Reducing inflation will take time, patience and pain

Products are seen in a supermarket, in Los Angeles, California, on May 27, 2022.

Lucy Nicholson | Reuters

Tackling runaway inflation will not be easy or quick, and it may come at a high price that is only just beginning to be paid.

To stop 40-year highs in price increases, the economy will have to slow down. The ability of producers to get their products to market will have to improve a lot. Supply and demand will have to rebalance. More worryingly, fixing all of that will have limited impact until the Ukraine war is resolved.

Even in the best of conditions, a trend you’ve seen Gasoline hits new nominal highs near $5 a gallon, the price of everyday foods like cereal, eggs, and hamburgers have increased by double-digit percentages over the past year and housing costs are getting higher, they will come down only gradually, which means little relief for consumers in the short term.

“Slow decline” is how Wells Fargo senior economist Sarah House described the likely downward path of inflation from now on. “If you think about inflation, a lot of it is driven by momentum. Pricing is slow. Companies don’t just change their prices on a dime.”

In fact, Friday’s highly anticipated inflation report is likely to show only modest relief, if any.

The consumer price index, a measure that encompasses the cost of a huge basket of goods and services, is expected to show inflation rising at a pace of 8.3% over the past year, the same as in April, according to Dow Jones estimates. Excluding food and energy prices, the so-called core CPI is expected to show 5.9% growth, slightly down from the previous month’s 6.2% pace.

Additionally, monthly gains are expected to accelerate: 0.7% for headline inflation versus a gain of just 0.3% in April. The core is expected to change little, 0.5% more, which would represent a monthly decrease of a tenth of a point.

looking through the numbers

However, economists will review the headline figures and try to find trends in the CPI components.

Food and energy, for example, comprise about 22% of the index, so any slowdown will be considered noteworthy. Housing costs account for 32%, making it a vital component. More generally, services comprise around 60% of the CPI compared to 40% for goods. Goods are where most of the current wave of inflation has emanated.

“A slower economy would help. Seeing weaker demand growth would ease some of the pressure,” House said. “However, it’s not just about a slowdown. Composition effects are important. Some areas are more important than others. Goods inflation is one area where we could start to see spending slow down. That’s where there are a lot of the pressure points.

The Federal Reserve hopes to help that process by raising short-term interest rates, which had been pegged near zero as the economy recovered from pandemic-related restrictions.

Markets widely expect the Federal Reserve to continue raising its benchmark interest rate to around 2.75%-3% from the current range of 0.75%-1%.

However, the Fed may have even more work to do than that.

A lesson from the 80’s

A National Bureau of Economic Research recently published working paper by former Treasury Secretary and Obama administration adviser Larry Summers, along with a team of other economists, suggests the Fed may need to raise rates considerably more to bring inflation down to its 2% target.

The paper compared the current run of inflation to that of the early 1980s, which was the last time price increases were so rapid. During that episode, the Paul Volcker-led Federal Reserve raised the funds rate to 19%, triggering a recession that eventually helped send inflation into a downward spiral that would last nearly 40 years, until the current run-up.

Many economists say that kind of adjustment won’t be necessary because inflation was running at 14.8% at the time.

But Summers’ newspaper said the CPI was calculated differently then, mainly in the way it represented housing costs. Using the same methodology would take core CPI to around 9.1% now, still well above the 6.2% reading in April 2022, but much closer.

“Returning to 2 percent core CPI inflation today will require about the same amount of disinflation as was achieved under President Volcker,” Summers’ team wrote.

biden’s plan

President Joe Biden recently released his plan to help reduce inflation.

In a Wall Street Journal op-ed, Biden said he would take action to fix supply chain issues and reduce the budget deficit, which totaled nearly $2.8 trillion in fiscal 2021, but is on track to be a fraction of that this year: at just $360 billion through seven monthsdue in large part to Congress not approving additional Covid relief money.

But such measures are likely to only nip the edges of inflation, with the chairman himself pointing out that much of the heavy lifting should be done by the Fed.

“They have the primary role of bringing down inflation,” Treasury Secretary and former Fed Chair Janet Yellen said at a congressional hearing earlier this week. “It’s up to them how they do it.”

But Fed hikes also take time to work into the system, and until then economists will be looking at other factors.

recent announcements of Goal and other retailers saying will work to reduce excess inventory could also be deflationary. But given that clothing has only a 2.5% weight in the CPI, those kinds of moves won’t dent those terrifying headline numbers.

“If anyone tells you that recent news that some retailers are marking down clothing will have any measurable effect on CPI, ignore them,” DataTrek Research co-founder Nicholas Colas wrote in his daily market note. “Retailers could give away free clothes and inflation in the US would still be above 5 percent.”

Ultimately, then, bringing inflation under control will require a slow purging of the forces that have led to the current situation. That means a combination of slower growth, reduced labor market stress and a recipe for other things that will have to work well before measurable relief arrives.

“It’s not going to be easy,” said House, an economist at Wells Fargo. “Since you have decent consumer spending and business spending, that will keep pressure on inflation overall.”

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