U.S. Economy: Factors Behind the Latest Inflation Spike

At the end of 2023 and the beginning of 2024, the U.S. economy seemed poised for what many termed "economic nirvana."

by Faruk Imamovic
U.S. Economy: Factors Behind the Latest Inflation Spike
© Getty Images/Kevin Dietsch

At the end of 2023 and the beginning of 2024, the U.S. economy seemed poised for what many termed "economic nirvana." Growth appeared steady, inflation was manageable, and there was hope that the Federal Reserve might ease its tight monetary policies. This optimistic outlook envisioned a continuation of America's four-year economic expansion, potentially even leading to interest rate cuts. However, recent data has significantly altered this rosy picture, leading to a reconsideration of the immediate economic future.

Signs of an Inflationary Boom

The past few months have upended expectations, pointing instead to an inflationary boom. The U.S. economy has remained robust, but inflation has surged anew. The labor market's resilience has been notable, with job reports often surpassing forecasts and the Employment Cost Index—an important gauge of employee compensation—on the rise. These developments indicate strong economic momentum.

However, the most striking shift has been the persistence and resurgence of inflation, which has surprised economists, analysts, and, crucially, Federal Reserve officials. The core personal consumption expenditures (PCE) index, the Fed's preferred inflation measure excluding volatile categories like food and energy, has accelerated, undoing much of the previous progress in curbing inflation. This unexpected uptick has led to delayed expectations for interest rate cuts, with some analysts even predicting a potential rate hike to combat renewed inflationary pressures.

Economists have been reevaluating expectations in light of new data. Clinging to outdated projections only to avoid being wrong is poor practice. Upon examining the recent inflation dynamics, some believe the concerns over renewed overheating are somewhat overstated.

Unpacking the Inflation Dynamics

Before the start of 2024, inflation seemed to be cooling, aligning with the Fed's target of 2% year-over-year. Core PCE inflation was at an annual rate of 1.9% by December. However, in the first three months of this year, this measure surged to 4.4%. Such rapid acceleration in core inflation is uncommon and hard to explain based solely on economic fundamentals.

Inflation can be conceptualized as a triangle, with each leg representing a key factor: expectations, aggregate demand, and supply shocks. Expectations are measured through various surveys to gauge how deeply inflation is embedded in consumer and business mindsets. Aggregate demand can be inferred from indicators like unemployment rates, while supply shocks involve one-off disruptions affecting prices of goods and services.

Long-term inflation expectations, as measured by the Survey of Professional Forecasters, have stabilized at 2%, the Fed's target. Unemployment is slightly higher than a year ago, suggesting that the inflationary pressures aren't stemming from a surge in consumer demand. Supply chains also appear to be functioning smoothly, with no significant bottlenecks.

Inflation Continues To Surge
Inflation Continues To Surge© Getty Images/Joe Raedle

The recent inflation spike appears somewhat random, driven by industry-specific factors rather than broad economic conditions. For instance, healthcare services inflation increased due to changes in government rules affecting Medicaid payments. Similarly, financial services costs rose as fees tied to stock market performance increased, reflecting the strong market gains at the end of 2023. These specific factors have disproportionately influenced the overall inflation picture.

Looking Ahead: Stability Amidst Fluctuations

Despite the current hot inflation readings, the fundamental case for returning to a steady economic path remains strong. Economic growth isn't spiraling out of control. Real GDP grew at a 1.6% annualized rate in the first quarter, with private demand—a measure excluding inventory buildups, government spending, and net exports—up 3.1%. This suggests a robust yet steady economic state, rather than a sudden boom.

Bringing inflation down from multidecade highs was always going to be a complex task, as evidenced by the start of the year. Investments in residential real estate boosted GDP, but rising borrowing rates and declining building permits indicate this trend is unlikely to continue. Recent consumption increases were largely fueled by dipping into savings, which isn't sustainable as wage growth moderates. The Indeed Wage Tracker shows a slowdown in wage growth, predicting further moderation in the broader Wage Growth Tracker from the Atlanta Fed.

Market Reactions and Future Expectations

Equity markets have surprisingly shrugged off the inflation news, but persistent inflation could pose real risks to growth. Strong inflation erodes real incomes, potentially dampening household consumption and corporate earnings. This isn't a repeat of last year; labor markets are in a different state. Therefore, rather than supporting the inflationary boom narrative, stronger inflation today suggests more downside risks for the economy.

Fortunately, there are strong reasons to expect the recent inflation pickup to fade. Inflation expectations remain stable, labor-market turnover is low, and inflation continues to moderate in many developed countries.

From a market perspective, if the analysis holds, a slowdown in core inflation combined with stable economic growth could renew optimism for a soft landing. This scenario would favor bonds over stocks in the near term, though both could perform well.

Reducing inflation from its recent highs was never going to be simple or straightforward, as the start of this year has shown. Expecting inflation to continue its downward trend isn't about maintaining blind faith; it's about interpreting the data accurately. Economic nirvana is still within reach.