Are We Out of the Woods?

Inflation was a key topic in a recent meeting at the Brookings Institution. While it has trended downward recently, the details are critical to tracking the path ahead.

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Welcome to Thoughts on the Market. I'm Seth Carpenter, Global Chief Economist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about inflation and the U.S. economy. It's Monday, February 13th at 10 a.m. in New York.

This past week, I was fortunate to be part of a panel discussion at the Brookings Institution, a research think tank in Washington, D.C. I was one of three economists in discussion with one of the White House's main economic advisers. Unsurprisingly, the topic of inflation came up.

One key chart from the White House economist juxtaposed services wage inflation with core services inflation, excluding housing. The key point of the chart was that falling wage inflation in the services sector may put some downward pressure on inflation in core services, excluding housing. This topic is timely because Chair Powell has repeatedly referenced services inflation, excluding housing, as a key risk to their goal for achieving price stability.

A couple of weeks ago I'd written on the same topic, and there we tried to show that even the link itself between wage inflation and services inflation is a bit tenuous. But just looking at the raw data, it is clear that the monthly run rate on other services remains elevated. But a question we have to ask ourselves is, 'is it elevated a lot or a little?'

Since June of last year, core services inflation, excluding housing, has trended down, and for December, it was at about 32 basis points on a month-over-month basis. That December pace is 3.9% in annual terms and would contribute about 2.1 percentage points to core PCE inflation. To put those numbers into context, recall that from 2013 to 2019, before COVID, core services inflation, excluding housing, averaged about 18 basis points a month or 2.2% at an annual rate. So yes, services inflation is higher than it has been historically, but it is nowhere near as high, relative to history, as housing inflation has been or core goods inflation has been, until recently. Indeed, from 2013 to 2019, core PCE inflation ran below the Fed's 2% inflation target. If goods inflation and housing inflation just went back to their averages from that period and services inflation, excluding housing, was at the rate that we saw in December, core PCE inflation would have overshot target, but by less than a half a percentage point. And we can't forget, for the past year, month-over-month services inflation, excluding housing, has been trending down.

So are we out of the woods? No. Clearly, services inflation, excluding housing, is still high and needs to come down over time for the Fed to hit its target. But goods inflation and housing inflation were much bigger drivers of the surge in inflation. So, we really need to consider what's the path from here.

Goods Inflation has been negative for the past few months, but used car prices look to have edged up a bit. Our US economics team expects the monthly change in core goods prices to be positive five basis points in January, interrupting that losing streak. We do not expect this reversion to last long, but the next couple of months could have some bumps in the path.

Similarly, for housing inflation, the data on current new leases clearly points to a sharp deceleration in housing inflation over the rest of this year. Although overall housing inflation should come down, the closely watched component of owners' equivalent rent will likely stay elevated a bit longer and possibly give markets a bit of a head fake. The details matter, as always.

The bottom line for us is twofold. First, inflation is coming down, but it will not be a smooth decline. A return to target for inflation was never very likely this year, so patience is required no matter what. Second, the recent high wage inflation does not spell failure for the Fed. Services inflation is not too far off target and the link between wages and inflation is there but it's small and both wage inflation and price inflation has been trending down despite the strong labor market.

I conclude with what might be the most underappreciated moment from Chair Powell's public comments last week. He said he sees inflation getting close to 2% in 2024. When the FOMC did their projections in December, the median forecast was for 3.5% inflation at the end of this year. So, it seems like, based on the incoming data, Chair Powell might be pointing to a meaningful downward revision to the March forecast for inflation.

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