The Fed is sounding more optimistic about inflation

In the second half of last year, Fed communications had the tone of a stern parent punishing a wayward child. "This is going to be painful, we hate to have to do this, but it's for your own good."

• But something is shifting in these early days of 2023, with top officials at the central bank sounding, dare we say, a bit optimistic that they can vanquish inflation without Americans experiencing too much economic pain.

Why it matters: The Fed is likely to raise interest rates by a quarter-percentage point at its meeting next week, but appears set to wind down its campaign of rate hikes before much longer, assuming inflation cooperates.

• The focus is on whether recent progress proves lasting, and not causing more economic distress for its own sake.

What they're saying: In a Friday speech titled "The Case for Cautious Optimism," Fed governor Christopher Waller said that while there are reasons to be cautious about the recent good news, "it is good news."

• "Six months ago, when inflation was escalating and economic output had flattened, I argued that a soft landing was still possible — that it was quite plausible to make progress on inflation without seriously damaging the labor market," Waller said.
• "So far, we have managed to do so, and I remain optimistic that this progress can continue," he added.
• While Waller is not part of the Fed's leadership troika (chair Jerome Powell, vice chair Lael Brainard, and New York Fed president John Williams), his speeches last year were a good guide to where the Fed was heading.

Meanwhile, Brainard argued in a speech on Thursday that "wages do not appear to be driving inflation in a 1970s-style wage–price spiral." She noted inflation-adjusted pay hikes for low-wage workers have been offset by a drop in real wages for higher earners.

• She also suggested the spike in business profit margins that coincided with the inflation surge could reverse in coming months.
• "Retail markups in a number of sectors have seen material increases in what could be described as a price–price spiral," Brainard said. "The compression of these markups as supply constraints ease, inventories rise, and demand cools could contribute to disinflationary pressures."

Yes, but: Fed leaders are attuned to the risk that low core inflation in the fourth quarter of 2022 could be a false dawn, as was the case in summer of 2021. "We do not want to be head-faked," Waller said.