MNI: Inflation Seen Staying High, Making Fed Rate Pause Harder

A deceleration in inflation the Federal Reserve hopes could allow it to slow or pause rate hikes in the fall may not materialize, with current and former Fed staff economists telling MNI supply shocks and strong domestic demand are likely to keep prices rising more than expected for months longer.

The full inflationary impact of the war in Ukraine and China's zero-Covid policy is only starting to be felt, the economists said. Meanwhile, continued reopening after pandemic restrictions could further fuel demand for services, a sector already experiencing acute staffing shortages and wage pressures. Housing costs are also headed higher still.

While war has already sent energy prices soaring, the inability of Russia and Ukraine to export wheat and key fertilizer components like ammonia, natural gas and potash are just beginning to make their way into the production process and could hit food prices later this year, said Robert Rich, director of the Center for Inflation Research at the Cleveland Fed.

"Fertilizer prices are three to four times higher compared to 2020. How this will potentially show up in terms of production hasn't played out," he said in an interview. In response to higher costs, some farmers may use less nutrients, which would reduce crop yields. "There's a lot of uncertainty because we don’t know what the reaction will be in the farming community right now. Prices are high and could potentially go even higher."

SUPPLY DISRUPTIONS

Prolonged Covid lockdowns in China are forming other supply shocks. "There's a direct effect on global supply chains, but an important question is how are firms responding to the ongoing supply chain issues," Rich said, adding that a wave of reshoring could see more expensive local production substitute for imports. "The anticipation is this could extend the surge of elevated inflation readings."

The Fed's preferred PCE inflation measure fell several tenths to 6.3% in the 12 months ended April, while CPI eased to 8.3% over the same period. Fed officials have penciled in larger-than-usual 50 bp rate hikes for June and July to take the fed funds rate target close to 2.0%, the low end of estimates of neutral, and are looking for a deceleration in month-to-month inflation readings to decide whether to slow the pace of tightening in September.

But Joseph Haslag, a former Dallas Fed economist now at the University of Missouri, told MNI he's losing hope that inflation will fall to 4%-5% by year-end. "I think inflation is at its peak, but suspect the peak will be pretty flat because of Ukraine, China and other fears," he said. "Inflation seems to be entrenched in the data in a way that I have not seen in previous data."

SHIFTING TO SERVICES

Policymakers had hoped a pivot by U.S. consumers back to buying services instead of physical goods as the economy normalizes would also relieve price pressures, slowing goods inflation to zero or even slightly negative while any services inflation pick-up is contained by Fed tightening. But that's far from assured.

While core CPI goods inflation has slowed over the past three months, the three-month annualized growth in core services prices accelerated to 7.7% through April. Rents are still climbing, and a surge in demand for restaurants and hotels could create the conditions for a wage-price spiral.

"Given the relative weighting of services versus goods in the basket, even if goods prices were to fall by 5% or so over the next year and service price growth stayed where it’s been over the last three months, we’d still be dealing with above target inflation," Atlanta Fed economist Brent Meyer told MNI.