Stalled Inflation Vexes the Fed. Is It Noise or a New Trend?

02/05/2024

Explaining why underlying inflation fell steadily from its pandemic peak of over 5% in 2022 to under 3% at the end of last year is straightforward: improved supply, softer demand and well-anchored inflation expectations.

Explaining why it stalled in the first quarter is a lot harder. The fundamentals still look good: Supply and demand are coming back into balance, at least in the labor market, and inflation expectations have edged lower.

There’s a case that the past three months were noise, inflation is still headed to 2%, and the Federal Reserve should cut rates soon.

But at its meeting this week Fed officials didn’t make that case, and you can’t blame them. They thought high inflation was transient in 2021 and regretted that. What looks like noise today may be turn out to be the trend, leaving inflation closer to 3% than the Fed’s target of 2%. “Inflation is still too high, further progress in bringing it down is not assured, and the path forward is uncertain,” Fed Chair Jerome Powell told reporters Wednesday.

Supply, demand and expectations are the foundation of the Fed’s—and most economists’—inflation model, and in the decades before the pandemic, it worked pretty well. It predicts that when demand runs ahead of supply, unemployment falls and inflation pressure rises. When demand falls short of supply, the opposite happens. As long as the Fed does its job, inflation will converge to 2%, because that’s what the public expects, and those expectations tend to be self-fulfilling.

The inflation surge in 2021 seemed to defy that model because unemployment was still relatively high. In retrospect, the jobless rate was misleading; record vacancy rates showed the job market was historically tight. Shortages of labor, inputs and logistics held back supply as fiscal and monetary stimulus fueled demand.

The Fed bet that if supply and demand came back into balance and expectations remained anchored, inflation would head down. That’s more or less what happened—until the first quarter.

The price index of personal-consumption expenditures excluding food and energy, the Fed’s preferred inflation gauge, was up 2.8% in the year through March. That was down slightly from December, but the quarterly annual rate has popped up to 3.7%.

Inflation often fluctuates for reasons only tenuously connected to current economic conditions: a spike in energy because of a production outage, or a new cellphone plan.

A model co-developed by San Francisco Fed economist Adam Shapiro divides core PCE inflation into cyclical components—those more sensitive to changes in unemployment such as bicycles, apartment rent and child care—and less sensitive “acyclical” components, such as financial-service charges, insurance and doctor visits.

It shows that while cyclical inflation stayed around 4% between the fourth and first quarters, acyclical inflation leapt from around zero to 4%. This suggests idiosyncratic factors exaggerated both the fall in inflation late last year and its rebound.

Idiosyncratic forces can be important yet subtle. After the 2007-09 recession, core inflation ran below 2%, even as unemployment fell. This was often blamed on structurally weak demand globally, the “Amazon effect” and globalization.

But in a 2019 report David Mericle of Goldman Sachs said those factors had little impact. Something more mundane did: the Affordable Care Act, which restrained many healthcare fees and so held down core inflation.

“One should not expect all of the fluctuations in inflation to have a satisfying economic explanation,” Mericle wrote at the time. “Getting the direction of the economy right is no guarantee of getting the inflation forecast right.”

Mericle thinks something similar is going on now, in the opposite direction. Car prices went up two years ago, but that is only now being reflected in insurance because of the time it takes for states to approve premium increases, he said. Hospitals set multiyear contracts, which are now adjusting to cost increases in 2022 such as nurses’ salaries, he said.

Housing is the single biggest component of core inflation, and one of the most cyclical as newly signed leases flow into inflation measures of tenant rent and “owners’ equivalent rent”—what a homeowner would pay to rent his own house. Because leases turn over slowly, changes in market rents show up in inflation with a lag.

But even assuming that lag, economists are surprised housing inflation hasn’t fallen more, given that new tenant rent increases have plummeted from 12% in early 2022 to just 0.4% by the first quarter.

“By all accounts that should be feeding into OER and tenant rent and it has failed to do so with the timing and magnitude a lot of us expected,” said Jonathan Pingle, economist at UBS.

Powell has been predicting a big decline in OER since late 2022. On Wednesday, he acknowledged, “The lags are significantly longer than we thought.”

Forecasters have a natural temptation to classify as noise anything that doesn’t fit the expected trend. That’s risky—maybe the trend isn’t what they thought.

The San Francisco Fed data show that after excluding acyclical influences, cyclical inflation is still above 4%. In the labor market, wage growth has fallen steadily, yet first-quarter levels are consistent with inflation closer to 3% than 2%, absent a productivity boom.

Finally, survey data seem to suggest people expect inflation to run a bit above 2% in coming years, after years of expecting it to run below 2%. That shows “there has been at least some regime change” in trend inflation, said Emi Nakamura, an economist at the University of California, Berkeley who studies inflation dynamics.

Inflation a bit above 2% would be fine, she said, but the risk of 3% instead can’t be dismissed. “It’s hard to erase from people’s memories the recollection of really explosive inflation.”

The Fed isn’t a passive player here. If it treats the recent uptick as noise and cuts rates, it could fire up demand and raise expectations, in effect turning the noise into the new trend.

“The recognition that the Fed will react to substantial inflation is something that affects people’s beliefs,” Nakamura said. “A lot of what the Fed is doing is a confidence game.”

Write to Greg Ip at [email protected]