Will US inflation ever go below 3%?

0:05Pushkin. Here's something the Unhedged newsletter wrote back in September of last year.

0:36Aidan, can you tell me what was, when you wrote that back in September, what was core inflation? Core inflation is around 3.25%. And what's core inflation now, Aidan? 3.25%. And there was a jump in the middle. There was a jump in the middle. So today on the show, were we wrong about inflation in September? And can we be more right this time around? This is Unhedged, the markets and finance podcast from the Financial Times and Push I am Rob Armstrong coming to you from New York City, capital of the universe, joined today by my trusty lieutenant Aidan Reiter. You know, Reiter is Prussian for more right.

1:27Although that column back in September had both of our names at the top, I'm going to use my authority as boss of the newsletter to say that you wrote the whole thing. Now, nominally, we thought inflation was out the door and it hasn't gone out the door since then. The market was very relieved by what it heard about inflation in yesterday's report. Yeah, which is a little counterintuitive. Yes. Right? So inflation, at least headline inflation, which people we don't tend to care about, went up to 2.9 and people were freaking out that it would be higher. Right. That still was a pretty big jump. One point.

2:04Now, headline though, that's gas. Gas prices are up because it's cold. Yeah. Either way, core. Core inflation. No food, no energy. Yeah. Core only went down from 3.3 to 3.25. Yeah. Fed's target is two. We're not there. It's a very small step down. So why? I wouldn't say the market did backflips in response to that report, but it was clearly pretty relieved. Yeah. It was a sigh of relief. Bond yields fell, equities rallied, et cetera, et cetera. Yeah. And bond yields had been rising for about a month there. Strongly. People very concerned about a lot of things, as you and Katie discussed. But one of those things could have been concerns about inflation.

2:40So was this, I guess, one theory of the case is this was a relief rally, not because things got better, but because they didn't get worse. I think that's right. Right. 2.9 was just around where economists polled by Reuters expected things. Yeah. So we got what we expected. And after some big surprises, both in the job report and the last inflation report, that was good news. So it's like there was ugly things in the background. So the fact that the foreground was merely neutral. So let's talk about then why inflation isn't falling faster like we thought it was going to do a few months ago. What's going on?

3:17Yeah. Let me start with some things it's not. The problem doesn't seem to be housing inflation anymore. It is not. Shelter inflation has been on a steady decline since about September. And there was actually a pretty big drop in the annualized rate last month. So it went from 4.1 to 3.1. And that's, you know, taking that monthly change and annualizing it. So shelter is not the issue. Yeah. So and just for listeners who haven't been nerding out about inflation for the last four years like we have, everybody was worried about shelter inflation because for technical reason, it wasn't going down. And it was quite mysterious.

3:54And it was like a big part of the inflation problem a year ago or whatever. But that's not it anymore. Here's another thing I would say that it isn't. It doesn't seem really to be wages. Wages have come down the last couple of months. Like everything else, there's a million ways to measure wage growth. But I'm looking at average hourly earnings of production and non-supervisory employees, total private. So not including government employees. And that's come down below 4, 376. That was much higher in January last year. That was at four and three quarters. So that's coming down. So it doesn't seem like we're in a wage spiral.

4:38No, I think the point on both shelter and on wage though, is that while they're coming down, they're still pretty high. Yeah. So shelter, the headlines are still at 4.6. That's high by historical standards. So that doesn't help. It doesn't help, right? It's not that inflation is necessarily heating up because as we saw with the core, it came down a little bit. It's that it just is remaining in this two to three band. Okay. And it seems to be jumping up and down. Right. What are the prices that are actually staying high here? It's services, right? Yeah. I mean, services are high and some are heating up, but not all across the board.

5:09Yes. It kind of seems somewhat broad based across services. Goods are going down pretty considerably. So yesterday's reading gave us the biggest drop in furniture prices and appliances ever. And that's, you know - This is very good because my dishwasher is acting extremely poorly lately. I'm glad you can get a cheap dishwasher. But the point is dishwashers, those larger appliances are expensive. They're big for households. So the fact that they're coming down in price is a good sign. But it's those services that are broadly expensive. Restaurants, however, are flat. So it's kind of weird and across the board.

