Financial markets are confident that inflation in the US will reach the Fed’s target without significant costs to the economy. Interest rate markets price a return of inflation to the 2% level (see Chart 1) while risk markets rally without any fear of recession.1
The optimism has been boosted by the Fed’s shift in guidance. Based on the latest summary of economic projections, the FOMC expects inflation returning to target over 2024-25, alongside moderate growth, stable unemployment and nearly 200bps of rate cuts.2
Source: JP Morgan3
In our view, such “soft-landing” is possible but not assured. Our main concern is that the disinflation progress could lose momentum amid firm consumer demand, a tight labor market and housing conditions, and the return of supply-chain pressures.
We think inflation could temporarily reach the 2% level but worry that it will rise again during the year, towards 3%. As a result, we think the Fed is right to be cautious and to look for more evidence that inflation is moving sustainably toward 2%.4
Measured by the personal consumption expenditure deflator (PCE), the Fed’s official target for price stability5, headline inflation has dropped from a peak of 7.1% in June 2022 to 2.6% in December of last year.6 Looking at annualized 3-months-over-3-months (3m/3m) changes, the PCE deflator was up just 1.7% at the end of last year.7
Given the current dynamic, we think that headline PCE inflation has a chance of hitting the Fed’s 2% target at the end of the first quarter of this year. The question to us is whether 2% PCE inflation is sustainable.
Chart 2 shows the main components of the annualized 3m/3m changes of the PCE deflator. The first round of disinflation in 2022 came from energy and core goods prices. This was followed by a moderation in food price increases.
Source: U.S. Bureau of Economic Analysis and ZAIS’s own calculations.8
In 2023, the biggest disinflation push came from core services ex housing. Housing-related inflation has moderated a bit, but is still running high by past standards.
Source: U.S. Bureau of Economic Analysis and ZAIS’s own calculations.9
Table 1 exhibits the quarterly changes of the main PCE components in the fourth quarter of last year and their weighted impact on the overall change of the PCE deflator.
The currently favorable dynamic of the PCE deflator rests on the deflationary impact from core goods prices, lower energy prices and the moderation in core services prices ex housing, which is by far the largest component of the PCE deflator.
A lot can happen to derail the disinflation progress. For example, rising geopolitical tensions could boost energy and food prices. In our view, sustainability of inflation around the Fed’s 2% target depends primarily on the normalization of labor market, housing and supply-chain conditions as well as overall consumer demand.
Labor market conditions remain tight by past standards. The unemployment rate is near the lows of the last 50 years and below the Fed’s long-run estimate,10 employment growth is well above trend,11 the job opening rate – although off its peak – stays atop the unemployment rate12 and wage growth pressure is still very elevated (see Chart 3).
Source: Federal Reserve Bank of Atlanta13
We expect some moderation but absent a negative shock believe that labor market conditions will remain tight, keeping wage growth pressure elevated. This has implications for the demand side (solid income growth) as well as the supply side (cost pressure) and in our judgement means that a key source of underlying inflationary pressures will stay very alive in 2024.
The accumulation of excess savings during COVID has allowed consumers to spend more and save less over the last two years (see Chart 4). The fact that the savings rate stayed low through the end of last year suggests to us that some savings buffer remains to support above-trend consumption through at least parts of this year. Furthermore, with the run-up to the election, fiscal policy is unlikely to turn unfriendly to consumers this year.
The positive backdrop for consumers is also visible in the recovery of consumer sentiment over the last year, especially as the disinflation progress has improved consumers’ real spending power.14
Summarizing, we think that, absent any shock, consumer spending is likely to stay firm for at least the first half of this year.
Source: U.S. Bureau of Economic Analysis15
As pointed out before, a significant part of the disinflation progress was driven by core goods. In fact, falling core goods prices helped offset prevailing inflationary pressures in other sectors last year (see again Chart 2 and Table 1). We think this dynamic is likely to change this year.
Growth in goods consumption has moderated after the boom in 2020-21, but the level of goods demand remains high compared with the pre-Covid trend (see Chart 5).
On the other hand, supply-chain conditions, which were the main driver behind the disinflation progress, are no longer improving. Since the middle of last year, more manufacturers are reporting rising input prices, and the global supply-chain pressure index is moving higher, as well (see Chart 6). This partly reflects rising global transportation costs linked to the tensions in the Middle East.16
Source: U.S. Bureau of Economic Analysis and ZAIS’s own calculations.17
Source: Federal Reserve Banks of New York and Institute for Supply Management18
An additional problem in the manufacturing sector is declining productivity (see Chart 7). This is not new news and has been a trend for more than 10 years, but becomes more pressing given our outlook of persistent tight labor market conditions. As a result, we view manufactures as more likely to look for opportunities to pass on unit labor costs pressures as long as demand conditions are favorable. All in all, we think a resurgence in goods price pressures as seen in 2021-22 is not in the offing, but we expect core goods prices to gradually rise this year unless demand suddenly weakens.
Source: US Bureau of Labor Statistics19
Housing remains the most stubborn source of inflation so far. Housing accounts for 15% of the PCE deflator basket, yet its impact accounted for ro¬ughly half of the PCE deflator increase in the fourth quarter of last year (see Table 1, again). We are not prepared to enter the debate about the merits and faults of the calculation method of housing in the PCE deflator but we acknowledge research that suggests that the changes in new tenant rent inflation lead to changes in PCE housing inflation with a lag of about 12 months.20
Source: US Bureau of Economic Analysis and Zillow21
On that basis, Chart 8 suggests to us that the moderation in new-tenant rent inflation is largely reflected in the housing PCE deflator.
