Perspectives: Sticky Inflation

June, 2024

Having raised interest rates sharply between 2022 and the middle of last year to curb inflation, Federal Reserve officials entered this year expecting to reduce borrowing costs. Unfortunately, a resurgence of inflation above expectations early this year upended that plan. However, the most recent monthly data declined from prior readings and returned to signs of slowing again, proving that it will be a bumpy path to reach the Fed’s target level. While two months does not necessarily make a trend, when combined with other data points suddenly showing economic cooling, the prospects for beginning the journey to more normal interest rates appears encouraging.

Inflation came down rapidly in 2023 but has gotten stuck above 3% this year.

The Consumer Price Index (CPI) came in above expectations in January through March of this year. Fortunately, that situation reversed itself in April and May, with the latest reading index climbing 3.3% from a year earlier, down from 3.5% in March. The core index, stripping out volatile food and fuel prices to get a better sense of the underlying trend, rose 3.4% last month, down from 3.8% two months earlier. That was the lowest annual increase in core inflation since early 2021, easing concerns that inflation was re-accelerating.

Digging into the details of increasing prices, progress on housing costs remains stubbornly slow. Shelter costs in the CPI have continued to rise more quickly than before the pandemic, a pattern that continued in May with rents up 5.4% from a year earlier (albeit the smallest annual gain in nearly two years). Housing is by far the largest monthly expense for most families, which means that it also plays a large role in inflation calculations. Encouragingly, private-sector data shows rent increases slowing. Interestingly, headline and core CPI excluding shelter were up only 2.1% and 1.9% year-over-year last month. However, if rents keep rising at their current rate in the index, it will be difficult for inflation overall to return to normal.

While inflation is still too high, continued progress will also likely depend on further cooling of the U.S. economy and consumer demand to reach the Fed’s 2% goal. It could be taking longer for higher interest rates to work this time around as many homeowners and businesses locked in very low rates when borrowing costs were extremely low over the past decade. Fed officials have steadfastly maintained that they will keep interest rates at a high level until they see tangible proof that inflation has declined and will remain there. Moving too quickly to lower rates would risk boosting inflation and destroying the significant progress that has already been achieved.

Inflation returning to normal does not mean that prices will revert to historic levels. This is a lesson our younger generation is learning for the first time due to many price increases having been mostly minor for so long. Slower inflation just means that prices are no longer going up as quickly, not that they are coming down after their rapid rise in 2021 and 2022.

Investor expectations regarding interest rate cuts resulting from lower inflation have been dashed several times in the past year. Trying to predict these things with any type of precision is notoriously difficult. There was even concern recently that rates may need to be raised some more, an idea that Fed policy makers have called highly unlikely. The current thinking is that rate cuts may begin as early as late in the third quarter of this year. As this is an election year and the Fed wants to be viewed as politically neutral, that may also have an impact on the timing.

The stock market’s recent momentum is a result of the expanding economy and growing corporate earnings. It is conceivable that interest rate cuts may not begin until next year. That timeframe for lower rates could create additional near-term volatility, but should not derail the longer-term trajectory for stocks.