Here’s what is keeping core inflation hot.
Here’s what is keeping core inflation hot.
I n September 2022, we at Capital Matters advised readers that inflationary cycles had a predictable historical pattern. Today’s inflation data reveal that the regular historical pattern continues to be evident in the data. We are stuck at step eight of the ten steps of stagflation. Price inflation does not drop below wage inflation, so it stays high until the Fed really tightens.
The consumer price index (CPI) for March came in hot, beating expectations yet again and sending jitters through markets. Anticipation in the days before the release of the data focused, rightfully, on a higher headline inflation print due to elevated energy prices, especially given the recent rise in oil prices. However, the biggest news from the March CPI is the persistent price pressure from the wage-sensitive services sector.
Given price volatility in energy and food prices that can be driven by external factors, the Federal Reserve tends to focus on core (excluding food and energy prices) inflation when evaluating monetary policy and its price-stability mandate. Core CPI inflation came in at 0.4 percent month-over-month, or 3.8 percent year-over-year, matching the February pace. As a result, hopes for the beginning of a Fed pivot in June have quickly faded as the March data confirmed that “residual seasonality” alone could not be blamed for persistent inflationary pressures in the first months of 2024.
In some sense it is maddening that markets keep getting surprised by inflation data that are fully consistent with macroeconomic history. Last month we noted that while residual seasonality was observed in the January inflation prints, relying on a quick fall in the inflationary pace as the “residual seasonality” effect faded was wishful thinking at best.
So what is keeping core inflation hot? Late last year, we updated the evidence on sticky inflation and described how wage inflation was fulfilling its normal role. Higher wages are healthy for workers, but in an inflationary cycle, they can force businesses to keep prices high in order to protect their margins amid higher labor costs.
Turning back to the March core CPI print, the trend with wages is quite clear. Core CPI can be divided into three broad categories: core goods, housing services, and nonhousing core (or “supercore”) services. Over recent months, the disinflationary pressure from core goods seems to have run its course. The average contribution to core CPI’s monthly growth was roughly flat — just -0.03 of a percentage point — in the first three months of the year, matching the average pace in the final three months of 2023. Housing-services inflation is composed of both the rent of primary residences and owners’ equivalent rent (OER) and has remained sticky in recent months. In the final three months of 2023 and the first three months of 2024, the average contribution of housing services to the monthly growth in core CPI has remained steady at roughly 0.2 of a percentage point.
The culprit lies in the wage-sensitive supercore-services sector. The average contribution of supercore services to monthly growth in core CPI nearly doubled from the final three months of 2023 (0.11 of a percentage point) to the first three months of 2024 (0.2 of a percentage point). This acceleration dispels the claim cited frequently late last year that core inflation remained largely supported by housing services, and so the easing in inflation was more or less inevitable in the first half of the year.
Across various wage measures — to include the timely average hourly earnings series, the Atlanta Fed’s tracker of median wage growth, the New York Fed’s measure of trend wage inflation, and the Fed’s preferred Employment Cost Index (ECI) — wage pressures remain high. If you take the latest inflation numbers and annualize them, then inflation is running between 4 and 5 percent, exactly where the wage data would indicate.
It is possible that productivity growth is able to sustain a higher growth rate for wages. Others have pointed to an immigration influx that could support a robust, supply-driven labor market without the inflationary wage effects. However, these explanations, in our view, miss the link to inflation reacceleration in the most wage-sensitive sectors. With the Fed set to keep monetary policy restrictive for longer, the heightened risk of a cooling labor market may be the only thing to bring inflation to its knees.
Kevin A. Hassett is the senior adviser to National Review’s Capital Matters and the Brent R. Nicklas Distinguished Fellow in Economics at the Hoover Institution. Cale Clingenpeel served in the Trump administration as senior adviser to the chairman of the White House Council of Economic Advisers.