Comment: Inflation's track encouraging, but uncertainty looms

By Jonathan Levin / Bloomberg Opinion

Inflation optimists were riding high at the start of 2024. Price pressures seemed to be cooling quickly, and market pricing suggested that the Federal Reserve might lower policy rates by a whopping 1.75 percentage points this year. Fast forward 11 months and we'll be lucky if we get 1 percentage point worth. The pullback shows that we remain on high alert for inflation that could remain too high for comfort and policy that may exacerbate the problem. Despite this, there's room for measured optimism heading into 2025.

The latest report Wednesday showed that the consumer price index rose 2.7 percent in November from a year earlier, matching the median forecast in a Bloomberg survey of economists. While the progress toward 2 percent has slowed or even stalled in recent months, a lot of that comes down to the stubborn strength of the shelter category, a familiar thorn in everyone's side. Excluding shelter, the consumer price index is essentially already back to its pre-pandemic "normal" and has been for some 18 months. What's left of the price volatility of 2021 and 2022 is mostly just a narrow inflation in one large and important category, rather than a broad-based phenomenon.

The shelter story is well known at this point. Market rents first surged some three years ago, but it's taken a long time for the effect to percolate through the official government indexes. Inflation in new rentals returned to normal in 2023, but existing tenants have seen the prices in their lease terms creep up more gradually. What's more, the Bureau of Labor Statistics uses rental data to proxy the "inflation" experienced by homeowners — the so-called owners' equivalent rent category — so the effect of lagged rents is amplified. To the extent that optimists have misjudged the path of inflation, it's largely because they underestimated the lags in rent and equivalent rent.

Fortunately, relief has finally arrived. The "rent of primary residence" and "owners' equivalent rent" categories rose by 4.4 percent and 4.9 percent, respectively, in November from a year earlier, both the lowest since early 2022.

On a month-over-month basis, they rose just 0.2 percent apiece, the weakest since 2021.

With the positive signal from shelter, futures markets moved to price in nearly a 100 percent likelihood that the Fed's rate-setting committee will cut the fed funds rate by 25 basis points at its decision next Wednesday.

But it's still fairly unclear what will happen with monetary policy thereafter. President-elect Donald Trump has floated a panoply of buzzy-sounding policies that could have major impacts on inflation. Fixed-income markets have turned into a parlor game of guessing which ones will actually get implemented and how they might interact or even offset one another. He's threatened eye-popping tariffs on America's trade partners (which could mechanically raise consumer price levels, or maybe just hurt companies' profit margins); deportations of undocumented immigrants (which could drive up salaries and make services more expensive, but might also shrink the pool of consumers); and a perplexing mix of tax cuts and government "efficiency" measures. How it all shakes out is anyone's guess, and economists are on high alert for two-sided risks to their inflation and growth forecasts.

In some ways, there's also room for the data itself to surprise. First, just in the most recent month, new and used car prices jumped meaningfully, although they're still down sharply on a year-over-year basis. Grocery prices have also been ticking higher again, hitting consumers where it hurts the most ahead of the holidays. Second, there is still a significant gap between what holdover tenants pay and what many units would command from new tenants on the open market, and that gap could be a source of bumps and wiggles in the disinflationary trend for shelter. A simulation model published recently by the Federal Reserve Bank of Cleveland indicates that rent inflation may not fully revert to its pre-pandemic trend until the middle of 2026.

Putting it all together, the latest report suggests that overall inflation remains too high to get completely comfortable, especially at a time when policy risks loom. But for all the ways that market pricing has shifted, the story in the data hasn't actually changed that much. Inflation is still a relatively narrow phenomenon and the trajectory should remain encouraging as long as our leaders refrain from throwing a wrench in the works.

Jonathan Levin is a columnist focused on U.S. markets and economics. Previously, he worked as a Bloomberg journalist in the U.S., Brazil and Mexico.