The US economy is in the midst of a virulent attack of inflation. In January 2022, the consumer price index (CPI) rose 7.5% from a year earlier, the biggest increase in nearly 40 years. This rise in inflation was unexpected by most forecasters, financial market participants, and monetary policy makers. Now, however, aware of the dangers high inflation poses to the health and stability of the US economy, the Federal Open Market Committee (FOMC) is ready to start raising its policy rate. at the end of the meeting on March 15 and 16. Given that inflation is well above the FOMC’s 2% target, the number and timing of FOMC rate hikes will largely depend on the actual and expected path of the inflation rate this year. Encouragingly, the broader economy and labor markets are performing well: the consensus of most forecasters is that economic conditions will remain robust into 2022. As always, however, there is uncertainty about the near-term outlook, and perhaps more now than usual given the large inflationary shock and recent geopolitical events in Eastern Europe.
Inflation is high and the outlook is uncertain
In February 2021, the Philadelphia Fed Professional Forecasters Survey (SPF) projected that the headline and “core” personal consumption expenditure price indices (PCEPI) (excluding food and energy prices), which are the Fed’s preferred measures of inflation , would increase by 2% and 1.8%, respectively, in 2021 (Q4/Q4). Instead, headline inflation measured 5.5% and core inflation 4.6%. Inflation forecast errors of this magnitude are rare. Now, a year later, the SPF consensus is that both the headline and core PCEPI will rise 3.1% in 2022 (Q4/Q4).
The PCEPI index and the CPI have had an upward trend
Some important indicators of current and projected inflation suggest that there are a few key reasons why inflation will remain above the FOMC’s 2% inflation target in 2022:
- Increased costs of non-labor inputs. An important measure of input price inflation faced by businesses is the producer price index (PPI) for final demand for goods and services, which rose nearly 10% in January 2022 from a year earlier. . Anecdotal reports from recent Beige Books and the financial press indicate that companies have had little difficulty passing on higher material input costs that arose from supply chain disruptions or material shortages.
- Increase in labor costs. Robust demand for goods and services in 2021 has fueled strong demand for labor. Companies in many industries continue to report a near-record number of vacant jobs, and the number of people quitting their jobs was near an all-time high. In response, companies have been aggressively raising wages in an effort to fill job openings and retain existing workers to boost sales. In January 2021, the median hourly wage for private sector workers increased by 5.7% over the previous year.
- Rising prices of raw materials. Following Russia’s invasion of Ukraine on February 23, crude oil spot prices briefly exceeded $100 a barrel for the first time since August 2014, and other commodity prices rose sharply. Some energy analysts expect prices to rise even higher. Crude oil and commodity prices are often a major factor driving higher inflation in the near term, although their impact must eventually subside because prices will not rise indefinitely.
- Increased inflation expectations. Some measures of inflation expectations for the next one to three years are more than double the 2% inflation target. However, various measures of longer-term inflation expectations (5 to 10 years) have not risen much, if at all, relative to their pre-pandemic level.
A key element of the Fed’s new monetary policy framework is to keep long-term inflation expectations anchored at 2%; a steady rise in long-term inflation expectations would be worrisome. If inflation remains well above the Fed’s 2% inflation target for the second year in a row, this could start to boost long-term inflation expectations. Fed policymakers would risk an unwanted erosion in their credibility if such a development were to occur.
Near-term prospects for the economy and labor markets are good
The pace of economic activity ended 2021 on a strong note, as real gross domestic product (GDP) increased at an annual rate of nearly 7%. However, more than two-thirds of this growth came from increased investment in commercial inventory. Still, there was good growth in consumer spending and exports. A key question going forward is whether the companies’ inventory investment was unplanned or whether they ramped up production in anticipation of faster growth in 2022 with the waning omicron wave. Some support for the latter view was seen in the January retail sales report, with retailers in the country reporting goods sales up nearly 4%. Currently, however, most forecasters expect a sharp slowdown in real GDP growth in the first quarter, but a sizeable increase in final sales (GDP minus inventory investment), as companies plan to meet existing demand for goods from the increase in inventory investment from the previous quarter.
Labor market performance also ended 2021 on a strong note and started 2022 on an increasingly strong note. Non-farm payroll employment rose by 467,000 in January, much stronger than anticipated given expectations that the wave of omicron will take a toll on hiring in the service delivery sectors. Although the unemployment rate increased 0.1 percentage points to 4%, this was mainly due to a significant increase in the labor force, which is a positive development.
In summary, the most likely outcome for 2022 is real GDP growth of 3-4%, which would exceed the longer-term potential growth rate of the US economy (around 2-2.25%). This development is likely to trigger further declines in the unemployment rate, perhaps ending the year around 3%. If the pandemic fades into the background, there could be an increase in spending on consumer services, boosting growth in other areas. But it could also trigger a further rise in service price inflation.
Devin Werner, a Bank Research Associate, provided research assistance.
- The Personal Consumption Expenditures Price Index (PCEPI) is the FOMC’s preferred measure of inflation. The general PCEPI for January rose 6.1% compared to the previous year.
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