Among the many comments on inflation in the minutes of the last FOMC meeting was the following, rather gloomy, prediction:
Several participants assessed that healing in supply chains and labor supply was largely complete, and therefore that continued progress on reducing inflation may need to come from further softening in product and labor demand with restrictive monetary policy continuing to play a central role.

Translating from Fedspeak: Several Fed officials worried that they might still have to trigger a recession to get inflation all the way down to their 2% target. 

This perspective gained some support in Friday’s jobs report, which showed a stalling out in a long trend of falling wage growth. However, a broader analysis suggests that non-labor-market factors will continue to reduce inflation in 2024, giving the labor market time to normalize without the pain of recession. While there are plenty of shocks or policy mistakes that could disrupt this path, the mostly likely scenario is a continued slide in inflation to the Fed’s 2% target without a near-term recession – an outcome that should support both U.S. bonds and stocks. 

The Slide So Far
The progress on inflation since June 2022 has been remarkable.

In that month, not-seasonally-adjusted headline CPI inflation hit 9.1% year-over-year - its highest reading since November 1981. This 9.1% encompassed increases of 10.4% for food, 41.6% for energy and 5.9% for everything else. The reasons for this inflation spike are well-known. The pandemic interrupted global supply chains, while fiscal support boosted demand. In addition, Russia’s invasion of Ukraine disrupted global supplies of both food and energy.

Over the past 18 months, all of these impacts have faded so that, by last November, year-over-year headline CPI inflation had fallen to 3.1%, composed of a 2.9% increase in food prices, a 5.4% decline in energy prices and a 4.0% increase for everything else.

This overall level of CPI inflation translated into 2.6% and 3.2% year-over-year increases in the headline and core consumption deflators, respectively – clearly approaching the Fed’s 2% targets. Still, the path for monetary policy and interest rates this year depends a lot on whether inflation stalls out at its current pace or continues to slide.

Prospects For A Continued Decline
One reasonable inference from the fall in inflation so far is that food and energy have seen the most significant declines and so should not be relied upon to cool overall inflation further.

That being said, we have no reason to expect a resurgence in these areas either. In particular, a broad measure of global economic momentum, the Markit Global Composite Index, only rose marginally between November and December and remains well below its long-term average. This suggests that neither food nor energy prices are likely to be boosted by strong global demand growth any time soon.

Supply, of course, is another, less-predictable matter. The very unsettled situation in the Middle-East has already led to disruptions of cargo ships in the Red Sea. If this were extended to the Persian Gulf, it would clearly have a major impact on global energy prices. In addition, while gasoline refiner margins have fallen back to more normal levels since their peak in the summer of 2022, they remain vulnerable to weather-related or other disruptions.

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.

Investment Implications
It should go without saying that this forecast could easily be upset by shocks or policy mistakes. A geo-political or environmental shock that boosted energy prices is one example. Inappropriately stimulative fiscal policy or new tariffs are others. However, the bottom line is that, despite the fears of some Fed officials, the most likely path for inflation from here is not upwards or sideways but rather down. If inflation continues to slide, it should provide further support for U.S. bonds. If, as we hope and cautiously expect, inflation continues to slide without a recession, it should provide even greater support for U.S. stocks.

David Kelly is chief global strategist at J.P. Morgan Asset Management.