During the mid-term elections, Americans were preoccupied with inflation. A Gallup poll indicated one in five respondents deemed it the nation’s most pressing issue. Fast forward to today, America’s r focus is elsewhere. Inflation currently falls behind government leadership and the “economy in general” and just ahead of immigration and firearms; only 9% of Gallup respondents now cite inflation as the most significant problem. Inflation was scarcely mentioned in the debate in Washington over raising the debt ceiling.
This may indicate that individuals have become accustomed to higher inflation, which would be unfortunate. The more individuals act as if excessive inflation is permanent, the more likely it is to persist. The Federal Reserve would be forced to choose between inducing a potentially severe recession to reduce inflation or abandoning its 2% inflation objective.
The Labor Department reported on Wednesday that consumer prices rose 4.9% from January through April, the lowest increase in two years and a significant decrease from June 2022’s 9.1% increase. The current decrease is primarily due to the decline in petroleum prices. This decline helps explain why people are less concerned about inflation, although they are still more concerned than before the pandemic.
Nevertheless, inflation remains a significant problem. It is more accurate to predict underlying price trends by using the core inflation rate, which excludes food and energy. Core inflation was 5.5% in April, down from 5.6% in March. Core prices increased 0.4% every month, or 5% annually, by the previous four months. According to independent analyst Omair Sharif, core services prices, which the Fed closely monitors, increased by a much more subdued 0.1% for the month, excluding shelter. Wages, which affect service prices significantly, increased by 4% to 5% in the first four months of the year.
There were two primary causes for the initial surge in inflation: pandemic and war-related disruptions to the supply of products, services, and labor, and federal stimulus and near-zero interest rates that fueled demand.
These factors have diminished considerably. Labor supply has substantially recovered, with the supply chain operating normally and the labor force participation rate returning to its pre-epidemic level. The price of gasoline has returned to its level before the Russian invasion of Ukraine. Fiscal stimulus has expired, and since March 2022, the Federal Reserve has increased its short-term interest rate objective from near zero to between 5% and 5.2%.
Two years ago, it was believed that once these temporary supply and demand factors subsided, inflation would return to 2%. Some prices have decreased, apartment rents are increasing slower, and employers are less frantic to hire.
However, this theory has always been accompanied by a caveat: the longer it took for these transitory factors to subside, the greater the possibility that people would adapt to quicker price and wage increases, which could make them self-sufficient. That may already be in progress.
Bruce Kasman, the chief economist at JPMorgan Chase, stated they are beginning to see a process in which persistent, large shocks to inflation become embedded in price and wage formation. Even though energy prices have decreased and growth has slowed, pricing power and profit margins have exceeded expectations.
Price- and wage-setting psychology is frequently inferred from future inflation expectations. Fed officials find solace in that long-term expectations, i.e., five to ten years from now, remain close to 2%.
However, the central bankers’ belief that long-term expectations are more predictive of behavior than short-term expectations is empirically unsupported. If they are incorrect, it is ominous that the University of Michigan reports that consumers’ one-year expectations have been above 4% for nearly two years. According to a survey by economists Olivier Coibion and Yuriy Gorodnichenko, firms that determine prices predict inflation to exceed 5% in the upcoming year.
In earnings reports, companies complain significantly less about input costs and labor shortages but report raising prices without difficulty. The new watchword among chief financial officers is “elasticity”: the price sensitivity of sales volume, and less sensitivity is healthier for businesses.
When Coca-Cola, Pepsi, Kimberly-Clark, Kraft Heinz, and Conagra raise prices, this trickles down to restaurants. When Hilton and Marriott talk about increasing average daily revenue, this translates into services inflation, said Samuel Rines, a strategist at market advisory firm Corbu. This will persist until the consumer responds with resistance.
According to him, consumers believe that if prices increase, so must their earnings. Until this assumption is disproven, consumers will not bat an eye at paying an additional 5 or 6 percent for ketchup.
Some policymakers assert that corporations exacerbate inflation by increasing profits. Eventually, it may not matter whether wages influence prices or vice versa. Once inflation has stabilized at a higher steady-state growth rate, wages and prices increase.
In such a circumstance, a severe recession may be required to reduce inflation. This appears to be why markets believe inflation will fall significantly over the next year and the Fed will begin cutting interest rates. However, there is currently no evidence of even a moderate recession. The housing market, which is most sensitive to higher interest rates, has stabilized, and construction employment is growing.
According to Fed Chair Jerome Powell, slow economic growth, not a recession, should be enough to return inflation to 2%. The central bank has signaled that rate hikes may be complete.
Mr. Kasman remarked that central bankers appear committed to gradualism, accepting a sluggish inflation decline to avoid excessive harm to the labor market. The difficulty with gradualism is that the longer the path to reducing inflation, the less likely it is to occur.