MNI INTERVIEW: Demand-Driven Inflation Rising -Fed's Shapiro

Demand factors are increasingly responsible for persistently high inflation since 2022, offsetting some of the price relief from easing supply disruptions, Federal Reserve Bank of San Francisco economist Adam Shapiro told MNI.

His analysis adds to arguments that the U.S. central bank will need to tighten further to slow the economy and bring down stubbornly elevated inflation. The FOMC last week signaled strong support for two or more quarter-point increases this year even as officials opted not to raise rates in June.

The 0.7pp fall in core PCE inflation since its peak of 5.4% in Feb 2022 is "almost all due to supply-driven inflation declining," Shapiro said, adding that this had contributed -1.2pp to the reduction. Meanwhile, "demand-driven inflation has risen, counteracting this disinflationary process." The contribution of demand factors to year-over-year core PCE inflation is up 0.5pp during this period.

Demand-driven inflation has been "more or less steady over the last three to four months but relative to a year ago, it's higher," Shapiro said. "You'd certainly want that to come down and stop rising for inflation to be coming down."

SCANT PROGRESS

Inflation in the past three months has come in higher than anticipated, prompting FOMC members to revise up quarterly forecasts last week. With the price growth of goods and housing slowing, Fed Chair Jerome Powell again pointed to the diverse non-housing core services inflation category, which spans the most labor-intensive sectors in the economy, as a useful indicator.

It is showing only the "earliest signs of disinflation," Powell said. "Many analysts would say that the key to getting inflation down there is to have a continuing loosening in labor market conditions."

Yet Shapiro notes that while price growth in the sector has been closely correlated with pay growth, "wage increases tend to follow price growth. That means an exogenous increase in wages in and of itself is a bad gauge of where inflation is going, because it likely represents a price increase that’s already happened."

There’s no evidence of a demand-driven component of wages impacting prices, either, he added. "It’s almost as if the wage increase didn’t really even happen, because people are just able to afford again what they used to be able to afford. Real wages basically haven’t changed."

EXPECTATIONS

Non-housing core services includes everything from Medicare and Medicaid and private health care to airfares and haircuts to financial management -- with prices ranging from government-determined to market-based to imputed.

"It's a confluence of a lot of industries that price differently according to which sector they’re in. So it’s hard to gauge where inflation is going" for that category, Shapiro said. "It’s not well understood, and it’s such an important category."

The best signal of future progress on inflation is the evolution of expectations, which should come down at the same time as firms and individuals look back on recent trends to set prices going forward, Shapiro said.

"There’s been some comfort in that we’ve seen a broad range of expectations coming down from very high levels six months to a year ago, but they’re still above where they were in 2019. They haven’t fully normalized," he said. "I find that concerning, because this is such an important indicator in terms of how firms set prices and how workers demand higher wages."