Should the Fed just live with 3% inflation and move on?

WELREX® Director John Longo shares his view on the July 2023 meeting of the Federal Reserve.

In an almost forgone conclusion, the Federal Reserve raised interest rates another 25 basis points last week. The Fed Funds Rate now stands at a generational high of 5.5% with the Fed remaining in a “hawkish pause” stance. That is, the Fed has said they will wait and analyze additional economic data before increasing rates again but are not ruling out further rate increases. Any rate cuts will likely not occur until 2024, at the earliest. The Fed’s full statement published after their July meeting may be found here.

After admitting that they were late to recognize out-of-control inflation, the Fed quickly played catch up with the most aggressive rate hike campaign since the early 1980s. The latest readings from the Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE) Index both now stand approximately at a 3.0% annualized rate.  The Core PCE, purportedly the Fed’s preferred measure of inflation, came in at an annualized rate of 4.1%, its lowest reading in about 2 years. Since each of these numbers are greater than the Fed’s oft-stated target of 2.0% it is easy, on paper, to understand the Fed’s continued somewhat hawkish stance.

Artificial Intelligence (AI) will keep inflation at bay

Inflation is trending in the right direction, despite occasional hiccups, and the Fed continues to shrink its balance sheet via its quantitative tightening program. Perhaps most importantly, AI is likely the biggest technological innovation since the widespread adoption of the Internet in the 1990s. Although AI has been around in various forms for more than a half-century, the relatively new techniques of deep learning and generative AI (which is able to quickly produce text, images, audio, and video in response to prompts) have resulted in the technology reaching a tipping point.

Most analysts agree that increased use of technology is generally deflationary. Perhaps the best recent example of this dynamic is the introduction of the iPhone/smartphone which, for many people, replaced the cell phone, camera, video recorder, video game player, music player, alarm clock, stopwatch, GPS navigation system, calculator, handheld computer, (virtual) banking, photo album, health monitor + much more.

AI will initially impact white-collar workers, which may be able to adapt more easily

AI will increase the productivity of most workers allowing companies to pay higher wages while holding on to their cherished profit margins. In addition, AI will supplant some jobs, increasing unemployment in the short run, and keeping a lid on inflation. To simplify, blue-collar workers (especially those that work with their hands) will be less affected by the early impact of AI. In fact, “hard hat” jobs recently had the highest level of job openings ever. White-collar workers, who generally have higher post-secondary education levels, are more likely to adapt to new economic environments. The purpose of the “core curriculum” at most universities is to provide their students with a portable knowledge base and skill set that may effectively operate in new environments, with the appropriate training. In brief, college is supposed to teach people how to think, learn new things, and create new knowledge.

In the long run, technology does not have to be net job-destroying.  Most people would agree that technology plays a bigger role in our lives than ever before and yet the unemployment rate was recently near a 50-year low. Although many jobs, such as customer service representatives, may decrease as AI applications take hold, many other new jobs will be created. For example, social media manager and influencer jobs were relatively unheard of a generation ago, while today they are commonplace.  Similarly, AI ethicists, AI compliance managers, and AI risk managers will be prevalent positions in the decade ahead.

Venture capitalist, Mark Andreessen, recently wrote a provocative essay, arguing that AI isn’t killer software and robots that will spring to life and decide to murder the human race or otherwise ruin everything. Rather, at its best and most aspirational case, AI could be a way to make everything we care about better.

More rate hikes may lead to a recession: history shows the U.S economy can handle 3% inflation

In summary, AI may hold inflation to reasonable levels and pressure unemployment in the short run, doing part of the Fed’s job without raising interest rates further.  Demographic trends are also deflationary with the older population spending less in many economic sectors while the younger population tends to be more technologically savvy and able to shop efficiently at Amazon and numerous other low-cost venues. So, the Fed should consider living with the current 3% inflation readings and move on.  Continuing to raise interest rates may push what has a pretty good chance of a soft-landing economic scenario into a recession. To say that the U.S. economy can’t function properly with 3% inflation doesn’t logically follow since it has averaged more than 3.5% over the past 100 years and the country’s growth has been among the best in the world. The stock market is clearly pricing in a soft landing, as evidenced by the nascent bull market. If the Fed compounds its early inflation error with a market-killing rally induced by further rate hikes, it could make a bad mistake worse.

John M. Longo, PhD, CFA

Director, WELREX®