First, the good news. Given what we know about current economic conditions, it is likely that the consumer inflation rate has peaked in the U.S. for the current cycle. Recent inflation reports on the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Implicit Price Deflator, which is the Federal Reserve’s preferred measure, show a jump to new 40-year highs in March but signs of moderation in coming months. For example, consumer goods with very large 12-month cost runups such as used cars and food away from home are starting to see prices moderate. Likewise, prices of important household goods like apparel, furnishings, prescription drugs and recreation commodities (think TVs and Pelotons) are flattening. Furthermore, some important energy prices such as crude oil and gasoline have stabilized in April after jumps in the first quarter. So, while inflation will surely remain elevated for some time, it is unlikely to get much worse.
Now, some bad news. Inflation is really high and it is widespread, not just in the historically volatile food and energy sectors. The figure below shows the annual percent change in the PCE Deflator through March for both the headline (all items) index and the “core” index, which excludes food and energy. While the headline index has soared more, the core index shows inflation now running above 5% — well above the Fed’s target of 2%. Inflation as measured by the CPI has reached 5% in key sectors such as housing and transportation services.
Today’s CPI data for April also shows a moderation in core inflation over the previous 12 months to 6.2% (down from 6.5% in the 12 months through March). A concerning trend in the CPI data, however, is the continued acceleration in core services prices, and specifically the closely watched index of “Services Excluding Energy Services” plotted in the figure below. In April this series reached a 30-year high of 4.9%, and this also represents a widening of inflation pressures in the economy. A large part of this increase comes from shelter, and in particular owners’ equivalent rent (the measure of housing costs for people who own homes), which rose 4.8% in the year through April — the most since 1990. One caveat to the concern on services prices is that energy can still bleed through to this index. For example, airfares (up 18.6% in April alone) can be pressured by increases in jet fuel prices, which are the largest cost component for airlines.
While inflation is causing real problems for households today, there is longer-term danger for economic prospects as well. First, wage gains for many households are lower than the inflation rate so that “real” inflation-adjusted incomes decline. Second, Federal Reserve policymakers may be forced to engineer a “hard landing” by tightening policy so much that the economy tips into a recession. Third, if households and businesses come to expect higher inflation, it can become a self-fulfilling cycle. There is, however, some additional good news on this front. The graph below shows consumer expectations for inflation both for the near term (next 12 months) and long term (next 5-10 years). While near-term inflation expectations have jumped to over 5%, long-term expectations are up to just 3%, which is barely above the historical average since the global financial crisis. Consequently, consumers seem to still believe that inflation will come back down (thus making the Fed’s job easier).
There are a few other encouraging signs suggesting inflation has peaked. The recent bump in mortgage rates will help bring the housing market back into equilibrium. The recent decline in COVID-19 cases should allow more workers to reenter the labor force, helping cool the overheated labor market. In addition, the decline in COVID cases will help shift the economy back toward its pre-pandemic mix of goods and services — specifically, a shift back toward services will help moderate inflation in goods prices.
The big wild cards are how COVID-related supply disruptions in China play out and if continued hostilities by Russia in Ukraine cause further increases in energy prices. We hope things improve on both of these fronts, and not just for the sake of lower inflation, of course. Bottom line: Inflation conditions are not what we would like them to be nor what policymakers were expecting last year, but the worst is likely behind us.