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The Federal Reserve’s policy-making committee will meet on January 31-February 1, 2023, and their decision will be tough, more difficult than any of their 2022 choices. Inflation seems to be dropping, but at possibly unrealistic rates, while labor markets continue to show plenty of strength in the economy. With mixed signals coming to the committee, none of their possible choices is obvious.

Inflation is issue number one for the Fed, and the news is pretty dang good. The Fed watches the Personal Consumption Expenditures Price Index excluding food and energy. The most commonly-watched calculation, the 12-month percent change, dropped to 4.7% in the last reading from its peak of 5.4% in February 2021. That’s not a huge drop, but the 12-month change misses short-term swings. The last three-month change, annualized, was just 3.6%, down from 5.1% three months prior. Now that’s a significant deceleration.

Economists are usually skeptical about month-to-month blips in any time series. Our underlying data reflect sampling errors and idiosyncratic variation. We take a couple of months of change with a grain of salt. Still, the recent figures bring hope that the worst inflation lies behind us.

Although encouraging, inflation optimism baffles those who look at historical trends. The usual time lag between changes in monetary policy and inflation is about two years. That’s an oversimplification but captures the rough picture. Such a time lag was found in early Keynesian structural models of the economy, later non-theoretical analyses (vector auto-regressions), and most of the latest econometric models (dynamic stochastic general equilibrium models).

When assessing the plausibility that the Fed has conquered inflation, recall that their first interest rate hike of this cycle was in March 2022 and only one-quarter percent. They waited until May to push short-term interest rates up a half point, and then spread their four big rate hikes over a six-month period. (The full history is laid out in Forbes Advisor.) So the big inflation decline recorded in the autumn of 2022 came half a year from the beginning of the Fed’s anti-inflation effort, which was a very gradual beginning. It’s simply not plausible that monetary policy worked so quickly. More likely, the transitory elements—and there were some—came down, but the underlying problem of excessive stimulus remains.

So far interest-sensitive economic activity has declined, primarily single-family housing starts. Retail sales have fallen in the latest months. Layoff announcements are common news headlines. But declines in spending, employment, and production typically precede declines in inflation.

One good leading indicator of economic activity shows surprising strength: initial claims for unemployment insurance. Recent months (best viewed over a shorter time horizon) are well below the historical average, which includes recessions as well as booms.

My calculations, based on historically average responses of inflation to monetary policy, suggest another full percentage point increase in short-term interest rates, which could be implemented in stages over the next few months. Then rates would have to remain high until the middle of 2024.

Of course, there’s no guarantee that this business cycle will be average. There are actually reasons to expect the eventual recession to be delayed. First, business capital spending’s response to higher interest rates will likely be delayed because companies are trying to use equipment to substitute for the workers they have been unable to hire. Second, business labor force adjustments begin with the elimination of open positions, and when employees are actually let go they can often walk across the street to another company that remains understaffed. Third, savings that people accumulated during the pandemic have not yet been fully spent, so hefty bank accounts will cushion the eventual decline in spending.

Within the Fed’s meeting, there will be voices claiming substantial victory over inflation and no need to put the economy through more pain. There will be other voices pointing to historical experience and econometric models showing their work is not yet done. Both sides will have data to support their positions. This is a time of unusual uncertainty, and the Fed has no easy choice in front of it.

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