Inflation has slowed–but high prices are here to stay. Here’s why the next rate hike should be the Fed’s last

On January 12, the Bureau of Labour and Statistics announced that U.S. Inflation has fallen to its lowest level in more than a year, another sign that price pressures are diminishing amid the Federal Reserve’s campaign to tighten monetary policy.

Inflation in the world’s largest economy is now at the lowest it has been since October 2021, with prices marginally dropping from last month by 0.1%. Inflation is clearly moving in the right direction–something consumers who saw their budgets stretched to breaking point in recent months will likely be relieved to hear.

However, even though the annual increase in prices has slowed to 6.5% (down from 7.1% in the previous month) it is still near a multi-decade high–and pressure on the U.S. economy remains strong. In November, the rate of wage growth was 6.2% (which is 0.5% less than October). We are still experiencing a loss of purchasing power net-net, which is cause for concern.

Also, prices are not dropping from gasoline to all other goods. Clothing prices increased 0.5% in November and December, and 2.9% over the previous year. This suggests that prices are not falling as quickly as analysts, including this one, would have expected.

How much more can the Fed tighten the U.S. Economy? 

The Federal Funds rate increased 50 basis points (bps) last time. That’s 0.25% less then the previous four increases, which were all 75 basis point increases. The Fed is already easing off the gas, realizing that the U.S. could be in a very serious recession.

Nonetheless, there is still a need to stabilize prices–especially given the tight labor market in the U.S. right now. According to the latest figures, unemployment has fallen to 3.5%, the lowest it has been since late 2020–and well below the 30-year average. This combined with wage growth of 6.2% indicates that inflation may be shifting from being driven solely by supply to being driven entirely by demand.

The demand for essential goods is still not increasing. In addition, we still see supply-side pressure in categories like clothing. This means that the Fed must tread carefully while it balances inflation, recession, uncompetitive dollars strength and a fraying tightrope in its ongoing interest rates campaign.

Lock the screws

While we wouldn’t be surprised to see the Fed continue to take a less aggressive stance in its effort to return inflation to 2%, it does need to continue to dampen demand. This is especially true for costly items like cars and homes, which will slow the economy down and help ease rising prices.

Of course, one way to achieve this is to increase borrowing costs–and this will mean more interest rate hikes regardless of declining topline inflation. The U.S. economy is at an important moment. The Fed will need to move fast to stop the Fed from cutting rates or holding rates. No one knows if the Fed can avoid a major recession.

While it is clear that inflation is cooling and will continue to do so over the coming months, another rate hike of at least 50 bps is likely at the Federal Open Market Committee’s next policy meeting from Jan. 31 to February 1st. This will bring the federal funds rate to 4.75%-5%–a crucial moment that historically has tended to mark the turning of the tide for inflation.

It is better to act sooner than later

The U.S. economy will face a crucial decision in the final quarter of 2023. Policymakers, investors, and consumers will be holding their breath to see how the Fed’s game of brinkmanship has played out. If all goes to plan, we will see inflation start to hover around 4.5%-5% come Q2–and this means the Fed could start to unwind and even cut rates this year.

Spotting the fine point at which to start this process will be the greatest challenge–and February would be a good time to start. If the Fed is going to pull the United States from the brink of recession, it should cut rates as soon as possible.

Oliver Rust is head of product for independent data aggregator Truflation.

Fortune.com commentary pieces express only the views of their authors. They do not necessarily reflect those of Fortune.com. Fortune.

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