Inflation forecasts were wrong last year. Are we to believe now?

By this time last year, economists were predicting that US inflation would quickly disappear in 2022 as supply chain problems are resolved, consumer spending shifts towards services rather than products, and pandemic-related relief payments. Now they are predicting the same thing for 2023, and they invoke many of the same reasons.

But as consumers know, predictions of a big drop in inflation this year were wrong. Although price increases have started to ease slightly, they are still hovering close to their highest levels in four decades. Economists expect new figures announced on Tuesday to show that the Consumer Price Index rose 7.1% in the year to November.

This raises the question: should the United States believe the new optimistic forecasts about inflation?

“There are better reasons to believe that inflation will come down this year from last year,” said Jason Furman, an economist at Harvard University, who was skeptical of last year’s predictions that there would be a quick return to normality. Still, “if you decide to accept only the good news and not take into account the bad news that offsets it, you will be making a mistake.”

Economists are a little less optimistic than last year

Economists believe that inflation will decline notably in the coming months, but after a year of frustrated expectations, they are not betting on a decline as drastic as the one they anticipated in December of last year.

The Federal Reserve (Fed), the central bank of the United States, officially monitors the Personal Consumption Expenditure Index, which is linked to the consumer price indicator. Officials are closely watching a version of the index that illustrates underlying inflation trends, stripping out the influence of volatile prices like food and fuel—so these forecasts offer the best picture of what experts are anticipating.

Last year, economists polled in a Bloomberg poll anticipated the so-called central index to fall to 2.5% by the end of 2022. Instead, it remains around 5%, twice as high as expected.

This year, analysts anticipate that inflation will drop to 3% by the end of 2023.

Federal Reserve forecasts have followed a similar pattern. Last December, central bankers expected central inflation to end 2022 at 2.7%. Its projections for September this year showed price increases falling to 3.1% by the end of next year.

Fed officials will release a new set of 2023 inflation forecasts on Wednesday after the December meeting of the Fed’s monetary policy committee.

Supply chains are healing

One reason to believe that the long-awaited but elusive inflation slowdown will finally happen in 2023 relates to supply chains.

At this time last year, economists were anticipating that roadblocks in transport and industry worldwide would soon be removed; consumer spending would shift from products to services; and the combination would allow supply and demand to come back into balance, delaying price increases of everything from automobiles to sofas. This has been happening, but only gradually. And the process also took longer than some economists expected to translate into lower consumer prices.

But the long-awaited change is finally coming, albeit with a delay. After months of work to address supply chain issues, consumers are now starting to feel the benefits. Used car prices started to drop significantly in October, furniture prices are falling and clothing is falling in price. The expectation is that similar cost drops weigh on next year’s inflation.

“It’s too early to declare commodity price inflation defeated, but if current trends continue, commodity prices should start to exert downward pressure on headline inflation in the coming months,” said Jerome Powell, chairman of the Fed, in a recent speech.

The Fed is working to cool demand

Unfortunately, moderation in commodity prices alone is unlikely to be able to bring the US back to a normal rate of inflation, as service price increases are accelerating. That category — ranging from meals to monthly rents — accounted for half of consumer price inflation in October, based on a Bloomberg analysis, up from less than a third in the period a year ago.

Many types of service inflation are closely linked to what is happening in the labor market. For businesses like hair salons, restaurant chains, and accounting firms, employee salaries are one of the biggest, if not the biggest, operating cost. When labor is scarce and wages are rising rapidly, firms are more likely to raise prices to try to cover higher wage costs.

This means that today’s very low unemployment and abnormally fast wage growth could help keep price increases at a higher-than-normal pace, even if the labor market was not a big driver in the initial boom in unemployment. inflation.

That’s where the Fed’s policies can make themselves felt. Companies will only be able to charge more if their customers are able — and willing to — pay more. The Fed can block this chain reaction by raising interest rates in order to reduce demand.

Monetary authorities raised interest rates from close to zero in early 2022 to nearly 4%, and are expected to announce yet another interest rate hike this week. These changes have made it more expensive to borrow money to buy a home, finance a big purchase, or expand a business.

Rent growth is moderating

In at least one category of services, however, a slowdown in inflation is a pretty safe bet in 2023: rents.

Rent increases take time to have an effect on inflation indicators, because existing tenants only start paying more when their rents are readjusted. This means that the increase recorded in 2021 in new rents has been slowly making itself felt in the official price figures, which has pushed inflation upwards throughout 2022.

The market price of rents has started to cool down or even fall in recent months, which suggests that the rise in rents should also start to moderate. The uncertainty is about when the slowdown will kick in – some economists believe as early as the second quarter – and how quickly rents will slow down.

But there remain great unknowns

The challenge with predicting inflation is that while it is possible to make assumptions about specific categories such as rents, many inflation factors come as a surprise. Predictions in 2021 had no way of guessing that Russia would invade Ukraine in early 2022, dramatically raising food and fuel prices.

Likewise, it’s hard to guess what will happen in the geopolitical landscape next year. An escalation of the conflict in Europe could put renewed pressure on natural gas prices. The return of Chinese consumers, after years of prolonged lockdowns, could lead more people to compete for the products available in the world market.

And things could simply take longer than expected to get back to normal. This is, in part, what happened in 2022. Both consumption and the labor market exceeded expectations, which helped to maintain pressure on prices.

“The economy was more resilient than expected,” said Laura Rosner-Warburton, senior economist at Macro Policy Perspectives. “Supply chain problems lasted much longer than expected and proved difficult to predict, both on their way up and down.”