Inflation Rate: US economy will likely need drastic action from the Federal Reserve as food and shelter prices soar

NEW YORK CITY– US inflation is showing signs of entering a more intractable phase that will likely require drastic action from the Federal Reserve, a shift that is panicking financial markets and raising risks of a recession.

Some of the long-standing drivers of higher inflation — soaring gas prices, supply chain snarls, soaring used-car prices — are fading. But the underlying inflation readings are actually deteriorating.

The continued development of the forces behind an inflation rate near a four-decade high has made it harder for the Fed to contain it. The prices are no longer increasing because the costs of some categories have skyrocketed. Instead, inflation has now spread further through the economy, fueled by a strong labor market that is pushing up paychecks, forcing companies to raise prices to meet higher labor costs, and giving more consumers the wherewithal to spend spending there.

On Tuesday, the government said inflation rose 0.1% from July to August and rose 8.3% year on year, below the four-decade high of 9.1% in June.

But excluding the volatile food and energy categories, so-called core prices rose by a stronger-than-expected 0.6% in July-August, after a more modest 0.3% rise in the previous month. The Fed is closely monitoring core prices, and the latest numbers fueled fears of an even more aggressive Fed and sent stocks plummeting, with the Dow Jones plunging more than 1,200 points.

The core price numbers added to fears that inflation has now spread to all corners of the economy.

“One of the most notable things is how broadly based the gains are,” said Matthew Luzzetti, chief US economist at Deutsche Bank. “The underlying inflation trend has certainly not shown any progress towards moderation so far. And that should worry the Fed as the gains are increasingly demand-driven and therefore likely to be more sustained.”

Demand-driven inflation is a way of saying that consumers, who account for nearly 70% of economic growth, keep spending even as they resent having to pay more. That’s partly because of widespread income gains and partly because many Americans still have more savings than before the pandemic after postponing spending on vacations, entertainment and dining.

When inflation is mostly demand-driven, the Fed may need more drastic action than when it’s mostly driven by supply shocks, such as an oil supply disruption, which can often resolve on their own.

Economists fear the only way for the Fed to curb robust consumer demand is to hike interest rates high enough to spike unemployment and potentially trigger a recession. Typically, when fears of layoffs mount, the unemployed don’t just cut spending. This also applies to many people who are afraid of losing their jobs.

Some economists now believe the Fed will need to raise its short-term interest rate much higher to 4.5% or more by early next year, up from previous estimates of 4%. (The Fed’s policy rate is now in a 2.25% to 2.5% range.) Higher Fed rates would, in turn, lead to higher costs for mortgages, auto loans, and business loans.

The Fed is widely expected to hike its benchmark short-term interest rate by a sizeable three-quarters point next week for the third straight month. Tuesday’s inflation report even led some analysts to speculate that the central bank could announce a full percentage point hike. If that were the case, it would be the largest increase since the Fed began using short-term interest rates to guide consumer and corporate borrowing in the early 1990s.

Although headline inflation has barely increased over the past month, underlying inflation, which reflects broader economic trends, has deteriorated. A measure the Federal Reserve Bank of Cleveland uses to track median inflation, which essentially ignores categories with the greatest price volatility, rose 0.7% in August. That was the largest monthly increase since records began in 1983.

Higher prices haven’t yet caused much of what economists call “demand destruction” — a drop in spending that could stifle inflation. Though higher gasoline prices have prompted Americans to drive less, there isn’t much evidence of significant cuts elsewhere.

Restaurant prices, for example, rose 0.9% in August and are up 8% over the past year. But that hasn’t noticeably stopped people from going out. Restaurant traffic at Open Table, an app that tracks reservations, has exceeded pre-pandemic levels and continued to increase into September.

Overall, consumers have largely maintained their spending despite rampant inflation, albeit perhaps with clenched teeth. In July, expenditure increased by 0.2% in real terms.

The spread of inflation to services such as rent and health care largely reflects the impact of higher wages. Hospitals and doctor’s offices have to pay more for nurses and other staff. And as more Americans find jobs or get a raise, the more they can move out of the home or parting ways with roommates. Rental costs rose 6.7% last year, the fastest since 1986.

Wages and salaries rose 6.7% year over year in August, the largest increase in nearly 40 years, according to the Federal Reserve Bank of Atlanta’s wage tracker. And Luzzetti noted that the same data shows a record wage premium for people who change jobs compared to those who stay. That means employers are still offering big raises to try and fill positions.

Economists had hoped rising prices for services would be offset by falling costs for goods such as new and used cars, furniture and clothing after these items surged during the pandemic. As supply chain backups improved, it was expected that a better flow of such goods would drive down prices.

But so far that hasn’t happened.

“We’ve seen shipping costs go down, we’ve seen supply chain congestion ease a bit, production has improved and inventories have increased,” said Laura Rosner-Warburton, senior economist at MacroPolicy Perspectives. “So all this points to an improvement on the supply side. And yet companies are still enforcing large price hikes on these goods, and that’s problematic.”

Such trends could renew debate about the extent to which firms’ ability to raise prices has been fueled by a lack of competition, a phenomenon known as ‘greedflation’. But most economists attribute companies’ ability to charge more to consumers’ willingness to pay.

“It seems retailers are now raising prices because they can, not because they have to. Consumer demand is still too strong,” said Aneta Markowska, chief economist at Jefferies, an investment bank, in a research note.

Copyright © 2022 by The Associated Press. All rights reserved. Inflation Rate: US economy will likely need drastic action from the Federal Reserve as food and shelter prices soar

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