The Fed’s inflation battle gets tougher as the cost of services rises

Economists warn that it will be difficult to crush persistently high inflation in the United States after it takes root in the services sector of the economy, which indicates that the Federal Reserve will have to push forward with increasing interest rates in 2023.

After a year of skyrocketing consumer prices, the US inflation rate is expected to drop rapidly next year. But many economists warn that fundamental pressures will keep it at levels well above what the Fed considers palatable.

said Jean Boivin, a former deputy governor of the Bank of Canada who now heads the BlackRock Investment Institute. But those numbers at the end of the year won’t be anywhere close to the zip code of [what] The Fed will be comfortable with it.”

The US central bank has aggressively raised interest rates this year in an effort to stem high inflation. But her task is made more difficult by the divergence between price trends for goods and services.

Inflation related to everyday commodities such as used furniture, cars and appliances is declining. Prices for these materials soared early in the pandemic as demand soared and manufacturing and shipping were disrupted. Recent data suggests that the trend is beginning to reverse and is likely to continue in 2023 as retailers run down bloated inventories.

Economists say housing costs are also likely to fall. Rising mortgage rates linked to a hike in interest rates by the Federal Reserve drove down home prices. New leases for real estate have passed their recent peak, with rental demand posting the largest monthly decline in the seven years since real estate company Zillow began tracking the data.

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Taken together, most Fed officials expect the PCE price index — once volatile food and energy costs are removed — to fall to an annualized rate of 3.5 percent next year. Economists polled by Bloomberg expect core personal consumption expenditure inflation to ease to about 3 percent by the fourth quarter of next year.

Both projections are still well above the Fed’s 2 percent target. In November, the core personal consumption expenditures index rose 4.7 percent year-on-year, according to data released Friday, slowing from a peak of 5.4 percent earlier this year but above the Fed’s target.

Offsetting declining commodity inflation are the costs of dining out, haircuts, commuting and other services-related activities — a dynamic Federal Reserve Chairman Jay Powell warned against in his final press conference in 2022.

“Commodity inflation has shifted very quickly now that it hasn’t shifted at all for a year and a half,” he said after the Fed’s December monetary policy meeting, at which the central bank slowed the pace of interest rate increases. to a new target range of 4.25 percent to 4.5 percent. But there’s an expectation that service inflation won’t go down that fast, so we’ll have to stay there [and] We may have to raise interest rates to get where we want to go.”

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The extent to which service inflation persists depends primarily on the labor market. Amid labor shortages and increasing consumer demand, employers have had to increase wages and benefits to keep up. Compared to November of last year, wages increased 6.4 percent, according to data from the Atlanta Fed.

Fed officials have acknowledged that its efforts to reduce inflation will include job losses, but they maintain the possibility of avoiding a recession. Most officials expect the economy to expand by just 0.5 percent next year and the unemployment rate to rise by nearly a full percentage point, to 4.6 percent.

“What they’re trying to do is calm inflation faster than they cut wages,” KPMG chief economist Diane Swonk said of the Fed.

Swonk expects the economy to slide into recession next year while inflation drops to just under 3 percent by the end of 2023. And the prospect of being blamed on job losses puts the Fed “in this terrible position of having to appear to be against the labor market.” , She said.

Officials maintain that they can control inflation by raising the benchmark federal funds rate to between 5 percent and 5.25 percent next year and maintaining that level at least through 2024 — a view that runs counter to current market rates, suggesting a central position. . The bank will not have to raise its interest rate any higher than 5 percent, and it will cut its interest rate nearly twice by the end of next year.

Powell also warned that the Fed may need to be more aggressive if data does not cooperate, given its unwavering commitment to bringing inflation back down. One concern is the potential impact of China reversing its “zero Covid” policy, which some economists warn could unleash another round of commodity price increases.

“Without price stability, you get nothing,” said Stephen Cicetti, an economist at Brandeis University who previously headed the monetary and economics department at the Bank for International Settlements. You do not have economic stability and general prosperity. You do not have financial stability. You just have a mess.”

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