5:40It seems to be that we're just having little spikes and little drops across the broad basket of goods. And we are still seeing a general shift up in some of the core goods that people really need. So one way to look at this is the Cleveland Fed releases what they call the median CPI and then the 16 % trimmed mean. I'm giving you a quiz, Aiden. Please. What is the difference between the median and the mean, just in abstract terms? The median is the central reading across a range of readings that is like the one in the middle. And the mean is the average, right? So sum divided by. I was really hoping you would screw that up and you've gone and known the answer to my question.

6:18I've been trained well. Extremely disappointing. But anyway, the median CPI is looking at the median price move across the basket of goods. Yes. And what is that doing? Yeah. And that kind of takes both of these kind of special measures of inflation are designed to remove the outliers. Exactly. And core removes the outliers, right? Core, you have gas and food are very volatile. This does that, but still keeps them in the basket. Right? So you can see what does everything look like. So if you mix out the stuff that leaps wildly month to month or in a random month, you have a high reading somewhere.

6:51Yeah. This kind of gives you the central value. Exactly. It's a noise removal approach. Yeah. So one of those two series, so you have the 16 % trimmed mean. Which is just you take the most volatile 8 % on the top and the bottom and then you do a mean of the rest. Okay. And then, you know, the median. And what they show us, well, the 16 % trimmed mean is sideways. Right. Like not heating up, not going down. Nothing. And it's above, it's like three-ish, something like that? It's three-ish. Yeah, yeah. And then the median is well above three. It's closer to four. And it's falling, but only gently.

7:22Yeah. Like, it almost looks sideways. Right. The Fed wants 2 % inflation. And we are in something closer to a 3 % world and going sideways or declining slowly at best. So let's call it the two-plus world. Yeah. And the point of bringing up those two measures is that, like, the inertia of price change, right, across the broad basket of goods, whether that be core. because core has been essentially sideways for five months now. Or, you know, those two measures show we're just kind of sideways. Like there's been pops and dips across the basket, but nothing is conclusive. Okay. As far as I know, when Moses came down from the mountaintop, the 11th commandment was not 2 % inflation.

8:03In other words, is 3 % the end of the world is like a 2 % to 3 % world? Of course, the Fed has to say we remain committed to our 2 % target because if they said anything else, it would be pandemonium. But in reality, you're sitting there on the Federal Open Market Committee and you're looking at something between two and three and trending sideways. Are you really that worried, do you think? I think it's a matter of politics at this point. And I mean, you know, there is a difference between two and three percent for a lot of households. Yes. We shouldn't, you know, I don't want to be glib about inflation.

8:40But for the most households, it's not that big of a deal if it's at 2.5 or 2.6. The question is, does more inflation engender more inflation? So if you're above 2%, is that naturally a hotter economy that will eventually kick itself back up? Yes. Hard to say. I mean, there's other... And also politically, it's got to be harder, even if you think it's the right thing to do on balance, if you're Jay Powell or other members of the committee, it's got to be harder to cut rates when you're still above target. Yes. That's just hard to explain. You huff and you puff about 2%, and now we're sliding sideways at 2.5 % or 3%, and you're going to cut?

9:20That's hard to explain. It's hard to explain, and it risks theoretically stagflation, right? The worst outcome here would be the next job report is terrible. They have to cut because they want to save the job market, and then that reignites inflation. Right. And then you have bad jobs plus inflation flying up, and then you can wind up in stagflation in the long run. Yes. I mean, the clear consensus is that you need some inflation for an economy that's natural, that's healthy, shows things are growing. There are some debates. Wait, wait, no, you have to explain to me. I'm always curious about this.

9:48Let me put you on the spot. Why do we want 2 % inflation? I can't even remember. This has been explained to me many times, but why isn't the target zero? Well, think about the zero inflation, right? inherently you always want an economy that's chasing things, right? And growing and investing. And those things are inherently inflationary. So having over time, you want more people or things chasing fewer goods, that is a sign of a growing economy. Also, deflation is bad for an economy, right? So say you have deflation. Say I have$10 today and I want to go buy an expensive cup of coffee at Starbucks or whatever.

