Thoughts

January 06, 2023 | 13:32

The Crux of the Inflation Problem

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)

In the Fed’s mind, tackling inflation ultimately boils down to cooling the labour market. In fact, apart from this one area (and, to a lesser extent, food costs), most inflation drivers are heading in the right direction. Resource prices are well off their peaks, notably energy. The CRB spot index has made a round-trip back to year-ago levels after hitting record highs last spring. House prices are in freefall, taking pressure off rents. Lower demand for goods amid costlier credit and a preference for services has cooled goods inflation. Core goods PCE prices have fallen for two straight months, halving the yearly rate to 3.8% in November from 7.6% in February. Supply chains are far less snarled today than a year ago. While the New York Fed’s index of global supply chain pressures has stalled in the past three months at just above one standard deviation from the norm, that’s down from more than four standard deviations in late 2021. The index should resume its downward lurch as China eases COVID restrictions and microchip shortages lessen.

In his November 30 speech on “Inflation and the Labor Market”, Chair Powell said three things are needed to reduce inflation: lower core goods inflation (check), lower housing services inflation (check, though it will take time to show up in the official stats), and lower core services inflation excluding housing. The latter covers most services, from biggies like health care and education to haircuts, hotel stays and dining. It also accounts for over half of the core PCE deflator, so it matters. Since workers are the biggest expense for most service providers, “the labor market holds the key to understanding inflation in this category”. And what does the Fed expect for this category? The minutes of the December policy meeting said that “core non-housing services inflation was forecast to move down as wage growth eased”, as it “tended to be closely linked to nominal wage growth”.

But that’s a forecast clouded in uncertainty. There is limited evidence that this newfangled inflation guidepost is slowing. While it eased to 4.3% y/y in November after peaking at 5.1% in late 2021, the 3- and 6-month annualized rates have held above 4% for most of the past year, indicating stickiness. All eyes will now turn to next week’s December CPI and notably the services ex-shelter metric, though it will likely be biased down by fizzling natural gas prices and falling health insurance premiums. Still, even a particularly weak figure likely won’t change the Fed’s hawkish bent unless mirrored by a sustained moderation in wage growth.

We reviewed several compensation measures in the December 9 Focus Thought, “Waging War on Inflation”, concluding that wage growth might be rolling over, but the pace of decline remains in doubt given the severe tightness in labour markets. We expect the jobless rate to top 5% this year as the economy sinks into a mild recession. That’s above the so-called neutral rate, which the FOMC believes is centered in a wide range around 4.0%, thereby easing wage pressure. Still, restoring price stability will take time, likely a couple of years.