The Road Back to 2% Inflation

Subscribe to the?Notes on the Week Ahead newsletter?to receive it directly in your inbox and access Market Insights on Amazon Alexa & Google Home.

It seems like a distant memory now, but in the decade before the pandemic, the main preoccupation of the Federal Reserve was boosting inflation, as measured by the headline personal consumption deflator, to 2%.?Inflation undershot this target in ten of the twelve years between 2008 and 2019.?

The inflation surge of the past two years has completely changed the Fed’s focus.?Moreover, it has also altered the outlook of many economists and strategists.?It is now deeply unfashionable to talk about “transitory inflation” and many argue that inflation pressures will be permanently stronger going forward than in the decade before the pandemic.

However, a rational examination of recent data strongly supports the idea that most of the inflation surge is, (or rather was), transitory.?Moreover, a quick survey of the forces that led to low inflation in the last decade suggests that most are still operating beneath the surface, implying that when transitory inflation has fully ebbed, what’s left should look pretty close to pre-pandemic inflation.

The Short-Term Fade

If transitory inflation is defined as year-over-year inflation in excess of the Federal Reserve’s target, then most of the transitory inflation surge is behind us.?Annual inflation, as measured by the personal consumption deflator, normally runs about 0.3% cooler than CPI inflation.?Consequently, a consumption deflator target of 2.0% amounts to a CPI target of 2.3%.?

Year-over-year CPI inflation peaked at 8.9% last June, 6.6 percentage points above that target.?By last month, year-over-year CPI inflation had fallen to 5.0%, or 2.7 percentage points about that target. By this yardstick, 59% of the transitory inflation surge is now gone.

The details are equally reassuring, as can be seen on page 30 of the Guide to the Markets.?Energy prices fell a further 3.5% in March and, while the recent OPEC+ agreement appears to have put a floor under oil prices for now, there are few signs of renewed shortages.?Grocery prices fell in March and the World Bank’s global food commodity index has now fallen for 12 consecutive months.

Core goods inflation has also cooled substantially, registering just a 1.5% year-over-year gain in March and declines in three of the last six months. The global purchasing manager vendor delivery index peaked in the midst of the pandemic, as strained supply chains were unable to keep up with booming consumer demand.?This has now completely reversed with the index now sitting below pre-pandemic levels.

On the services side, inflation remains stickier.?However, there is plenty of evidence of stabilizing rents which, with a substantial lag, should cut shelter inflation, particularly later this year and in 2024.?Even in the area of core services, ex-housing, which appears to worry Chairman Powell the most, there is some evidence of softening and slowly declining wage growth should help cool inflation in this area also in the year ahead.

Overall, we expect headline CPI inflation to fall below 4% year-over-year by June of this year, hover at around 4% for the rest of the year and then drift down to its long-term trend over the course of 2024.?But what is that long-term trend?

Longer-Term Forces

There are, of course, many long-term forces that impact inflation.?Together, they led to a steady decline in inflation from the early 1980s to the first decade of this century and a generally sideways move in inflation at low levels in the decade before the pandemic.?In considering where U.S. inflation is headed in the long run, it makes sense to review these forces:

Income Inequality:?Rising income inequality tends to reduce inflation since the richest households tend to save more of their income than the rest, diverting income from the purchase of consumer goods and services to financial assets.?According to the 2021 Consumer Expenditure Survey, the top 10% of households by income saved 33% of their after-tax income while the rest saved just 7%.?According to calculations by economist, Emmanuel Saez[1], the share of income earned by the top 10% of households rose from 34.6% in 1980 to 50.0% in 2019.?Since then this trend has continued with the top 10% of households earning 55.4% of income in 2021, the highest share on record, suggesting continued downward pressure on inflation going forward.

Declining Unionization: The percentage of the workers represented by unions fell from 23.3% in 1983 to 11.6% in 2019.?After a brief increase during the pandemic, due to the layoff of non-union workers, this trend has resumed with just 11.3% of workers represented by unions in 2022.?Not coincidentally, strike activity has also declined.?Strikes involving more than 1,000 workers exceeded 200 every year from 1964 to 1979.?In 2019, there were just 25 major strikes.?Last year, despite high inflation and the tightest job market in over 50 years, there were just 23.?In the first three months of this year, there have been just 3.?This suggests that workers may not be able to exercise the bargaining power that a tight labor market should give them and could also help explain why year-over-year wage growth has now lagged behind CPI inflation for 24 straight months.

Information Technology:?An equally important long-term force in reducing inflation has been the use of information technology in transactions.?In traditional transactions, the seller knows more about the product than the buyer and is somewhat expert at selling it at a high price.?However, in recent decades, an increasing share of goods and services have been bought over the internet or with knowledge gained over the internet, giving an advantage to buyers.?The pandemic has led to a further transition to the purchase of goods and services over the internet and could well, therefore, act as an even stronger disinflationary force going forward.

There are of course many other long-term forces, some of which will tend to increase inflation.?We expect the dollar to continue to fall in the decade ahead, in contrast to the last 15 years, and this should put upward pressure on the price of imports which equaled over 15% of our GDP last year.?A stalling out of a long trend of globalization since 2008 and a lack of deflation emanating from China could also boost prices.?And tight labor supply caused by aging demographics could at least sustain inflation although other demographic forces such as a declining birth rate could tend to erode it.

And finally there is government policy.?

For 40 years, until the last two, the Federal Reserve has been able to adopt ever more dovish policy positions in response to economic downturns without paying an inflation penalty.?Over the same period, fiscal policy also became progressively more reckless.?However, going forward, even if inflation drifts down to the Fed’s target and the economy enters recession, we do not expect a return to the zero bound for the federal funds rate.?The Fed may, at least, now appreciate the damage done by sustaining that policy for so many years after the financial crisis.?Similarly, the federal government is unlikely to be as generous going forward both because of divided government in the short-run and the recognition that recent inflation was stoked, in part, by a too-powerful fiscal response to the pandemic.

In summary, while there are some forces that will tend to support long-term inflation, on balance, there is little reason to expect higher inflation in the middle of this decade than in the middle of the last.?While this may only be a mild positive for American consumers, it is a big positive for investors, since it should set the stage for a return to an environment of low long-term interest rates that did so much to support the value of both stocks and bonds in the decade before the pandemic.

[1] Income Inequality in the United States, 1913-1998, with Thomas Piketty, Quarterly Journal of Economics, 118(1), 2003, 1-39 – data updated to 2021, February 2023.

For more insights, visit the?On the Minds of Investors?webpage.

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).