Inflation could take several years to get back to 2%, Cleveland Fed researcher says

Inflation could take several years to get back to 2%, Cleveland Fed researcher says

Officials at the Federal Reserve are expecting inflation to keep easing over the next two years and have penciled in a return to their 2% target in 2026.

But a senior research economist at the central bank’s Cleveland branch, Randal Verbrugge, is warning that it could actually take several years to reach that target — a level designated by the interest-rate-setting Federal Open Market Committee as consistent with maximum employment and price stability. That’s because of what he calls intrinsic characteristics of inflation that make it unlikely to get to 2% in a timely way. The model he came up with shows inflation will still be above target, at 2.7%, by the second quarter of 2025 and close to, but slightly above, 2% as of mid-2027.

The path of inflation has been among the most important issues facing the financial markets for the past few years. Friday brings the next major inflation update, known as the personal-consumption expenditures price index, for May. The report has the potential to reinforce or alter current expectations for the Fed’s first interest-rate cut to be delivered by September.

Market participants are counting on Friday’s data to confirm the view that the U.S. economy is heading into a period of tamer price gains — a theme that contributed to the S&P 500 and Nasdaq Composite’s climb toward closing records on June 18, and which is keeping Treasury yields contained. The median estimate of economists is for PCE, the central bank’s preferred inflation measure, to fall to 2.6% on a year-over-year basis, from 2.7% in April, and for the narrower annual core reading to ease to 2.6%, from 2.8% the previous month.

The central bank looks for inflation to average 2% over time, but has consistently missed that mark since April 2021 — and, in turn, has left interest rates at a 23-year high of between 5.25% to 5.5%. On June 12, the Fed released median projections showing PCE and core PCE inflation should fall to 2% in 2026, though Fed Chair Jerome Powell has long made it clear that policymakers do not need to wait to get there before cutting interest rates.

In an interview with MarketWatch, Verbrugge expanded upon a paper he wrote in May that outlined why “the last half mile” of inflation could prove to be so stubbornly resistant. He identifies three big forces that tend to push inflation around: a recession, an overheating economy, and supply-chain pressures. Absent any of those forces, he says, inflation generally carries durable, “intrinsic” properties that tend to make it move sluggishly toward 2% when it is not being pushed.

“This paper would say if you don’t have any of those three things pushing inflation around, then you are stuck around with the intrinsic amount of persistence that inflation has. Just kind of left to its own devices without shocks, how fast does inflation move to 2%? This paper would say, not very fast,” Verbrugge said.

The Cleveland Fed — one of 12 regional Fed banks around the country and home of the Center for Inflation Research — is led by Loretta Mester, a voting member of the FOMC this year who is set to retire at the end of this month. Generally seen as a hawkish-leaning policymaker, Mester said earlier this month that the Fed needs to see further low inflation readings before cutting interest rates. Verbrugge noted that his views are his own and not reflective of those of the Fed system or the FOMC.

Earlier this month, Powell conceded that it could take a little longer to get inflation down to 2%. The central bank has selected 2% as the level consistent with its mandate for full employment and price stability in the long run on the belief that businesses and households make sounder decisions, and the economy works better overall, when inflation remains low and stable.

All this year, the consensus forecast of top analysts, as reflected by the Blue Chip Economic Indicators, has been for PCE inflation to come close to 2% in 2025 — sooner than Verbrugge’s model indicates.

“In general, there are always a lot of risks around inflation forecasts because there are so many little shocks that could happen that we don’t see ahead of time,” said the Cleveland Fed economist. “There’s always going to be some upside risk and downside risk.” Relative to the average of the Blue Chip Economic Indicators forecast, however, his model would say “most forecasters out there are underestimating the persistency of inflation,” according to Verbrugge. “I could be wrong, of course. No model is perfect. But this model is saying that inflation, left to its own devices, just does not move to 2% very fast.”

Inflation’s intrinsic persistence is based on how people form expectations about the future and how prices are set in the economy, Verbrugge said. He makes the argument for why businesses could keep raising prices even during a time when they expect inflation to be falling.

“Inflation has been coming down relatively fast since April 2023, but since inflation is positive, most of those adjustments are positive as well, so the question is how much more positive?” he said. “Wages are part of that. If you are suddenly having to pay much higher wages, that’s cutting into your margins and you may try to raise prices just so you are not getting squeezed.”

Another way to think about this, Verbrugge added, would be to ask, “how does inflation behave, cleanly on its own? That’s the intrinsic part of inflation. This paper would say the intrinsic part of inflation is sluggish even if inflation expectations are anchored. It just doesn’t move that fast to 2%. It’s just very sluggishly chugging along to 2%. So if we don’t have something that pushes you back to 2%, this paper would say that it’s just going to take a few years before we get back to 2%.’’

That’s proven to be the case over history — particularly from 2012 to 2019, when it took roughly six years for 12-month trimmed-mean PCE inflation to move only a half percentage point. Trimmed mean is another way of looking at core inflation, after excluding the fastest- and slowest-growing components each month.

Verbrugge came up with a mathematical formula that describes all of the factors that go into inflation. One of those forces is expected inflation, or people’s belief about what inflation will be in the next year or a few years. A second factor is recent past inflation, which is especially relevant for businesses that haven’t had a chance to adjust their prices and make up for margins that got squeezed. A third set of factors is extrinsic forces such as a recession, an overheating economy or disrupted supply chains. And a fourth factor is “one-off” shocks that can include sudden increases or drops in gas prices.

One variable that isn’t included is interest-rate levels because the “statistical link between inflation and interest rates and wages is hard to discern,” according to Verbrugge. He said his work is silent on the issue of whether 2% inflation can be reached during a period when interest rates are being lowered.

“Inflation just doesn’t move very fast back to 2% unless it’s being pushed there by some external force or some intrinsic force that’s outside of the norm,” he said. “Most people view the movement to 2% as being a strong force. My model says it doesn’t zoom back down there — it trudges back down.’’

To get there, Verbrugge’s model indicates “that, if there are no more pushes from improving supply chains, the only other place that would give you a downward push is a recession. If you don’t have a recession, then be patient because it’s going to take a while.” A recession would help firms decide that instead of raising prices 4% or wages by 3.5% this year, they can do so slowly over time, he said.