Inflation Is Headed Lower—but Maybe Not Low Enough

The more important question is what comes after that? The hope by many—including the Federal Reserve—is that it keeps heading down toward the Fed’s 2% target by itself. But there are good reasons it will stay around 4% or even drift higher. That wouldn’t be acceptable to the Fed, and opens the door to even higher interest rates than markets now expect, more market carnage and a weaker economy.

The forces that drive inflation tend to move slowly, so the almost unprecedented surge since early 2021 means something anomalous is going on. In fact, only twice since the late 1940s has inflation risen as much as in the past year, and both were periods like the present, when supply shocks hit a hot economy.

In 1951, the economy was already booming when the Truman administration warned that mobilization for the Korean War would “pull men and materials, as well as plants, away from existing peacetime uses,” fanning inflation. JPMorgan economist

Michael Feroli

has constructed an index of economic disruption based on how much employment growth varies between individual sectors. It shows disruption was exceptionally high during the Korean War and the Covid pandemic. The Korean War analogy is comforting because while the Fed did tighten monetary policy, it avoided a recession. Inflation shot from 2% in mid-1950 to 9.6% the following April, and was back below 1% by December 1952.

In 1973, the Arab oil embargo hit an economy already trying to cope with soaring food prices and strong demand. As an analogy for the present, this episode is a lot less comforting than 1951: Inflation peaked at 12.3% in 1974, and the Fed raised interest rates sharply, triggering a deep recession. Even so, inflation only fell back to 5% in 1976—then headed higher.

What’s the prognosis now? Analysts are bothered that even though annual inflation eased to 8.3% in April from 8.5% in March, the monthly inflation rate remained stubbornly high as airfares (in part because of costlier jet fuel) and new-car prices rose sharply.

And yet looking forward, the supply disruptions that have fueled so much of the rise in inflation are likely to get better, not worse. Gasoline prices hit another record this week but aren’t likely to rise much more since oil has stabilized around $100 per barrel. The queue of container ships waiting off the coast of California has shrunk by more than half, and freight rates have plummeted. About three quarters of China’s top 100 cities by gross domestic product have now either loosened restrictions to pre-Omicron levels or removed them entirely, according to Ernan Cui of the research firm Gavekal Dragonomics. One sign that goods shortages are subsiding is that manufacturing, retail and wholesale inventories, which plummeted 5% between the start of the pandemic and last September, are up 3% since.

Omair Sharif, proprietor of the analytical service Inflation Insights, predicts the near-term course of inflation by digging into the industry-level dynamics driving specific components of the consumer-price index. In his baseline forecast inflation falls to 5.3% by December. At my request, he also computed scenarios in which prices of new and used cars, shelter, food and energy follow plausible high and low paths. The high scenario is 7.1%, and the low scenario is 4%.

More important, Mr. Sharif thinks monthly rates of inflation will be much lower over the balance of the year than last year. As a result inflation, annualized over three months, would fall to 2.5% in December in his baseline scenario, 2.2% in the low scenario and 5.1% in the high scenario. Meanwhile, inflation-linked bonds and derivatives are currently projecting inflation of 3% to 3.3% by early 2024, or 3.6% excluding energy, according to Barclays.

So inflation reaching 4% is a pretty safe bet. The hope, among investors and the Fed, is that from there, inflation gradually eases to between 2% and 3%. The problem is that in a year, inflation will be driven primarily not by supply but demand, i.e., whether GDP is at or above its potential (what the economy can produce with available capital and labor) or unemployment is at or below its natural level. GDP today is below its prepandemic potential trend, but the pandemic seems to have depressed potential by, for example, driving millions of people out of the workforce. Record job vacancies suggest the current unemployment rate at 3.6% is too low to be sustained in the long run.

Indeed, annual wage growth has accelerated from about 3.5% before the pandemic to between 5% and 6%. That is consistent with inflation of 4% if productivity maintains its recent, tepid pace, or 3% if productivity perks up. For the Fed to feel confident inflation is headed below 3%, it needs to see lower wage growth, which generally requires slower economic growth and higher unemployment, and it will keep raising interest rates until those things happen. If that means more carnage in the stock market—well, that’s a feature, not a bug.

Write to Greg Ip at [email protected]

Corrections & Amplifications
Source credit for Inflation Insights LLC was incorrectly given as Inflation Analytics in an earlier version of this article. (Corrected on May 12)