Just how high is inflation in the U.S. going to go?
The yearly increase in the cost of living is primed to top out close to 5% soon, which would easily outstrip the annual pay raise of the average American worker.
The good news is that inflation is all but certain to subside soon. The big question is how much. Will Americans actually get relief from surging costs of all sorts of goods and services, ranging from gas and lumber to used cars and vacation rentals?
Let’s try to unpack the problem.
The consumer price index, the government’s main tool for tracking inflation, is expected to rise by an outsized 0.5% in May. The report comes out Thursday morning.
If the Wall Street forecast is on the mark, inflation over the last 12 months would climb to 4.8% or a bit higher. That would put the inflation rate at its highest level since 2008, when the price of oil
peaked at $150 a barrel.
Another closely followed measure in the CPI report that strips out volatile food and energy costs, meanwhile, could accelerate to a 3.5% yearly pace. That would be the biggest increase in 28 years.
Yet starting in June inflation should start to taper off, at least strictly by the numbers. How come? Because of what economists call “base effects.”
More economist goobledygook? Unfortunately, yes. But it’s important to understand.
The yearly rate of inflation is determined by averaging the increase over each of the past 12 months. Inflation sank last year in March, April and May, during the early stages of the pandemic. Those readings have been suppressing the true level of inflation.
As the negative readings from those three months are dropped from the 12-month average, the yearly rate of inflation has soared to 4.2% in April from just 1.4% at the start of the year.
Now the reverse is about to happen. The sharp increase in the 12-month rate of inflation will begin to unwind starting in June.
So does that mean rising inflation is not a problem? Not at all.
Even if price pressures ease, the odds are rising that U.S inflation will easily top 3% in 2021 for the first time in a decade. And a higher cost of living will pinch consumers.
The more critical question is whether inflation continues to wane in 2022. The Federal Reserve, the nation’s inflation watchdog, has insisted for months that the surge in inflation is temporary.
The central bank predicts inflation will slow to a 2% annual rate by next year, using its preferred PCE price gauge.
In the Fed’s view, almost the entire increase in inflation reflects the lingering effects of the pandemic and a full reopening on the economy.
The pandemic forced many companies to slash production and disrupted trade around the world as countries closed their borders to travel and instituted safety rules. With the economy reopening, businesses are scrambling to ratchet up production and obtain badly needed supplies from domestic and overseas suppliers.
The result: widespread shortages that have raised prices and inflation.
The reopening of the economy and end of coronavirus restrictions have also unleashed a storm of pent-up demand.
Cooped-up Americans, many of them flush with stimulus money and excess savings, are rushing to do all the things they couldn’t do during the pandemic: dine out, travel, take a vacation and so forth.
Hotels, rental-car agencies, vacation resorts, airlines and other companies have responded by raising prices to precrisis levels — or even higher — as business gets back to normal. These service-oriented businesses cut prices during the pandemic.
“It appears everyone is trying to raise prices,” said senior economist Sam Bullard of Wells Fargo. Rarely was that the case before the crisis, he said.
So far consumers haven’t balked all that much.
“Right now consumers are a little more tolerant of higher inflation than they otherwise would be. They have a lot of extra savings,” said chief economist Richard Moody of Regions Financial. “And this desire to get out and about makes them more willing to accept higher prices for a while.”
What could become a problem later on, however, is if consumers and businesses continue to expect higher inflation.
Workers could demand higher raises and companies would charge more, creating a situation in which inflation exceeds the Fed’s 2% annual target for a prolonged period and potentially forces the central bank to raise interest rates sooner than it would like.
Even top Fed officials admit they’ve been surprised by how much and how quickly inflation accelerated.
That story will take a year or longer to play out.
Moody and many other economists predict the CPI inflation barometer will rise by close to 4% in 2021, while SIFMA, an influential lobbying group for Wall Street, predicts consumer prices will increase 3.8%.
The rubber will meet the road if inflation, using the CPI and PCE, doesn’t start to taper off toward 2% by early next year, since the Fed is banking on precisely that.