Thoughts

December 13, 2024 | 14:00

U.S. Inflation: Progress, But…

Economist

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Despite the perky economy, U.S. inflation behaved largely as expected in 2024. A year ago, we thought annual CPI growth would ease to 2.8% this year and, with just a month to go, it should come close to the mark. The decline from 4.1% in 2023 reflects several factors, including moderating energy and food costs, a strengthening dollar, and sturdy productivity growth (2.2% y/y in Q3) which held unit labour costs to a moderate 2.2% pace. Importantly, labour markets loosened, with the unemployment rate rising half a percentage point in the past year to 4.2%, a level the Fed deems consistent with both low inflation and full employment, a.k.a., nirvana.

Not that there haven’t been bumps on the road to price stability. The downward trend in core CPI inflation has stalled at around 3.3% y/y since early summer. Some of this reflects challenging base effects. But the real sticking point is the broad services sector, where inflation clocks in at 4.5%, a stark contrast with a mildly deflating goods sector. The positive news is that CPI rent increases, though still more than 4% y/y, have cooled and should continue to do so in a soft rental market. The bad news is that other services are running hotter due to robust demand. Adding to the sticky situation is the fact that inflation expectations remain stuck above pre-pandemic levels, with the University of Michigan’s five-year-ahead measure holding just above 3.0%, compared with 2.4% in 2019.

Still, inflation should renew a downward trend in 2025, with the CPI averaging 2.5% and the Fed’s preferred measure (the PCE price index) easing to 2.3% by year-end before hitting the target in early 2026. Wage growth should moderate as the jobless rate moves slightly above current levels, reinforcing consumers’ sensitivity to price increases as cited in the Beige Book. Oil prices should hold steady near US$75 in 2025, with domestic production rising as more federal land is made available for drilling. The mighty dollar could stay aloft, even as Fed easing clips its wings a bit. A bumper harvest should tamp down food costs, though deportations might provide some offset.

Tariffs are the main risk to our inflation call. A threatened 25% duty on goods from Canada and Mexico (and a 10% increase for China) could directly raise U.S. consumer prices by 1%, though the final impact will be diminished by an appreciating dollar and foreign producers trimming prices. Layering on a potential 10% tariff for all other countries and at least a 60% hike for China could easily double the hit to inflation. However, barring repeated rounds of tariffs, the upward pressure on inflation should prove transitory, as economic growth will also get dinged by tariffs, especially if other countries retaliate. Still, regardless of how long the inflation spike lasts, price levels would remain permanently higher, unless the tariff increases are revoked.

Where goes inflation, so goes interest rates and growth. Barring a trade war, U.S. inflation should cool further, paving the way for lower rates and healthy growth.