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Bringing Inflation Down Is Going to Take Time, Patience — and Pain

Lucy Nicholson | Reuters
  • To stop 40-year highs in price increases, the economy will have to slow, supply chains will need to get fixed and demand will have to come back in line with pre-pandemic norms.
  • Friday's highly anticipated CPI inflation report for May is likely to show only modest relief, if any.
  • A recent paper by former Treasury secretary and Obama administration advisor Larry Summers suggests harsh interest rate hikes may be needed.
  • President Joe Biden himself noted that much of the heavy lifting has to be done by the Fed.

Tackling runaway inflation won't be easy and it won't be quick, and it may carry a steep price tag that is just beginning to be paid.

To stop 40-year highs in price increases, the economy will have to slow. The ability of producers to get their goods to the marketplace will have to get a lot better, and demand and supply will have to come back into balance. Most troublingly, until the Ukraine war settles, these factors will have a limited impact on fixing the economy.

Even under the best of conditions, a trend that has seen gasoline reach nominal new highs near $5 a gallon, the price of everyday foods like cereal, eggs and hamburger jump by double-digit percentages over the past year and housing costs rise ever higher, will ease only incrementally. That means little relief for consumers anytime soon.

"Slow descent" is how Wells Fargo senior economist Sarah House described the likely downward trajectory of inflation from here. "If you think about inflation, a lot of it is momentum driven. Price setting is slow moving. Companies don't just change their prices on a dime."

Indeed, Friday's highly anticipated inflation report is likely to show only modest relief, if any.

The consumer price index, a measure that encompasses the cost of a massive basket of goods and services, is expected to show inflation increasing at an 8.3% pace over the past year, same as in April, according to Dow Jones estimates. Excluding food and energy prices, so-called core CPI is expected to show growth of 5.9%, slightly off the 6.2% pace from the previous month.

What's more, the monthly gains are expected to accelerate — 0.7% for headline inflation versus a gain of just 0.3% in April. Core is expected to be little changed, up 0.5%, which would be a one-tenth point month-over-month decline.

Peering through the numbers

Economists, though, will look beyond the headline numbers and try to find trends in the CPI components.

Food and energy, for instance, comprise about 22% of the index, so any slowdown there will be considered noteworthy. Shelter costs, a vital component, make up 32%. More broadly, services comprise about 60% of CPI compared to 40% for goods. Most of the current inflation wave comes from the goods component.

"Slowing the economy would help. Seeing weaker demand growth would take some of the pressure off," House said. "It's not just about a slowdown, though. Compositions effects are important. Some areas are more important than others. Goods inflation is one area where we could begin to see spending slow. That's where a lot of the pressure points are."

The Federal Reserve is hoping to help that process along by raising short-term interest rates, which had been anchored near zero as the economy recovered from pandemic-related restrictions.

Markets widely expect the Fed to keep raising its benchmark borrowing rate to around 2.75%-3% from the current range of 0.75%-1%.

However, the Fed may have even more work to do than that.

A lesson from the '80s

A National Bureau of Economic Research working paper released recently by former Treasury secretary and Obama administration advisor Larry Summers, along with a team of other economists, suggests that the Fed could need to raise rates by considerably more to bring inflation down to its 2% goal.

The paper compared the current run of inflation to the early 1980s, which was the last time price increases were of a similar concern. During that time, the Paul Volcker-led Fed took the funds rate up to 19%, causing a recession that eventually helped send inflation on a downward spiral that would last almost 40 years, until the current run-up in prices.

Many economists say that kind of tightening won't be necessary because inflation was running at 14.8% back then.

But the Summers paper said CPI was calculated differently then, primarily in the way it accounted for housing costs. Using the same methodology would bring core CPI to about 9.1% now.

"To return to 2 percent core CPI inflation today will thus require nearly the same amount of disinflation as achieved under Chairman Volcker," the Summers team wrote.

Biden's plan

President Joe Biden recently released his plan to help bring down inflation.

In a Wall Street Journal op-ed, Biden said he would take measures to fix supply chain problems and bring down the budget deficit, which ran to nearly $2.8 trillion in fiscal 2021 but is on track to be a fraction of that this year — at just $360 billion through seven months, due largely to Congress not approving additional Covid-19 relief money.

But those measures are likely to just nibble at the edges of inflation, and the president himself noted that much of the heavy lifting has to be done by the Fed.

"They have the primary role on bringing inflation down," Treasury Secretary and former Fed Chair Janet Yellen said at a congressional hearing earlier this week. "It's up to them in how they go about doing it."

But Fed hikes also take time to work through the system and, until then, economists will be looking at other factors.

Recent announcements from Target and other retailers saying they will work to bring down excess inventory also could be deflationary. But with apparel carrying just a 2.5% weighting in the CPI, those kinds of moves won't make a big dent in the potentially scary headline numbers.

"If someone tells you recent news that some retailers are discounting clothes will have any measurably effect on CPI, ignore them," DataTrek Research co-founder Nicholas Colas wrote in his daily market note. "Retailers could give clothes away for free and U.S. inflation would still be over 5 percent."

Ultimately then, taming inflation will require a slow bleed of the forces that have led up to the current situation. That means a mix of lower growth, reduced strain on the labor market and a recipe of other things that will have to go right before measurable relief is possible.

"It's not going to be easy," said House, the Wells Fargo economist. "Given that you have decent consumer spending and business spending, that's going to keep the pressure on inflation overall."

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