10:21If we have deflation, I go, well, tomorrow my money is actually be worth more. Yeah. Right. It's 11. I'm not going to invest today. And then you get a deflationary spiral. Right. So you want inflation. You want to be far from deflation. You want to be far from deflation is a big part of it. And also inflation is just the natural outcome of investment, of spending, of consumption. I mean, I think also I wonder how this is true, but I think somebody once said to me that, you know, think about yourself as an employer. This is a tangent, but I think it's a good tangent. Think of yourself as an employer, right?

10:47If you're an inflationary world, you can kind of give all your employees a couple of percent. a year, and they're like, I got a raise this year, you know, but in real terms, you're where you were. In other words, it's a little bit, it's a little bit like it kind of lubes things up. Like, you know, I wonder if that is part of it. Anyway, there's debates of whether 2 % is the right level for every economy. My understanding, some central banks don't explicitly say 2%. But then also, this brings up conversations we've had in the past about the neutral rate. So, right, what is the right level of interest rates to keep the economy chugging along at the Fed's target?

11:22Right? You don't know about the neutral rate until you blow past it. Yes. Right? Theoretically, you get one more cut, inflation spikes again, and that means you're past the neutral rate. Yes, below it. Below it. But, you know, there's the problem, of course, that, well, the neutral rate is pegged to what the inflation outcome you want is. Yes. So if we're changing the inflation outcome, that also theoretically changes the rate at which the economy would be chugging along at the rate it needs. All right. Let's return to Earth from these airy worlds of abstraction where we have been traveling for the last few minutes.

11:51given what we know about inflation and growth right now, how many times do we think the Fed is going to cut in 2025? I should say, how many times do you think the Fed is going to cut? Well, you know, the Fed's on pause right now. They're waiting for data. We are waiting for data. So with the most amount of, you know, throat clearing possible. Yeah, exactly. I am of the pessimistic belief that the Fed will not cut this year. Yes. Things are going to, you think inflation is almost a little. I think inflation is sideways and it wouldn't take much to heat it up again. Yes. And we have a big thing happening on Monday that could theoretically usher in some inflationary policies.

12:31You speak, of course, of the national football championship. No, we have a presidential election coming up. Inauguration. Yeah. Yeah. So Donald Trump will be coming into the White House. Yes. We've talked on this podcast before about the Fed and how they want to react to and or predict what Trump might do. Yes. Rightly or wrongly, they do seem to be doing that. I would say more rightly, but I think the communication is a little off. That being said, the market is currently expecting between one and two 25 basis points cuts this year. And that the first cut will probably come somewhere around July.

13:04What do you think, Rob? I'm more or less with you. Labor market, still pretty tight. Economy, still quite hot. retail sales, we just got a number. That was once again, pretty muscular. It just feels like we're in this two and a half percent world. And if I had to say where the risk is, I say it's a little more to the upside. We have a very rare thing, which is unhedged consensus. And we agree that the market is wrong to the upside on cuts. And just to the inflation report we put out four months ago, when we agree, you're probably wrong. So on that very tragic observation, we are going to pause for a moment and then come back with Long and Short.

14:00And we're back. This is Long and Short, which is the portion of the show in which we go long things we like, and we go short things that we do not like. Aiden, do you like something or not like something today? It's not that I not like something, but I am short people's New Year's resolutions. It's only January 16th, and the first few weeks of January, the gym or the pool or wherever you work out is full of people. Yes. Anyway, I went swimming this morning, and the pool was empty. So I'm short collective people's willpower. It took a week. It took 16 days. I myself am long OH10. Now, you may not know what OH10 is.

14:46I do not. About 30 years ago, I was working or more, 35 years ago, I was working at a summer camp. And one of my fellow counselors was a Englishman named Henry. and Henry looked down at a map of the United States and said to me, you have a state called OH-10. Of course, he was looking at the state of Ohio. Anyway, the OH-10 Buckeyes are going to win the national championship by a lot on Monday, which whatever our politics are on that day will give the good people of Ohio and the world something to smile about. Listeners, we will be back in your feed next Tuesday with a post-national championship and post-inauguration show.

15:35Until then, stay sharp out there.

15:53and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Rob Armstrong. Thanks for listening.

16:23You