Tyler Le/BI
What a difference three months makes.
At the end of 2023 and the start of 2024, it appeared that the US was on a glide path to what I termed "economic nirvana": Growth would stay steady, if not spectacular, as inflation cooled off to a more manageable pace. This combination would not only let America continue its four-year expansion but also allow the Federal Reserve to ease up on its attempts to rein in the economy — and maybe even cut interest rates.
The data released over the past couple of months has forced me to reconsider my expectations for that nirvana, or at least the timing of its arrival. Recent signs point instead to an inflationary boom: a slightly hotter economy in which growth has stayed strong while inflation has sped back up. The labor market has been resilient, with recent jobs reports mostly coming in ahead of expectations and the Employment Cost Index, a widely followed measure of employee-compensation growth, picking up.
But perhaps the most eye-catching development has been the persistence of inflation, which caught economists, analysts, and, most importantly, members of the Federal Reserve by surprise. The core personal consumption expenditures index — the Fed's favored inflation gauge that excludes volatile categories such as food and energy — has accelerated, undoing much of the progress from the previous six months. This inflationary-boom dynamic has pushed out expectations for rate cuts, caused some more alarmist analysts to suggest that the US is about to be gripped by another bout of high inflation, and left some wondering whether the Fed's next move will instead be to hike rates.
It is, of course, fair to reevaluate one's expectations when new data is presented. Sticking with one's projection just to avoid being wrong is a sign of poor analysis. But after carefully examining the underlying inflation dynamics that have driven the recent freak-out about renewed overheating, I estimate the worries are overdone.
In the lead-up to 2024, the pace of price hikes was falling back to earth — or at least the Fed's goal of 2% year over year. Core PCE rose at an annually adjusted rate of 1.9% in the six months ending in December. It seemed like "mission accomplished." But in the first three months of this year, the measure heated back up: Core PCE surged to 4.4%. Typically, price increases are a slow-moving process, so it is rare to see core inflation accelerate this much this quickly. When I started digging into the data, however, I had a hard time explaining the reversal based on the fundamentals.
I think of inflation as a triangle: Each leg helps explain our overall price picture. The first leg is expectations — various surveys help gauge the degree to which inflation has become embedded in the minds of consumers and businesses. If these expectations start to creep up, that could be an indication that inflation is soon to follow. The second element is aggregate demand: If people suddenly have more to spend, that can push up spending and cause prices to rise along with it. One way to measure this is unemployment — if there is a sudden surge in Americans getting new jobs, demand is likely to jump as well. The final piece is supply shocks: How much have one-off disruptions helped raise prices on things like imported consumer goods or oil? Using this framework, it's difficult to pinpoint why inflation has strengthened so much.
The Survey of Professional Forecasters has found longer-run expectations for inflation have leveled out at 2% — the Fed's target. The unemployment rate is up modestly from 12 months ago, which suggests that price hikes aren't being driven by a sudden surge in consumer or household demand. And there have been no widespread supply bottlenecks to speak of. The ISM vendor-deliveries index, which measures the amount of time purchasing managers have to wait to get the goods they need, indicates that the supply chain is running smoothly.
On a deeper level, it appears that the acceleration in inflation is somewhat random, with much of the recent pickup being driven by industry-specific factors as opposed to overall economic conditions. Healthcare-services inflation is a notable example. PCE inflation includes both what consumers pay out of pocket for their care and payments made on behalf of individuals by employers or the government. Well, because of government rule adjustments in the first quarter, Medicaid payments surged, helping to drive up the overall index. Similarly, the cost of financial services went up as fees paid to financial advisors increased, but this is simply a lagged response to the strong performance of the stock market at the end of 2023. Since fees are a set percentage of a person's portfolio, the big run-up in equities at the end of last year meant that people may have paid more in total dollars to their advisor, but that's only because the value of their investments was also soaring.
These one-offs have had an outsize impact on the overall inflation picture. Ahead of 2024, the contribution from acyclical components to core inflation was essentially zero. Over the past three months, it has swelled to 4.4%. By contrast, the impact of cyclical components — those elements that are correlated to the overall health of the economy — on inflation has slowed marginally since last year.
Given the nature of the recent hot inflation readings, the fundamental case for a return to the path of nirvana is strong.
For one thing, economic growth is not getting away from the Fed. If growth were materially accelerating, it would drive up the demand leg of the inflation stool, increasing prices as Americans went out and threw around their newfound cash. But that's not what's happening. Real GDP rose at a 1.6% annualized pace in the first quarter, with private demand — which excludes company inventory buildups, government spending, and net exports — climbing 3.1%. The strong growth in private demand suggests that second-quarter GDP could be even more robust. Rather than a sudden reignition of the economy, the under-the-hood data suggests that this is simply the US settling into a steady-state economy.
Bringing inflation down from multidecade highs was never going to be a simple or straightforward task — the start of the year has proved as much.
For one, investments in residential real estate surged, adding half a percentage point to GDP in the first quarter. But with borrowing rates rising and building permits declining, that kind of housing contribution is unlikely to repeat. Second, the rise in consumption over the past two months was driven almost entirely by declines in the savings rate. Put another way, Americans were fueling their purchases by dipping into their cash reserves. I would not expect households to dip into their savings quite as much going forward, especially since wage growth is still moderating. The Indeed Wage Tracker, a measure of changes in wages and salaries advertised in job postings on Indeed, has been steadily slowing — down to 3.1% growth over the past year. This measure tends to move ahead of the more widely followed Wage Growth Tracker from the Atlanta Fed by roughly eight months. Add all this up, and it paints a picture of a resilient but certainly not red-hot economy.
I've been surprised at how quickly equity markets have shrugged off the inflation news. If inflation persists as it has, it introduces real downside risks to growth. Real incomes will slow as inflation remains strong, which will weigh on household consumption and, in turn, corporate earnings. This is not like last year. The labor markets are not in the same place. Thus, instead of reinforcing the inflationary-boom narrative, stronger inflation today implies more of a downside risk to the economy.
The good news is that there are strong reasons to expect the recent pickup in US inflation to fade. Expectations are steady, labor-market turnover remains low, and inflation continues to moderate in many parts of the developed world.
In terms of an outlook for the market, the upshot is that if my analysis is right, the slowing in core inflation and stability in economic growth ought to renew some of the enthusiasm for the prospects of a soft landing. If that's right, I'd take bonds over stocks for the time being, though they should both do well.
Bringing inflation down from multidecade highs was never going to be a simple or straightforward task — the start of the year has proved as much. Expecting inflation to continue its downward trend is not a matter of keeping the faith. It's a clear reading of what the data is really telling us: Nirvana is still possible.
Neil Dutta is head of economics at Renaissance Macro Research.