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We have entered a world of zombie inflation. Wall Street is fearlessly afraid.

Persistent inflation surprised economists, analysts, and especially members of the Federal Reserve.Tyler Le/BI

What a difference three months makes.

In late 2023 and early 2024, it appeared that the US was on a glide path to what I called “economic nirvana”: growth would remain steady, if not spectacular, as inflation cooled to a more manageable pace. This combination would not only allow America to continue its four-year expansion, but also allow the Federal Reserve to ease its efforts to rein in the economy — and perhaps even cut interest rates.

The data released in recent months has forced me to reconsider my expectations for that nirvana, or at least the timing of its arrival. Recent signs point instead to an inflation boom: a slightly warmer economy in which growth has remained strong while inflation has risen again. The labor market has proven resilient, with recent employment reports largely above expectations and the Employment Cost Index, a widely followed measure of wage bill growth, picking up.

But perhaps the most striking development is the persistence of inflation, which has surprised economists, analysts and especially members of the Federal Reserve. The core personal consumption expenditure index — the Fed’s preferred inflation gauge that excludes volatile categories like food and energy — has accelerated, reversing much of the progress of the previous six months. This inflation-boom dynamic has raised expectations for rate cuts, led some more alarmist analysts to suggest that the US is about to be gripped by another bout of high inflation, and led some to wonder whether the The Fed’s next step will instead be to raise interest rates. .

Of course, it’s fair to reevaluate your expectations when new data is presented. Clinging to your projection just to avoid being wrong is a sign of poor analysis. But after carefully examining the underlying inflation dynamics that have driven the recent panic about renewed overheating, I think the concerns are overblown.


Leading up to 2024, the pace of price increases fell back to earth – or at least the Fed’s target of 2% year over year. Core PCE rose at an annualized adjusted rate of 1.9% in the six months ended December. It seemed like ‘mission accomplished’. But in the first three months of this year, the metric warmed up again, with the core PCE rising to 4.4%. Typically, price increases are a slow process, so it is rare for core inflation to accelerate so quickly. However, when I started digging into the data, I found it difficult to explain the reversal based on the fundamentals.

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I think of inflation as a triangle: each leg helps explain our overall price picture. The first phase consists of expectations: various studies help measure the extent to which inflation has become entrenched in the minds of consumers and companies. If these expectations start to rise, it could be an indication that inflation will soon follow suit. The second element is aggregate demand: if people suddenly have more to spend, this can increase spending and thus increase prices. One way to measure this is unemployment: if there is a sudden increase in the number of Americans getting new jobs, demand will likely increase as well. The final piece is supply shocks: to what extent have one-time disruptions helped raise the prices of things like imported consumer goods or oil? Using this framework, it is difficult to determine why inflation has increased so much.

The Survey of Professional Forecasters found that longer-term inflation expectations have stabilized at 2% – the Fed’s target. The unemployment rate has risen modestly compared to 12 months ago, indicating that price increases are not driven by a sudden increase in consumer or household demand. And there have been no significant bottlenecks in supply. The ISM supplier delivery index, which measures how long purchasing managers have to wait to get the goods they need, indicates that the supply chain is running smoothly.

At a deeper level, it appears that the acceleration in inflation is somewhat random, with much of the recent increase driven by sector-specific factors rather than general economic conditions. Inflation in healthcare services is a notable example. PCE inflation includes both what consumers pay out of pocket for their care and payments made on behalf of individuals by employers or the government. Well, due to government rule changes in the first quarter, Medicaid payments soared, pushing the overall index up. Similarly, as fees paid to financial advisors rose, the cost of financial services rose, but this is simply a delayed response to the stock market’s strong performance in late 2023. Since fees are a fixed percentage of one’s portfolio, The big rise in share prices at the end of last year meant that people might have paid more dollars in total to their adviser, but that was only because the value of their investments also soared.

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These one-off events have had an outsized impact on the overall inflation picture. Before 2024, the contribution of acyclic components to core inflation was close to zero. This has risen to 4.4% in the past three months. In contrast, the impact of cyclical components – those correlated with the overall health of the economy – on inflation has slowed marginally since last year.


Given the nature of the recent high inflation rates, there is a strong case for a return to the path of nirvana.

To begin with, economic growth cannot escape the Fed. If growth were to accelerate substantially, it would push up the demand side of the inflation crank, causing prices to rise as Americans went out and spun their new money around. But that’s not what happens. Real GDP rose 1.6% year on year in the first quarter, with private demand – excluding business inventory build-up, government spending and net exports – rising 3.1%. Strong private demand growth suggests that GDP could be even more robust in the second quarter. Rather than a sudden rebound in the economy, the data under the hood suggests this is simply the US entering a stable economy.

First, residential real estate investment has soared, boosting GDP by half a percentage point in the first quarter. But with loan rates rising and building permits declining, these types of contributions to housing construction are unlikely to be repeated. Second, the increase in consumption in the past two months was almost entirely caused by a decline in the savings rate. In other words, Americans fueled their purchases by tapping into their cash reserves. I wouldn’t expect households to benefit as much from their savings in the future, especially as wage growth continues to moderate. The Indeed Wage Tracker, a measure of changes in wages and salaries advertised in job postings on Indeed, has been steadily slowing – down to 3.1% growth over the past year. This measure tends to lead the Atlanta Fed’s more widely followed Wage Growth Tracker by about eight months. Add all this together and it paints a picture of a resilient, but certainly not red-hot economy.

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I’m amazed at how quickly the stock markets are shaking off the inflation news. If inflation continues at this rate, it poses real downside risks to growth. Real incomes will slow as inflation remains strong, which will weigh on household consumption and, in turn, corporate profits. This isn’t like last year. The labor markets are not in the same place. So rather than reinforcing the inflation wave narrative, stronger inflation today implies greater downside risk to the economy.

The good news is that there are strong reasons to expect the recent rise in US inflation to fade. Expectations are stable, labor market turnover remains low and inflation continues to moderate in many parts of the developed world.

In terms of the outlook for the market, the upshot is that if my analysis is correct, the slowdown in core inflation and the stability of economic growth should renew some enthusiasm for the prospects of a soft landing. If that’s true, I would choose bonds over stocks for now, although they should both do well.

Reducing inflation from its highest level in decades was never going to be a simple or straightforward task; the beginning of the year has proven that. Expecting inflation to continue its downward trend is not a matter of continuing to believe in it. It’s a clear representation of what the data really tells us: Nirvana is still possible.


Neil Dutta is head of economics at Renaissance Macro Research.

Read the original article on Business Insider

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