The higher you climb, the harder you fall?


When the Fed refers to current inflation as “transitory,” it is effectively calling for an eventual slowdown in the pace of inflation rather than a reversal in the price level. That said, there are a number of categories where the price level seems ripe for reversal. In this report, we brush off our prior work looking at where prices across a wide range of categories are versus their pre-COVID trend. We show three scenarios for inflation a year ahead based on how much prices in categories significantly above their prior trend could revert, leading to a drag on overall inflation.

Our analysis suggests inflation could slow markedly by the middle of next year following sharp gains in categories where prices were already well above their pre-COVID trends, such as used autos and car rentals. The return toward “normal” price levels for these categories now has more ground to cover, implying a somewhat bigger drag down the road. But the drag may not be too extreme and might not start for a while. Persistentsupply constraints beyond just the auto sector will keep the pressure upon prices, while lean inventory levels may leave firms with increased pricing power even as constraints eventually do start to ease. Shelter costs, which are the largest component of the CPI, are also set to grow faster ahead generating a bigger contribution to inflation over the next year. But ultimately, the higher prices have climbed recently, the further they may eventually fall. The overall rate of inflation may therefore temporarily fall below what will be its post-COVID trend, keeping the inflation picture for the Fed unsettled for a while yet.

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Price levels of some categories are ripe for reversal

Fed Chair Powell finally put the kibosh on the debate over whether the Fed viewed “transitory” inflation in the context of a reversal in the overall price level or mere slowdown in future price gains. We had already been interpreting the Fed’s view as referring to the pace of price growth, rather than the absolute level. However, there are a number of areas where the price level seems ripe for a reversal, which will influence how quickly and how much inflation will slow once supply constraints ease and demand growth cools. With each passing month prices surge well ahead of income, the potential for payback mounts. For example, used car prices were 30% above their pre-COVID trend in May, but after another 10.5% leap in July, prices are now 43% over their prior trend. The distance back to a level considered more “normal” is now larger. How much could even a partial reversal in prices for categories with exceptional gains end up denting inflation down the road?

The drag will depend on in-nite combinations of which categories see prices decline, how much each category declines, and over what time period, something no one can state with much conviction right now. Therefore, to get a general sense of the potential payback, we brush off our work looking at where prices across diflerent categories are versus their pre-COVID trend and construct three scenarios.

As illustrated in Figure 1, prices overall in June were 3.3% higher than where they would have been having they grown at their 2010-2019 pace over the past 18 months. But average hourly earnings (AHE) are even further above what the trend would have predicted at 4.9%. With wage cuts notoriously rare and employee compensation often businesses’ largest expense, we use that as a cutoff for which categories
are most ripe to see prices reverse. Categories where prices are not as far above their trend as wages view as much less likely to see prices fall. Our ripe-for-payback categories can be seen to the right of the lavender bar in Figure 1. We recognize that some categories like new autos might also decline, but others like household operations or health insurance may not. The timing is also likely to vary, but simply we assume the reversal occurs over the next 12 months.

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