In theory, achieving the Federal Reserve’s 2% inflation target might appear straightforward. Focus on taming inflation in services and shelter costs, and everything should fall in line. However, in practice, it’s a far more intricate challenge.
While many components of inflation exhibit signs of easing, prices in pivotal areas like services and shelter have proven stubbornly resistant to decline. These two components, which are vital for achieving the 2% target, have remained remarkably stable, unlike more cyclical components such as food and energy costs, or used and new car prices, which fluctuate with the broader economy.
In the view of Steven Blitz, the chief U.S. economist at GlobalData TS Lombard, achieving control over rents and medical care services, among other factors, could require a drastic solution. He asserts, “You need a recession. You’re not going to magically get down to 2%.”
Annual inflation, measured by the consumer price index, fell to 3.7% in September, or 4.1% when excluding volatile food and energy costs. Although these figures still exceed the Fed’s target, they signify progress from a time when inflation exceeded 9%.
A closer look at the CPI components reveals a mixed picture, with some components benefiting from easing, such as used-vehicle prices and medical care services. However, sharp increases in shelter (7.2%) and services (5.7%, excluding energy services) have offset these gains. Shelter costs, specifically, have risen significantly, including rent of shelter (7.2%), rent of primary residence (7.4%), and owners’ equivalent rent (7.1%).
Without progress in these areas, it’s improbable that the Fed will achieve its target in the near future.
Economic Uncertainty Looms
The challenge lies in the resistance of “sticky-price” inflation, affecting rents, services, and insurance costs, which has persisted at a 5.1% rate in September, down from 6.1% in May, according to the Atlanta Fed. In contrast, flexible CPI, which includes food, energy, vehicle costs, and apparel, grew at a slower 1% rate. These statistics illustrate progress but don’t signify the achievement of the 2% goal.
Market analysts are pondering the Federal Reserve’s next move: should policymakers implement another rate hike before year-end, or should they adhere to the newer “higher-for-longer” approach while monitoring inflation dynamics?
Lisa Sturtevant, chief economist for Bright MLS, emphasized housing’s role in elevated inflation numbers, saying, “Inflation that is stuck at 3.7%, coupled with the strong September employment report, could be enough to prompt the Fed to indeed go for one more rate hike this year.” She highlighted that housing plays a pivotal role in inflation.
The impact of higher interest rates is most evident in the housing market, affecting sales and financing costs. While prices remain high, concerns linger that elevated rates might deter new apartment construction, keeping supply constrained.
Long-Term Concerns
A significant factor that might keep the Fed from acting is the notion that rate increases totaling 5.25 percentage points have not yet fully permeated the economy. This brings us back to the idea that the economy needs to cool down before the central bank can complete the final stretch of its journey to achieve 2% inflation.
Despite the fading of pandemic-related effects, challenges remain. “Pandemic-era effects have a natural gravitational pull, and we’ve seen that take place over the course of the year,” said Marta Norton, chief investment officer for the Americas at Morningstar Wealth. Norton added that the remaining journey to reach the 2% target requires economic cooling, which is no easy feat given fiscal easing, strong consumer activity, and the overall financial health of the corporate sector.
Fed officials expect economic growth to slow this year, although they’ve backed away from earlier predictions of a mild recession. Policymakers have been counting on the idea that when existing rental leases expire, they will be renegotiated at lower prices, thus reducing shelter inflation. However, rising shelter and owners’ equivalent rent numbers challenge this assumption. Stephen Juneau, U.S. economist at Bank of America, suggests that more data is needed to determine if this is a temporary blip or a fundamental change in rent patterns, as historical examples don’t offer clear guidance for long-term trends in rent inflation.
