We are achieving 2% Inflation: A Tough and Unpleasant Road Ahead.
In theory, bringing inflation closer to the Federal Reserve’s 2% target might seem straightforward. The main culprits for the inflationary pressure are primarily associated with services and shelter costs, with other components of inflation showing noticeable signs of easing.
Therefore, concentrating on just two segments of the economy might not be an insurmountable challenge, especially when compared to the summer of 2022 when almost everything was rising in price.
However, in practice, achieving this goal could be much more challenging than it appears at first glance. Prices in the critical areas of services and shelter have proven to be “sticky,” meaning they do not respond as quickly to economic cycles as some other goods, such as food and gas or used and new cars, which tend to fluctuate with the broader economic trends.
A significant adjustment may be needed to address this, which could be rather unpleasant. As Steven Blitz, the chief U.S. economist at GlobalData TS Lombard, suggests, “You need a recession” to bring inflation down to the target of 2%.
It’s a stark reminder that achieving inflation control may require extreme measures, like an economic downturn, which policymakers typically aim to avoid.
As of the most recent data, annual inflation as measured by the consumer price index (CPI) fell to 3.7% in September, or 4.1% when excluding volatile food and energy costs, which have been increasing steadily. While these numbers still exceed the Fed’s 2% target, they represent progress from earlier periods when headline inflation was well above 9%.
However, it’s crucial to note that this progress is uneven. Some factors, like used-vehicle prices and medical care services, have experienced easing, but the rise in shelter costs (7.2%) and services (5.7%, excluding energy services) has been substantial.
More specifically, shelter-related figures are critical components in the CPI computation, with rent of shelter rising by 7.2%, rent of the primary residence up by 7.4%, and owners’ equivalent rent increasing by 7.1%, including a 0.6% gain in September.
Addressing these persistent increases in shelter and related costs, the Fed’s goal of 2% inflation will likely be achieved shortly. These “sticky” price increases present a significant challenge to policymakers and can thwart attempts to control inflation effectively.
It’s worth considering the broader economic forces at play. “Sticky-price” inflation, which measures items like rents, various services, and insurance costs, ran at a 5.1% pace in September, a whole percentage point lower than it was in May, according to data from the Cleveland Fed.
In contrast, flexible CPI, which includes food, energy, vehicle costs, and apparel, ran at just a 1% rate. These figures indicate progress but must still catch up to the desired target.
The dilemma now lies in determining the central bank’s next steps. Will policymakers opt for another rate hike before the year’s end to combat the persistently high inflation, or will they stick to the relatively new “higher-for-longer” approach while closely monitoring the inflation dynamics?
Lisa Sturtevant, the chief economist for Bright MLS, a Maryland-based real estate services firm, argues, “Housing is the key driver of the elevated inflation numbers.” Higher interest rates have primarily impacted the housing market, affecting sales and financing costs.
Yet, despite these higher rates, housing prices remain elevated, and there is concern that they could deter new apartment construction and keep supply constrained.
One crucial factor that could keep the Federal Reserve from raising rates further is that rate increases totalling 5.25 percentage points have yet to impact the economy fully. This brings us back to the idea that the economy needs to cool down before the central bank can successfully achieve its goal of raising inflation to 2%.
One positive aspect is that pandemic-related factors have primarily washed out of the economy. Still, other persistent factors are at play.
Marta Norton, the chief investment officer for the Americas at Morningstar Wealth, suggests that “bringing inflation the remainder of the distance to the 2% target requires economic cooling, no easy feat, given fiscal easing, the strength of the consumer, and the general financial health in the corporate sector.”
Federal Reserve officials expect the economy to slow down this year, although they have backed off from an earlier prediction of a mild recession.
Policymakers have been banking on the idea that when rental leases expire, they will be renegotiated at lower prices, bringing down shelter inflation. However, the rising shelter and owners’ equivalent rent figures contradict that expectation, even though asking rent inflation is easing.
This situation raises questions about whether this trend is temporary or driven by more fundamental factors, such as higher rent increases in larger cities offsetting softer increases in smaller towns. Historically, there are no good examples to rely on for predicting long-term patterns in rent inflation, making the situation even more uncertain.
In conclusion, the path to achieving the Federal Reserve’s 2% inflation target is more complex than it may seem in theory. Persistent factors, mainly related to shelter and services, have proven to be resistant to the usual economic cycles and may require more drastic measures, potentially even a recession, to address.
As the economy faces uncertainty and policymakers grapple with the best course of action, the challenges of controlling inflation in the current economic environment remain a complex and ongoing issue.
