Opportunistic Disinflation Redux?

Summary

• Fed Chair Jerome Powell has signalled he intends to keep inflation within its current range.
• He likely intends to implement opportunistic disinflation, a Fed strategy from the 1990s that relies on disinflationary shocks to lower inflation.
• But today’s macro backdrop is less favourable compared with the 1990s, suggesting the desired disinflationary shocks may not materialize.

Market Implications

• I still expect no cuts in 2025 against markets pricing about three.
• I still expect a December cut, in line with markets.

The Fed’s Super-Slow Last Disinflation Mile

The Fed is still easing policy despite inflation stabilizing above 2%. This likely reflects two factors. First, as Governor Christopher Waller has stressed, the monetary stance remains restrictive (Chart 1).

Second, the Fed is comfortable with returning inflation to target over an extended period. The SEP shows this, forecasting core PCE slowing to 2% by end-2026 from 2.6% at end-2024. Furthermore, at the 7 November FOMC, Powell stated, ‘the nonhousing services and goods, which together make up 80 percent of the core PCE index, are back to the levels they were at the last time we had sustained 2 percent inflation, in the early 2000s’ (Chart 2).

In his last speech on 14 November, Powell further specified, ‘Core measures of goods and services inflation, excluding housing, fell rapidly over the past two years and have returned to rates closer to those consistent with our goals. We expect that these rates will continue to fluctuate in their recent ranges. We are watching carefully to be sure that they do.’

I think the Fed plans to use the opportunistic disinflation strategy of the mid-1990s to bring inflation back to target without engineering a recession.

1990s Opportunistic Disinflation

Under opportunistic disinflation, once inflation had fallen close enough to target, the Fed stops trying to create economic slack (i.e., unemployment) to lower it. Instead, its reaction function becomes asymmetric. It tightens in response to inflationary shocks but does not ease in response to disinflationary shocks.

Philly Fed President Boehne first mentioned the strategy in 1989. Vice Chair Blinder mentioned it again in 1994, and it was formally described in a Finance and Economics Discussion Series (FEDS) note in 1996.

Based on Don Kohn’s recent comments, a 40-year Fed veteran who was vice chair during 2002-10, this approach explains Fed policy in 1982, 1984, 1988-89 and 1994-95. The Fed tightened in 1982 and 1984, even though unemployment was still high (Chart 3). The Fed tightened in response to accelerating or stabilizing inflation in 1988-89 and 1994-95, but only responded with a lag, and partially, to the resumption of disinflation even when unemployment was high.

Opportunistic disinflation was adopted for two reasons. First, policymakers’ assessment of the trade-off between unemployment and inflation changed as inflation approached target. Writing in 1996, Don Kohn said ‘we are still not very clear about the costs and benefits of that last little bit of disinflation.’

I think the other Fed motivation could have been financial stability. The stabilization of inflation in the early 1980s was followed by the beginning of financial liberalization and a period of financial instability. On Monday 19 October 1987, the DJIA fell 23%, without any clear driver. In addition, the S&L crisis lasted from the mid-80s to the mid-1990s. There were also a several large bank failures in the 1980s and early 1990s, most notably Continental Illinois in 1984, the largest bank failure in history at the time.

The advantage of opportunistic disinflation is that it does not require the Fed to hike aggressively. This limited the financial risks associated with policy tightening and disinflation.

There appears little Fed discussion of the outcome of opportunistic disinflation, possibly because it became ‘too successful’. Core PCE fell to 1% YoY in June 1998 and remained below target until the pandemic, except for the four years before the GFC. Furthermore, in 2003 the Fed declared low inflation ‘unwelcome.’

Like Don Kohn in the 1990s, Powell is likely unconvinced the last inflation mile is worth increasing unemployment, and that is why I believe he is hoping to rely on disinflationary shocks to return to target.

Can Opportunistic Disinflation Provide a Soft Landing?

If opportunistic disinflation is the Fed’s game plan for 2025, it is less likely to work than in the 1990s.

First, the era of globalization and fast manufacturing productivity gains is likely over. World trade has been falling relative to GDP, which suggests shorter supply chains, reshoring and reduced trade specialization (i.e., lower efficiency and higher production costs, Chart 4). In addition, productivity gains in semiconductors, that are the core of the IT economy, have slowed (Chart 5).

Second, domestically, renewed union militancy since the pandemic suggests more conflict over income distribution, higher wage growth, and a steeper Phillips curve (Chart 6).

Also, the Fed has allowed inflation to remain above target for over three years and is not planning for inflation to return to target for another two years. This could explain why long-term inflation expectations have increased, which could make the last disinflation mile very difficult (Chart 7).

By contrast, during the 1990s globalization was taking off, Moore’s law was in effect, and union militancy and inflation expectations were falling.

The likelihood of negative inflation shocks therefore seems lower this time. The risk to this view is energy prices. The incoming Trump administration will be looking for lower energy prices. However, compared with the 1970s, the US economy is much less energy intensive. This could explain the recent decoupling of energy and core inflation (Chart 8).

And if the Trump administration imposes tariffs or increases the budget deficit, disinflation shocks could be even less likely.

Market Consequences

The disinflationary shocks the Fed likely hopes for are unlikely to materialize in 2025. This suggests the Fed will be unable to cut the Federal Funds Rate. My 2025 view compares with markets pricing about three cuts.

I still expect a December cut, based on the next core PCE estimate remaining near 25bp MoM and on a large negative non-farm payrolls surprise in December. My conviction aligns with markets pricing about a 75% chance of a cut.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)