SF Fed Paper warns key inflation measure may prove hard to tame

By Michael S. Derby

NEW YORK (Reuters) – If economic trends that existed before the coronavirus pandemic reassert themselves, a modest cooling in the labor market may not be enough to bring down a key measure of underlying inflation, research released Wednesday from the San Francisco Fed said.

The report looked at what has come to be called supercore inflation, which is price pressures stripped of food and energy and housing-related factors. Fed officials have placed notable emphasis on this way of looking at price pressures amid their aggressive campaign of rate rises aimed at lowering high levels of inflation.

The paper notes that over the course of the pandemic and its immediate aftermath pressure in the labor market helped drive up supercore inflation. That suggested that if the tightened relationship were to continue, a slowing in the labor market would be a real help in lowering this underlying inflation measure.

“Supercore inflation is expected to moderate as the labor market and economic activity slow in response to higher interest rates,” wrote Sylvain Leduc, Daniel Wilson, and Cindy Zhao, the paper’s authors. “The size of this effect will depend on the strength of the relationship between supercore inflation and the labor market.”

If the pre-pandemic looser relationship returns, then it might be a different story, as longer run, “supercore inflation typically shows little sensitivity to local labor market conditions,” the paper said.

“There’s an important risk that the low sensitivity of supercore inflation to labor market conditions could return,” the study said, noting, “in that case, reducing supercore inflation would necessitate a more pronounced moderation in overall demand.”

The paper was released on the same day as the government data showed a notable decline in price pressures at the consumer level last month that indicated the end game for the Fed’s rate hike campaign is coming into view. Of particular note supercore inflation also cooled: Omair Sharif of Inflation Insights said it was at zero for June, and which points to further inflation moderation in the July data.

A number of economists said in the wake of the CPI data that the Fed is likely on track for a rate rise at the end of July, after which it would hold steady. If they’re right, that means the Fed will raise rates less over the remainder of the year compared to forecasts put out by the central bank last month.

That said, a sticky supercore could over time increase the odds the Fed will have to do more with interest rate increases.

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