Where Is Inflation Headed? 

12.13.2023 The path of inflation is probably one of the most important financial influences facing our economy and markets next year. Will pricing trends gradually decline on their own, allowing for lower interest rates without sacrificing economic growth, or will it take a recession to quell demand and put the kibosh on price growth? Each scenario carries starkly different market outcomes. A gradual slowing would likely usher in lower interest rates and higher equity markets, while a recession could be coupled with an equity market pullback. Which way are we headed?

US prices perked up in November, keeping monetary policymakers on guard in their multi-year inflation fight. Core consumer prices, excluding food and energy – the Fed’s preferred inflation measure – expanded 0.3% in November following October’s 0.2% advance, and four per cent year over year for a second consecutive month. Demand, one of the linchpins of price growth, is currently entwined with wage growth. While price pressure has declined from multi-decade highs, a shortage of workers and the availability of jobs are keeping wages elevated. Hourly earnings growth, a good directional indicator of price growth, is up 3.9% over the last 12 months through November, in line with core price inflation. Wage growth needs to decline in tandem with prices to approach the Fed’s two per cent target. 

Several inflation components remain stubbornly sticky and could influence inflation’s direction next year. One of the most influential factors is owners’ equivalent rent (OER), the cost of shelter, whether for homeowners or renters. OER comprises about one-third of the CPI, thanks to the dominance that shelter costs play in our daily lives. Year-over-year, shelter costs have risen 6.7%, more than double the rate of inflation overall. 

The good news is there are indications that owners’ equivalent rent could roll over. Average rent increases through September were less than three per cent, according to the Real Estate Investment Society (REIS). We expect further deceleration since new capacity will be coming online.  Notwithstanding a moribund market in residential new home building, multifamily construction growth was over 20 per cent as recently as September. As of October, it’s slipped to 17 per cent. This additional supply will ultimately weigh on rents.

Post-pandemic revenge spending has pushed restaurant menu pricing up dramatically. Dining out, another sticky pricing component, has become 5.3 per cent more expensive than this time last year. That $26 pasta dish I enjoyed last year is now priced at $31, a nearly 20 per cent increase. Unfortunately, we see no evidence that would suggest lower restaurant prices in the months ahead. Rarely do restaurants lower their prices once their menus are printed. 

Meanwhile, inflation expectations, particularly from households, remain high. Thankfully, consumer and market participants have done a poor job of predicting price growth. We suspect households are influenced by recency bias, meaning that current trends overly influence future expectations.  Consumers currently expect 3.4% inflation next year and three per cent annualized inflation over the next three years, according to Federal Reserve data. That’s well above the Fed’s two per cent target. Under that scenario, overnight rates will remain tight, crimping both stock and bond markets next year. We suspect consumer estimates are too high. The anticipated inflation rate over the last several years was well below actual price growth, thanks to low inflation leading into the forecast. 

While sticky prices challenge our forecast for slowing growth and lower inflation next year, we must remember that inflation measures price growth, not price levels. Prices don’t have to fall in order for inflation to fall. So, if that pasta dish remains at $31 next year, inflation as measured by the “Pasta CPI” would be zero. While a lot depends on the job market and wages, we expect inflation to gradually trend toward the Fed’s two per cent target next year. That would be good news for stocks and bonds. 

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About Cresset

Cresset is an independent, award-winning multi-family office and private investment firm with more than $45 billion in assets under management (as of 04/01/2024). Cresset serves the unique needs of entrepreneurs, CEO founders, wealth creators, executives, and partners, as well as high-net-worth and multi-generational families. Our goal is to deliver a new paradigm for wealth management, giving you time to pursue what matters to you most.

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