Federal Reserve’s path to 2% inflation could be short but tricky

The Federal Reserve will start its annual conference of central bankers in Jackson Hole, Wyoming, on Thursday, and the central topic will be inflation and interest rates. Clues may emerge about whether the Fed will begin cutting in September.

The July consumer price index did make a cut appear more likely. It came in at 2.9% over the prior 12 months. But, of course, that’s not 2% — the Fed’s inflation target — which means there’s still some ways to go. How hard will it be to get there?

To understand what the Fed is up against in the coming months, year or however long it takes, it’s helpful to understand why the Fed may start paring interest rates before inflation hits 2%.

“One of the analogies people give is you’re driving a car, but you only get to look in the rearview mirror,” said Narayana Kocherlakota, a former president of the Minneapolis Federal Reserve Bank.

We don’t exactly know what’s happening now because data lags. That means inflation could already be lower. So the Fed needs to plan ahead because not only is there a lag in the data, there will be a delay in how consumers and businesses respond to the central bank’s action.

“It’ll take time for the effects of that rate cut to filter through the economy,” he said.

Now you might wonder, can’t the Fed just plug all the data into a model and make predictions? The Fed does do that. But forecasting doesn’t account for the infinite uncertainties: What’s going to happen with commercial real estate? Will tariffs increase, which could raise prices? What if the last few months of data were a fluke?

“That’s very, very hard to predict. But I’m sure people at the [rate-setting committee] are going to be wringing their hands about, well, ‘Where are the risks?'” said Ken Kuttner, a former staff member at the Chicago and New York Federal Reserve banks.

That’s one reason, Kuttner said, the Fed will likely move slowly. “You might see a pause between meetings and [they’ll] say, ‘OK well, we’ll cut in December, maybe not in January because we want to see how things play out.'”

The Fed will also move slowly because, to borrow a well-used metaphor, the smaller the target, the more precise the tool.

“When inflation is at 9%, anybody could be a central banker. You raise interest rates,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. “So now they’re at the part where it takes a lot of judgment and good luck to hit it just right.” 

The risk of making a mistake, and pushing unemployment too high, is greater now.