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.