The Federal Reserve's path to two percent inflation could be short but difficult

The annual conference of central bankers of the US Federal Reserve begins on Thursday in Jackson Hole, Wyoming. The main topic is inflation and interest rates. Perhaps there will be clues as to whether the Fed will begin cutting interest rates in September.

July's consumer price index actually made a cut seem more likely. Over the previous 12 months, it was 2.9 percent. But of course that's not 2 percent – the Fed's inflation target – which means there's still a long way to go. How hard will it be to reach that target?

To understand what the Fed expects in the coming months, year, or however long it may take, it is helpful to understand why the Fed may start cutting interest rates before inflation reaches 2 percent.

“One of the comparisons people make is that you're driving a car but you can only look in the rearview mirror,” says Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis.

We don't know exactly what's happening because there's a lag in the data. That means inflation could already be lower. So the Fed needs to plan ahead because not only is there a lag in the data, but there's also a lag in the response of consumers and businesses to the central bank's actions.

“It will take some time for the effects of this interest rate cut to be felt in the economy,” he said.

Now you may be wondering if the Fed can't just feed all the data into a model and make predictions. In fact, that's what it does. But forecasts don't take into account the infinite uncertainties: What will happen to commercial real estate? Will tariffs be raised, which could drive up prices? What if the data from the past few months was a fluke?

“It is very, very difficult to predict. But I am sure the people at the [rate-setting committee] “People will be scratching their heads and asking, 'What are the risks?'” says Ken Kuttner, a former Federal Reserve Bank of Chicago and New York employee.

That is one reason why the Fed is likely to move slowly, according to Kuttner. “There could be a break between meetings and [they’ll] say, 'Okay, we'll cut in December, maybe not in January, because we want to see how things develop.'”

The Fed will also proceed slowly because – to use a popular metaphor – the smaller the target, the more precise the instrument.

“When you have 9% inflation, anyone could be a central banker. You raise interest rates,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. “So now they're at the point where it takes a lot of judgment and luck to get the point right.”

The risk of making a mistake and driving up unemployment too much is greater today.