Still, barring a shock, it is reasonable to expect low inflation from food and energy in the year ahead. The same can be said for core goods, as global vendor delivery indices continue to point to healing supply chains. As one manifestation of this, in December, the average transactions price for new vehicles fell 2.7% year-over-year, according to J.D. Power, while the wholesale price of used vehicles was down 6.3%, according to Manheim.  

The Crumbling Foundations Of Year-Over-Year Inflation: Housing And Auto Insurance
But if food, energy and core goods aren’t contributing to higher inflation today, what is sustaining inflation above the Fed’s 2% target? The short answer is rent, owner’s equivalent rent and auto insurance. Indeed, in November, these three categories, which comprise 36% of the CPI basket, accounted for 89% of year-over-year CPI inflation.

Crucially, all of this is likely to fade sharply in the year ahead.

Rent and owners’ equivalent rent were up 6.9% and 6.7% year-over-year, respectively, in November. However, actual rents on new leases, according to Zillow, were up just 3.1% and had increased at just a 2.0% annualized rate over the prior six months. This slower inflation in new leases is gradually feeding into the more lagged and smoothed CPI series and should drive CPI rental inflation down in the months ahead. In addition, average rents are still significantly higher relative to disposable income than before the pandemic, forcing renters to take a tougher line with landlords. Moreover, with a record-high, one million plus multi-family housing units under construction in recent months, supply should also act to depress rents going forward. All of this suggests that year-over-year inflation in rents and owners’ equivalent rent could be cut in half in the year ahead. This, on its own, would cut CPI inflation by more than 1%.

The second big issue is auto insurance. Auto insurance inflation in November was an astonishing 19.2% year-over-year, contributing just over 0.5 percentage points to the CPI inflation rate. Auto insurers have justified these rate increases based on the increased value of vehicles, increased repair costs and more accidents and auto theft in the wake of the pandemic. That being said, while some further outsized insurance increases are likely ahead of us, a sharp drop in the year-over-year increase would seem to be inevitable. A halving of the rate in the year ahead, (to a still sky-high 9.6%) would cut 0.27 percentage points from year-over-year CPI inflation. 

It should be noted that the CPI index measures average auto insurance rates in effect, not just those on new policies. As a result, an increase in rates on new policies being issued can impact month-to-month inflation readings for the following six months to a year. Consequently, as is the case with housing inflation, the decline in auto insurance inflation, once it starts, should turn into the gift that keeps giving.

Labor Market Normalization 
And then, finally, there is the issue of wages. Average hourly earnings for all workers rose 4.1% year-over-year in December, somewhat higher than the 3.9% consensus expectation. This also means that year-over-year wage growth has not fallen over the past three months following a very steady decline over the prior year and a half.

To some extent this may reflect the exercise of bargaining power by workers with the impact of the auto settlement showing up in a notable uplift in durable manufacturing wages. However, these wage increases could also just be seen as reasonable compensation for the inflation that workers have endured over the past two years.

Perhaps most importantly, we estimate that productivity in the non-farm business sector rose 1.8% year-over-year in the fourth quarter. Broadly speaking that should allow wages to grow 1.8% faster than consumer prices without labor’s share of national income rising and putting extra upward pressure on consumer inflation. Provided productivity growth remains strong, year-over-year wage growth has now fallen very close to a pace compatible with the Fed’s 2% inflation target.

Moreover, in time, we actually expect wage growth to slow further than this. Real GDP growth is slowing while job openings continue to fall and monthly quits have returned to pre-pandemic levels. Given all of this, we expect wage growth to slowly diminish going forward with businesses absorbing at least some of their higher wage bills rather than fully passing them on to consumers. Because of this, when the benefits of lower inflation from housing and auto insurance run out, the impact of higher wages on CPI inflation may well be lower than they are today.