lower interest rates.

News of lower inflation in April inspired investors to drive the S&P 500 index  to new highs, while the yield on the 10-year U.S. Treasury note dropped sharply.

I like a good rally, but the stock market overreacted — the U.S. economy is hardly near the Fed’s 2% annual inflation goal. In April, the CPI was up from March at a 3.8% annualized rate. That’s below the 4.6% rate posted in the first quarter of 2024, but above the 3.4% average for the prior 12 months.

For the past year, monthly changes in prices have bounced around. Stripping out food and energy, core prices were up 3.6% from March to April — the same as the 12-month average for month-to-month changes.

The history of struggles with inflation indicates the Fed should not lower interest rates until inflation hits the 2% target for several months. Easing policy too soon would likely reignite inflation and require to Fed to raise rates again.

Housing services account for 36% of the CPI, and policymakers have anticipated that declining increases for apartment rents, recorded by industry surveys, would bring down housing inflation.

However, the lion’s share of the shelter component is the imputed rent on owner-occupied homes — what homeowners anticipate they could obtain renting their properties. Since the global financial crisis, the pace of new home construction has slowed. Over the past year, even with higher mortgage rates, resale prices on homes rose 7%. The shelter portion of the CPI is up 5.5% over the last year and will not likely rescue the country from inflation.

Services, other than housing, account for 25% of the CPI and were up 5.1%. These are labor intensive, and prices are considerably sensitive to wages. The labor market may no longer be cherry-red hot but in May, the economy still added a robust 272,000 jobs.

All along, Fed policy has not been as tight as the task requires.

Inflation reached 8.5% in March 2022. The Fed ultimately raised the federal-funds rate — the overnight rate that banks charge each other to borrow reserves — to 5.3%, or about 62% of peak inflation.

When former Fed Chair Paul Volcker slugged it out with inflation that peaked at 14.6% in 1980, he pushed the target interest rate all the way to 19.1%.

Complicating matters, President Joe Biden’s fiscal policies have an inflationary bias. The Congressional Budget Office estimates the federal deficit will be 5.6% this year and 6.1% in 2025, up from 4.6% just prior to the pandemic. The International Monetary Fund estimates those larger deficits add about half a percentage point to inflation.

Biden’s climate-change agenda has similar consequences. The cost of installing a new air conditioner is up thousands of dollars. Overall, complying with new energy-conservation and emissions standards is raising new home prices an estimated $31,000.

The recent surge of immigration, enabled by Biden rolling back many of former President Donald Trump’s policies, allowed employment growth of about 250,000 a month in 2023. The sustainable pace under the prior immigration regime would been about 100,000.

All those additional workers are looking for apartments. No surprise, for example, that the apartment vacancy rate in New York City is at a historically low 1.4%.

Moreover, the recently approved $95 billion aid package for Ukraine, Israel and Taiwan, and Biden’s program to forgive an additional $475 billion in student debt, will add to the federal deficit.

Now a bipartisan group of U.S. senators is proposing the Pentagon spend an additional $32 billion annually on artificial intelligence to keep pace with Chinese and Russian military capabilities.

At the end of 2025, most of the personal tax provisions of the 2017 Tax Cut and Jobs Act will expire. Few observers expect these will be permitted to lapse entirely, and extending those without raising other taxes could cost up to $4.8 trillion over 10 years.

It’s safe to assume that the stimulus to aggregate demand and inflation created by bigger deficits will grow. Ordinary folks see this in their lives — groceries are taking the largest share of family incomes in three decades, and low-wage workers struggle with food insecurity.

Consumer expectations for inflation over the coming year, as tracked by the Conference Board, University of Michigan and New York Federal Reserve, average about 4%.

Against this backdrop, the Fed should not be talking about easing monetary policy. Rather, it should recognize that interest rates may yet have to go higher.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

More: Fed won’t move interest rates this week, but meeting will still be a feast for economists

Plus: Stock market faces midweek double whammy with Fed decision following CPI inflation reading

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