Ever since legendary Federal Reserve Chair Paul Volcker killed inflation with draconian interest rate hikes, his ghost has haunted successors at the central bank.

Inflation peaked at 12.2% in 1974, caused by Middle East oil shocks but also by rampant government spending on the Vietnam War and Great Society during the 1960s. Vietnam was deeply unpopular and new social programs had to overcome political opposition, so President Johnson refused to raise taxes to fund his massive new expenditures. The seeds of inflation were sown.

The cigar-chomping Volcker took the reins of the Fed in 1979 and eventually hiked rates to 20%, causing a severe recession. Unemployment soared past 10%. But the bitter medicine worked. By 1983, inflation had fallen to just over 3%.

To the current generation of policymakers, Volcker is the inflation whisperer. But luckily, a new inflation report arrived Tuesday that greatly reduces the odds of Fed Chair Jerome Powell going “full Volcker.”

The U.S. Bureau of Labor Statistics reported Tuesday that the Consumer Price Index (CPI) in November increased 7.1% over last year and 0.1% over the month. The consensus estimate had called for prices to increase at 7.3% annually and 0.3% on a monthly basis (see the following snapshot).

On a “core” basis, which removes the volatile food and energy components, prices rose 6.0% year-over-year and 0.2% over the month. Consensus estimates had called for a 6.1% annual increase and 0.3% monthly increase in the core CPI reading.

Investors were cheered by the cooler CPI numbers; Wall Street sees the latest inflation data as a positive game changer. The main U.S. stock market indices closed higher on Tuesday, as follows:

• DJIA: +0.30%
• S&P 500: +0.73%
• NASDAQ: +1.01%
• Russell 2000: +0.76%

All 11 S&P 500 sectors are higher, week to date.

Overall inflation has been easing on an annual basis since hitting a peak in June, demonstrating that price increases are turning a corner after several months of sharp spikes.

Many economists earlier this year had argued that inflation was transitory. They were premature in their assessment. Instead, inflation remained persistently elevated, propelled by food and energy shortages, disruptions caused by the Russia-Ukraine war, and pandemic-induced supply chain woes.

But that’s finally changing. Economists at JPMorgan (NYSE: JPM) wrote ahead of Tuesday’s CPI report: “We continue to believe that the underlying trend for inflation is moderating.”

All eyes have turned to the Federal Reserve’s Dec. 13-14 policy meeting. Powell is scheduled to hold a press conference immediately after the meeting on Wednesday. The expectation is that the Fed will hike interest rates by 0.50%, a step down from its series of 0.75% increases.

The Fed’s mandate is to keep prices stable without hurting the economy, preferably with inflation levels at roughly 2% annually. Make no mistake, the Fed doesn’t want to reverse inflation. The central bank also must guard against deflation, i.e. falling price levels, a dynamic that undermines the economy.

If overall prices are declining, consumers would be motivated to curb spending because they expect costs will be lower in the future. Decreased spending leads to less hiring and business investment, which translates into more layoffs and slower wage gains.

If Americans can be assured that prices will only rise at a stable and low rate of around 2%, they can better manage their finances and investments.

At long last, inflation is coming down, underscored by not just today’s CPI report but also by last week’s Producer Price Index (PPI) report. But with inflation running at its highest levels in 40 years, the U.S. is a long distance from the Fed’s stated inflation target.

Complicating the Fed’s work are data lags. The central bank can’t immediately witness the complete consequences of its rate hikes; it takes time for monetary policy to wend its way through the economy.

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