In fact, new-tenant rents reaccelerated since last August (see Chart 8 again). This is not yet a strong trend but we see this as a sign that the housing market remains tight, which is also evident in the reacceleration of house prices.22 We believe this tightness is largely structural23 and, while we do not expect another surge in rents and house prices as in 2021, we think housing inflation will remain well above the levels prior to COVID.
Given our outlook of persistent elevated housing inflation and fading deflation from the core goods sector, all depends on a favorable development of core services inflation excluding housing, often called super-core inflation, which Fed Chairman Powell referred to as "may be the most important category for understanding the future evolution of core inflation."24
As seen earlier in Chart 2, the inflationary pressure from the super-core component on the PCE deflator has declined by more than half since the beginning of 2023 and the 3m/3m annualized change was running at 2.3% in the fourth quarter of last year (see Table 1, again). However, we caution against expectations that super-core PCE inflation will ease much further and stabilize at or below 2% for four reasons.
First, the recovery of demand in the super-core sector continues with real spending in the super-core sector growing 2.7% in the fourth quarter of last year versus the pre-Covid trend of 2.3%.25
Second, we agree with Fed Chair Powell that wages are the largest cost component in delivering services.26 Thus, given our view that labor market conditions will remain tight this year, we also expect wage cost pressures in super-core inflation to persist.
Third, the PCE deflator is partly based on non-market-based price estimates.27 The share of non-market-based price estimates is particularly high in the super-core component, accounting for more than a quarter of the total, including financial services as well as insurance for health-care, income-loss, life, motor vehicle and workers’ compensation.28
Source: US Bureau of Economic Analysis29
Chart 9 shows the 3m/3m annualized changes of the two price estimates in the super-core PCE deflator. Non-market-based prices have historically been more volatile, but increased at a similar pace on a trend basis as market-based prices before COVID.30
This co-movement has broken down at the start of COVID with market-based price estimates rising at a much faster pace than-non-market-based prices over the last two years (see Chart 9 again).
Trying to reconcile the gap between the two price estimates in detail exceeds the scope of this report. However, the market-based price estimate is sticky in our view and will only moderate if wage pressures ease significantly, which we do not anticipate.
On the other hand, we expect that the non-market-based estimate will adjust towards the more stable market-based price estimate over time. In particular, we do not expect the non-market-based super-core PCE deflator to keep falling as it did at the end of last year. If we are right, we think upcoming reports will show upward pressure on the overall super-core PCE deflator.
Our fourth caution relates to health-care services, which account for nearly 40% of the super-core PCE deflator.31 The large majority of health-care services in the PCE deflator is typically paid for by insurance providers, of which roughly 40% is Medicare and Medicaid and the rest is private insurance companies.32
Typically, the producer price index (PPI) for private health-care services tracks the health-care services PCE deflator well (see Chart 10). Since COVID, however, the health-care services PPI has outpaced the health-care services PCE deflator. This means to us that Medicare and Medicaid have been able to resist the rising health-care cost pressures to some degree.
Source: US Bureau of Labor Statistics and US Bureau of Economic Analysis33
Efforts by Medicare and Medicaid to cap cost increases are understandable, but a full decoupling from the cost pressures in health-care services is unlikely in our view.
As a result, we expect PCE inflation in health-care services to remain elevated by past standards.
Table 2 shows our forecasts for PCE headline inflation and its main components for the fourth quarter of this year versus the fourth quarter of last year. As we outlined at the beginning, it is possible that headline PCE inflation moves temporarily lower, but we expect it to finish this year roughly at the same level where it was at the end of last year, which would be above the Fed’s projection of 2.4%.34
Source: U.S. Bureau of Economic Analysis and ZAIS’s own calculations and forecasts.
35
One obvious wild-card is energy prices, which could swing sharply in either direction and also move the overall inflation outcome significantly. However, excluding energy, our forecast does not change significantly (see Table 2, again).
As we argued at the start, sustainability of 2% inflation depends on the normalization of labor market, housing and supply-chain conditions as well as overall consumer demand. The tightening in supply-chain conditions may prove temporary and overall price stability may be achievable even if housing conditions remain tight. However, that means to us that much more cooling in labor-market and overall consumer demand conditions is needed to anchor super-core and headline inflation at 2%.
A different warning sign that underlying inflationary pressures persist comes from small businesses, which are an important part of the economy and heavily tied to the labor market.36 The Small Business Survey of the National Federation of Independent Businesses shows that employment conditions37 remain tight for the majority of firms and that more firms plan to raise prices again (see Chart 11).
Source: National Federation of Independent Businesses38
Throughout this report we have focused on the PCE deflator because it is the Fed’s official target. However, that does not mean that we ignore the consumer price Index (CPI). The CPI varies from the PCE in several ways; most importantly, housing has a much higher weight in the CPI than in the PCE deflator.39
Still, thanks to the earlier publication of the monthly CPI by about two weeks before the monthly PCE deflator40 we view the CPI as an important leading indicator of both short-term inflation dynamics as well as underlying inflation trends. In this sense, the just released January 2024 CPI report serves as a warning, that inflationary pressures persist, especially as super-core services prices increased strongly.41
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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