What’s Driving the Inflation Bus?
On November 3, 2022 the Federal Reserve announced another 75 basis point hike in the Federal Funds rate (the overnight interest rate on interbank loans), raising its target from 3.25% to 4.00%. The Fed is signaling through every possible channel that it is committed to slowing and then reversing the current inflationary trend. The most recent October inflation report from the Bureau of Labor Statistics did indicate slowing inflation which might give the Fed some breathing room, but there is also evidence that inflation will remain elevated for many months to come.
The Bureau of Labor Statistics’ most recent inflation report for October 2022 estimated the 12-month inflation rate for October was 7.7%. In other words, the Consumer Price Index (CPI) in October 2022 was 7.7% higher than it was in October 2021. While 7.7% inflation might not sound like welcome news to consumers, the Fed was likely encouraged given that September’s 8.2% 12-month inflation estimate was a 40 year high. Unfortunately for consumers and the Fed alike, the dip is likely transitory, to borrow the Fed’s language, and inflation is unlikely to disappear any time soon even if the Fed continues on its current rate path.
The Bureau of Labor Statistics monitors changes in the US price level using a market basket approach. BLS collects almost 94,000 data points every month from more than 23,000 retailers and service providers, including data on 8,000 rental units. These price data are grouped into eight major categories such as, Food, Shelter, Energy, and Healthcare. BLS then weights each category to reflect consumer spending patterns and constructs the CPI. Three of the most important CPI component categories are Shelter, Food, and Energy, which represent 33%, 14%, and 8% of the CPI respectively, which together make up 55% of the CPI. The remaining five component categories make up the remaining 45% of the CPI.
The problem facing the Fed is that all three of these major CPI components are seeing rapid price growth that will likely persist for several quarters. The latest CPI report showed that Food prices in October were 10.9% higher than they were 12 months prior, and Energy prices were 17.6% higher over the same period. By way of comparison, the year-over-year inflation rates of the Food and Energy components in January 2020, just prior to the Covid-19 pandemic, were 1.8% and 6.2% respectively. Food and Energy prices are likely to keep rising at least through the end of Q1 2023 just due to lingering supply chain issues and the war in Ukraine. If winter temperatures prove unseasonably cold, especially in Europe, then energy prices are likely to rise even more through the first half of 2023.
Perhaps more importantly, inflationary pressures have started bleeding out of the volatile food and energy components of the CPI into the housing and services sectors which will take longer to get under control. Evidence of this dynamic was provided by the October CPI which reported a 6.9% increase in Shelter costs, compared to 3.3% in January 2020.
The danger for the Fed is the degree of price momentum baked into the Shelter component of the CPI. Home prices and rental rates rose steadily throughout 2021 and 2022. The housing market has started to cool and home prices have started to fall, but the Shelter component of the CPI is likely to continue rising. First, higher interest rates are increasing borrowing and housing costs even as home prices fall. Second, rental rates are guaranteed to keep rising for several quarters as contracts renew and rents adjust upward to reflect current market prices. Because housing represents one-third of the CPI these price pressures are likely to keep the CPI elevated for an extended period.
In response to rising inflation over the past year the Fed has consistently raised rates over the last few months. The Fed has raised its Fed Funds Target rate from 0.5% in March to 4.0% in November, and we forecast the Fed will continue to raise its Fed Funds Target through the first three quarters of 2023 before starting to taper by the end of 2023. Of course there is no free lunch and the Fed’s rate hikes are having their intended effect of slowing the economy. Both the nation and state economies have slowed in 2022 and we forecast continued slow, but positive, growth by the end of 2023 though the first half of the year is likely to see a contraction in output.