Inflation keeps cooling as Fed begins to worry about ‘mild’ recession

The U.S. economy seemed to shift into a different phase in March, as inflation slowed to its lowest rate in nearly two years, and Federal Reserve staff projected that last month’s banking crisis could push the country into a “mild” recession later this year.

The central bank has spent the past year raising interest rates to fight rising prices, forcing seismic changes for many households and businesses.

Inflation easing could be welcome news that their approach is working, though prices for rent and food continue to push higher. The Bureau of Labor Statistics reported prices rose 5 percent in the year ending in March, the smallest 12-month increase since May 2021 and down from the 6 percent rate notched in the year ending in February. In comparison with February prices, March prices rose 0.1 percent.

But March also saw major problems in the banking sector, caused in part by rising interest rates. That instability is one factor that led Fed staff to project a mild recession later in 2023 during the central bank’s March policy meeting, according to minutes released Wednesday. Top Fed officials, though, issued projections at the same meeting that the U.S. economy would keep growing, and they say it could be too soon to tell how much banks pull back and tighten credit.

Reading the inflation report, economists emphasized the need to stay cautious and not treat all sources of price hikes as equal. For example, inflation reached a peak of 9.1 percent in large part because Russia’s invasion of Ukraine temporarily upended global oil markets. Falling energy prices since then have helped bring overall inflation down. But meanwhile “core inflation,” a closely watched measure that strips out more-volatile categories such as food and energy, rose 5.6 percent over the previous year in March—after months of declines.

“To use my car analogy, we’ve managed to get through really difficult conditions—slowing the car, getting around the wrecks—but that means we’re only part of the way to our destination,” said Betsey Stevenson, an economist at the University of Michigan and a member of the Council of Economic Advisers in the Obama administration. “If we were to hang a banner up right now that says ‘Mission accomplished,’ I feel pretty confident we would wreck the car.”

The markets initially cheered the inflation report Wednesday morning but later gave up their gains. The Dow Jones industrial average closed down 37 points, or 0.1 percent. The S&P 500 dipped 0.4 percent, and the Nasdaq fell 0.85 percent.

To get the economy back to normal, the Federal Reserve is raising interest rates, hoping it can get borrowing costs high enough to cool demand without forcing the country into a recession. The central bank has raised rates nine times since March 2022 and probably is on track for one more increase in May, before hitting pause and letting its work filter through the economy. Economists expect that the Fed’s policy rate, known as the federal funds rate, will ultimately hover around 5.25 percent and stay there through 2023. That rate is between 4.75 and 5 percent now.

But policymakers’ careful planning has been repeatedly thwarted by shocks beyond their control. Most recently, the failure of two banks triggered panic throughout the banking system and caused the Fed and other regulators to launch an emergency intervention to stave off broader contagion. That raised new questions about the ways higher borrowing costs can fuel instability in the financial system and whether banks are adequately preparing themselves for an environment where rates stay higher for longer.

It’s not uncommon for Fed staff to have slightly different outlooks on the economy than the central bank’s policymakers, and detailed meeting minutes often offer a range of views on what may lie ahead. The minutes also reflect what Fed staff were advising at the time of the March 21-22 meeting, right after the failures of Silicon Valley Bank and Signature Bank sent panic through the financial system and caused an emergency government response. The Fed’s policy committee will meet again May 2-3.

Any repercussions from the bank failures were not expected to show up in the March inflation report.

Fed officials do think last month’s events will eventually slow the economy by tightening credit conditions in ways that mimic interest rate increases, but how much remains to be seen. In a speech Wednesday, San Francisco Fed President Mary Daly said there is plenty of uncertainty as to where the economy is headed: Recent stress in the banking system means banks are becoming more risk-averse and issuing fewer loans. Central banks around the world are hiking rates at the same time. The Fed’s own moves over the past year have lag times that are not entirely known.

But through it all, inflation is still too high.

“While the full impact of this policy tightening is still making its way through the system, the strength of the economy and the elevated readings on inflation suggest that there is more work to do,” Daly said.

Without any sort of playbook, policymakers are trying to slow the economy without going so far that the labor market seizes up and large numbers of people lose their jobs. It’s looking good so far: Jobs data released last week showed that employers added 236,000 jobs in March. That was the 27th straight month of solid growth and brought the Black unemployment rate to a record low.

Stevenson cautioned that such progress could be undone if policymakers start getting jittery and raise rates too fast or too much. Once they stop raising interest rates, Fed officials will face the new challenge of waiting to tinker with borrowing costs until enough time has passed and they can see whether their policies are working.

“Doing nothing is an active choice, but it’s probably the least satisfying active choice,” she said.

Housing costs were by far the largest contributor to the monthly price increase in March, more than offsetting a 3.5 percent drop in the energy index. Rents rose 0.5 percent in March, although that was a slower pace than in the previous month.

Car insurance (up 1.2 percent), airfares (4 percent), household furnishings (0.4 percent) and new vehicles (0.4 percent) all rose in March.

Yet costs for medical care as well as used cars and trucks fell 0.3 and 0.9 percent over the month, respectively. In comparison with last year, used-car prices are down 11 percent.

In one of the largest turnarounds from last year, energy costs have fallen significantly since the start of the war in Ukraine and the imposition of new Western sanctions on Russia in response. That helped the overall inflation number tick down a full percentage point.

Gas prices are expected to jump again after the oil-producing bloc known as OPEC Plus announced plans to slash production. The average gallon of gas in the United States cost $3.62 on Wednesday, according to AAA, and some analysts expect that if demand picks up over the summer, prices at the pump could pass $4 again this year.

And the Fed has not seen enough relief in many other parts of the economy, either. In the housing market, rising interest rates triggered a huge run-up in mortgage costs, which can cause buyers to bow out of the market or drive prices down. That slowdown hasn’t meant much in the rental market, though. Rents on new leases are moderating in some parts of the country. But those gains are still being offset by rising rents for many tenants who are renewing their contracts.

“Inflation is running about three percentage points above the Fed’s target,” said Harvard economist Jason Furman. The Fed aims for an annual rate of about 2 percent, using its preferred method of gauging inflation, the personal consumption expenditures index, which isn’t the one updated Wednesday. “It is not as horrible as it was nine months ago. But no one thought inflation was going to stay at 9 percent.”

In the auto sector, wholesale used cars prices have risen more than expected this year. That has car experts bracing for a larger rise in retail prices, since dealers who are paying more for cars at auction will pass higher prices on to consumers.

At New Life Auto Sales, high wholesale prices have “been the story all along,” said general manager Horace Bruce. The used-car dealer in Charleston, S.C., focuses on models under $20,000, and consistent customer demand has kept business strong. Bruce said that people have learned “not to get too picky” about sticker price and that if they like one of the 50 cars he has on the lot, they should buy it.

But Bruce said his business comes down to supply and demand. He doesn’t see wholesale prices moderating until the computer chip shortage is fully resolved and sales of new cars pick up, so that those models can trickle down into the pre-owned market.

“If I had a crystal ball, I’d be rich,” Bruce said. “But I don’t know what the future holds.”