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Inflation is still high. What drives it has changed.




America is now two years into abnormally high inflation — and while the nation appears to be past the worst phase of the biggest surge in price increases in half a century, the road back to normal is long and uncertain.

The rise in prices in the 24 months ending in March eroded wage growth, burdened consumers and spurred a Federal Reserve response that has the potential to cause a recession.

What generated the painful inflation, and what comes next? A look through the data reveals a situation that arose from pandemic disruptions and the government’s response, was exacerbated by the war in Ukraine and is now cooling as supply issues resolve and the economy slows. But it also illustrates that U.S. inflation today is drastically different from the price increases that first emerged in 2021[ads1], driven by stubborn price increases for services like flights and child care rather than by the cost of goods.

New wages and prices data set for release on Friday are expected to show continued evidence of slow and steady moderation in March. Now Fed officials must assess whether the cooling is happening quickly enough to assure them that inflation will immediately return to normal – a focus when the central bank announces its next interest rate decision on Wednesday.

The Fed is targeting 2 percent inflation on average over time using the personal consumption expenditures index, which will be released on Friday. This figure pulls some of the data from the Consumer Price Index report, which was released two weeks ago and provided a clear picture of the recent inflation trajectory.

Before the pandemic, inflation hovered around 2 percent as measured by the overall consumer price index and by a “core measure” that strips out food and fuel prices to get a clearer sense of the underlying trend. It fell sharply at the start of the pandemic in early 2020 as people stayed home and stopped spending, then rebounded from March 2021.

Some of the initial pop was due to a “base effect”. New inflation data was measured against pandemic-depressed numbers from the previous year, making the new numbers look high. But towards the end of summer 2021, it was clear that something more fundamental was happening to the prices.

Demand for goods was unusually high: Families had more money than usual after months at home and repeated stimulus checks, and they spent it on cars, sofas and deck furniture. At the same time, the pandemic had shut down many factories, which limited how much supply the world’s companies could take out. Shipping costs increased, product shortages increased, and the prices of physical purchases from white goods to cars rose.

At the end of 2021, a new trend also started. Service costs, which include non-physical purchases such as tutoring and tax preparation, had begun to rise rapidly.

As with commodity prices, it related to strong demand. Because households were in good spending shape, landlords, babysitters and restaurants could charge more without losing customers.

Across the economy, businesses seized the moment to pad their bottom lines; profit margins rose at the end of 2021 before moderating towards the end of last year.

Businesses also covered their rising costs. Wages had begun to rise faster than usual, causing the company’s labor bills to swell.

Fed officials had expected goods shortages to ease, but the combination of faster services inflation and accelerating wage growth caught their attention.

Although wage gains had not been the original cause of inflation, policymakers were concerned that it would be difficult for price increases to return to a normal pace with wage rates rising rapidly. Companies, they believed, would continue to raise prices to pass on these labor costs.

Concerned central bankers began raising interest rates in March 2022 to slow growth by making it more expensive to borrow to buy a car or house or expand a business. The aim was to slow down the labor market and make it more difficult for companies to raise prices. In just over a year, they lifted interest rates to nearly 5 percent—the fastest adjustment since the 1980s.

Yet in early 2022, Fed policy began to combat yet another force fueling inflation. Russia’s invasion of Ukraine in February caused food and fuel prices to rise. Between that and increases in the cost of goods and services, overall inflation reached its highest peak since the 1980s: around 9 percent in July.

In the months since, inflation has eased as energy and commodity cost increases have cooled. But food prices are still rising rapidly and – crucially – increases in the cost of services remain rapid.

In fact, service prices are now the very center of the inflationary story.

They may soon begin to fade in one key area. Housing costs have been rising rapidly for several months, but rent increases have recently slowed in real-time data from the private sector. It is expected to be reflected in official inflation figures later this year.

That has meant politicians have focused on other services, which span a range of purchases, including medical care, car repairs and many holiday expenses. How quickly these prices – often called “core residential services” – can recede will determine if and when inflation can return to normal.

Now Fed officials must assess whether the economy is ready to slow enough to reduce the cost of these critical services.

Between the central bank’s interest rate moves and the recent banking crisis, some officials think it might be. Policymakers projected in March that they would raise interest rates just one more time in 2023, a move widely expected at their meeting next week.

But market watchers will be listening closely when Jerome H. Powell, the Fed chairman, holds his post-meeting news conference. He could hint at whether officials believe the inflation saga is headed for a quick end — or another chapter.

Ben Casselman contributed reporting.



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