Paul DavidsonUSA TODAY
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Since a key inflation report this month showed an unexpected surge in consumer prices, hopes for a flurry of interest rate cuts this year have dimmed, the stock market has tumbled and an upbeat mood on the economy has soured a bit.
But inflation is still on course to gradually ease this year and in 2025, top forecasters say. The recent price acceleration largely centers on a few categories, such as rent, car insurance and medical care.
While some economists say the cost of such services will continue to rise sharply in 2024, others expect a slowdown that could still allow the Federal Reserve to lower interest rates more than markets now anticipate.
“Despite the hand-wringing, there are good reasons to be optimistic that inflation will soon resume moderating and approach the Fed’s (2%) target by the end of the year,” Mark Zandi, chief economist of Moody’s Analytics, wrote in a note to clients.
Barclays economist Pooja Sriram disagrees. “Inflation in some categories…will just be stickier than expected,” she said in an interview.
With inflation a main reason President Biden is trailing former President Trump in polls, its course could determine whether interest rates will fall in coming months and possibly tip the scales in the November election.
How high was inflation last month?
The Labor Department’s worrisome report on the consumer price index (CPI) revealed that overall prices rose 3.5% annually in March, down from a 40-year high of 9.1% in June 2022 but up from 3.2% the previous month. A core inflation measure that strips out volatile food and energy items and is watched more closely by the Fed was unchanged at 3.8%.
The report marked the third straight hot inflation reading to start the year and a reversal from a steady drop-off last fall.
Will the Fed cut interest rates in 2024?
Fed officials, who have lifted their key rate to a 23-year high of 5.25% to 5.5% to fight inflation, recently have doused hopes for a June decrease. And markets that forecast the rate expect as little as one cut this year, down from three cuts just a few weeks ago. Since the CPI report, the Dow Jones industrial average has shed 380 points and the S&P 500 index has fallen 2.7%, even after a partial rebound early this week on strong corporate earnings news.
What is PCE inflation?
Another inflation report due out Friday could provide some solace. The personal consumption expenditures (PCE) price index – which the Fed follows more closely - has been running lower than CPI because certain products and services have different weights. Economists polled by Bloomberg estimate overall PCE prices rose 2.6% annually in March, up from 2.5% the prior month, while core PCE prices increased 2.7%, down from 2.8%.
PCE inflation, however, may have risen more sharply last month after Thursday's first-quarter GDP report said core PCE prices rose at an annual rate of 3.7% in the first quarter, more than the 3.4% economists had projected.
Although prices of goods such as used cars, furniture and appliances have declined as COVID-related supply chain troubles have resolved, service prices have jumped, in part because of increasing wages.
Here’s a breakdown of what’s keeping inflation elevated and how long it could take for it to return to normal.
Housing
Rent is by far the biggest culprit in the inflation run-up. It rose 0.4% in March and 5.7% the past year. And it’s up 23% since before the pandemic. That’s significant because housing contributed a whopping 36% to inflation last month, according to the CPI.
Rent soared during COVID as Americans living with roommates or family moved into their own homes for health reasons but faced a shortage of units available for purchase. If not for skyrocketing rent, core CPI inflation would be at 2.4%, instead of 3.8%, notes economist Bob Schwartz of Oxford Economics
For more than a year, rent for people moving into new apartments has fallen or flatlined. That has been expected to filter into renewals of existing leases on the belief that landlords fearful of losing tenants to rivals down the block would raise rents just modestly when existing leases expire.
But that hasn’t happened in part because landlords realize most tenants won’t go to the trouble of moving to save even $200 to $300 a month, says economist Matt Colyar of Moody’s Analytics.
“There’s a lot of inertia,” Sriram says.
A strong economy with healthy wage growth also gives tenants a reason to pay up and stay put, says Nomura economist Aichi Amemiya.
But analysts expect a shift in the second half of the year. There are lots of new apartment buildings opening and that should prod landlords to at least hold the line on rent, Colyar says. Tenants, however, are only surveyed by Labor every six months and so it takes time for moderating rent rises to show up in the CPI data, Colyar and Sriram say.
And while apartment rent increases already have slowed substantially, rent inflation for single-family homes will take longer to pull back and it carries more weight in the report, Goldman Sachs wrote in a note to clients.
Colyar expects a drop in yearly rent increases overall from 5.7% to 4.5% by December.
Auto insurance and repairs
New car prices have been virtually flat the past year as supply-chain snarls have resolved. Car insurance and repairs should follow since they're linked to the price of auto parts.
Instead, insurance rates jumped 2.6% in March and 22.2% annually while car repair costs increased 1.7% and 8.2% from a year ago.
Sriram doesn’t expect much relief in the near term. Both auto insurance and repairs are affected by technicians’ wages, which have risen briskly, she says. Many baby boomers have been retiring and fewer young people are going into the field.
Colyar says the bigger reason for rapidly rising insurance rates is that providers didn’t properly figure the risk of accidents into premiums a few years ago and they’re now catching up.
But he says insurance and repair cost increases have slowed as vehicle prices have stabilized, and the big leaps in both last month likely were blips. He expects inflation in those categories to downshift in the coming months.
Computer electronics and software
Holiday promotions drove down electronics and software prices at the end of 2023 and the end of those discounts propelled prices higher early this year, Goldman Sachs says. But the discounts largely have played out and prices should decline the rest of the year, Goldman says.
Medical care
Hospital service costs rose 1% in March and they’re up 7.5% annually.
Americans are undergoing elective surgeries and other procedures they put off during COVID, fueling strong demand, Sriram says. Meanwhile, many nurses, medical technicians and other professionals left the field during COVID, triggering labor shortages, Colyar says. The higher prices are still making their way into contracts between hospitals and health insurance providers, Sriram and Colyar say.
Colyar expects continued sturdy price increases for health services but not an acceleration.
Financial services
A roaring stock market swelled financial portfolios and drove up the commissions paid to investment firms, which are typically based on an annual percentage of the assets they manage. Financial services have a bigger weight in the PCE index than the CPI.
Recently, however, stock markets generally have fallen and that should lead to a drop in financial services inflation, Schwartz says.
Other services
The cost of services such as haircuts, dry cleaning and funerals also have advanced solidly in the past year, rising 5.4% overall. A measure of services inflation excluding housing that the Fed watches closely leaped by 0.6% in March.
Siriram points to labor costs.
Although wage growth has eased along with pandemic-induced labor shortages, Sriram notes that average monthly job growth of 276,000 this year signals that employers are still hunting for workers and willing pay them high wages.
A flood of immigrants have joined Americans returning to the work force after the pandemic, increasing the labor supply and softening pay increases, Colyar says. Also, the ranks of new hires and people quitting jobs have dipped below pre-COVID levels, underscoring that employers have growing leverage.
Yearly wage growth averaged 4.7% in March, down from 5% the previous month and 6.7% in June 2022, according to the Atlanta Fed's wage tracker. That’s still well above the 3.5% pace that aligns with the Fed’s 2% inflation goal.
But in March, just 21% of small businesses planned to increase employee compensation over the next three months, down from 30% in November, Schwartz notes, citing a survey by the National Federation of Independent Business.
What's the bottom line?
Sriram predicts that core PCE inflation will barely budge in the coming months and end the year at 2.8%, allowing the Fed to lower its key interest rate just once this year before cutting it four times in 2025.
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Colyar is more sanguine, largely because of slowing pay increases. He looks for inflation to approach the Fed's 2% goal by year's end. He forecasts a rate cut in September, followed by another in December.
