Kiplinger Inflation Outlook: Temporary Factors Boost Inflation Rate

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The inflation gauge that gets the most focus from the Federal Reserve, core services, bumped up more than usual in January, to 0.7%, leading to fears on Wall Street of more-persistent inflation. But there is reason to discount the significance of this increase. First, there were likely beginning-of-year cost-of-living adjustments that pushed up wages in labor-intensive sectors such as medical services, car repair, personal services, daycare and restaurants. Second, a technical measure of how home prices are rising, owners’ equivalent rent (OER), has an outsized influence on core services, accounting for almost half of the category. OER gains had been bouncing between 0.4% and 0.5% for the previous eight months before posting a 0.56% increase in January. This was larger than usual, but not excessively so. It is still likely that OER inflation will ease over the coming months as apartment leases are gradually renewed.

Overall annual inflation dropped from 3.4% in December to 3.1% in January and should drop below 3.0% in next month’s report. Grocery prices rose 0.4% in January, a bit more than usual, but that is not likely to continue. Energy prices were lower, on average, as a gasoline price drop counter-balanced an increase in electricity and natural gas service. The gasoline price drop will not be repeated in February, but the other energy price rises may not be repeated, either. Goods prices excluding food and energy have declined for eight straight months, as used vehicle prices dropped 3.4%. 

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Despite the coming decline in the headline inflation rate in the next few months, the Federal Reserve will still want to see a moderation in services prices before it acts to cut interest rates. Such a cooling trend would reassure the Fed that the downtrend in the inflation rate is not just a temporary blip. The Fed would also like to see wage increases start to soften, to prevent a cycle of further price increases, in which businesses try to maintain their profit margins by passing higher wages along to their customers.

The Fed may wait to cut short-term interest rates a quarter of a percentage point until its June 12 policy meeting. That would let it study four more monthly inflation reports. But we think the Fed will signal that it wants to cut rates at its May 1 meeting, and could take an intermediate step by slowing the current runoff of its portfolio of Treasury and mortgage-backed bonds, which would allow more reserves to stay at banks and keep liquidity in the financial system a bit higher. 

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