The economic story of the past year has been that inflationary supply shocks have been more acute than originally expected and inflation has proved to be more persistent, adding pressure to central banks facing a tradeoff between fighting inflation and supporting growth.
While there are nascent signs that US headline and core inflation are moderating, the underlying trend in CPI inflation now appears stickier and inconsistent with the US Federal Reserve’s 2 per cent target. As a result, we doubt Fed officials will declare victory and further monetary policy tightening is likely.
With a stubbornly persistent pace of underlying inflation, economic momentum already slowing, and a Fed still aiming for contractionary monetary policy, a US recession looks more likely than not over the next 12 to 18 months.
Inflation is complicated
Any evolution in the outlook for Fed policy will depend crucially on the persistence of inflation, where the outlook has become increasingly uncertain. While there is growing consensus that inflation is peaking, the destination remains uncertain and suggests it is not yet time for the Fed to declare victory.
According to the latest CPI data, US inflation – both headline and core – moderated in July. Assuming global food and energy commodity prices continue to ease, June likely marked the peak in the year-on-year rate of headline inflation.
The year-on-year rate of core inflation also appears poised to peak, although it may not happen until September due to a combination of easing supply chain bottlenecks, a stronger US dollar, and the pass-through of lower commodities prices onto core CPI components, such as transportation services, which includes airfares.
However, whether inflation is peaking and will moderate is no longer the key debate.
In a survey of 75 economists taken by the Wall Street Journal, all 75 expect inflation to moderate from its current level. Instead, the question is the destination for inflation after the initial moderation, and there disagreement is high.
In the same Wall Street Journal survey, the range of 2023 CPI forecasts spans 0.0 per cent to 5.3 per cent, while 2024 is not much better with a forecast range of 0.3 per cent to 4.1 per cent.
Elevated disagreement can also be seen in the most recent University of Michigan Survey, where the 25th and 75th percentile of longer-term inflation expectations is the widest it has been since the late 1980s. The New York Fed consumer survey of inflation expectations displayed a similar phenomenon.
The divergence in forecasts can likely be explained by differing assessments on the stickiness of underlying inflation – an important consideration in gauging inflation expectations.
Since households’ purchasing behaviour is influenced by near-term expectations, and households are more inclined to consume today if they expect prices to rise in the future, rising inflation in stickier categories can signal that inflation expectations are rising, even if other survey-based measures are well contained.
This divergence in signals appears to be happening today, likely contributing to the disagreement among forecasts for where inflation ultimately lands.
