Inflation in the U.S. seems to have finally peaked and is falling. And while the Federal Reserve just raised rates another 25 basis points, as predicted, Morgan Stanley’s economists think the Fed will hold rates steady until December 2023, and then begin trimming rates in quarter-point increments.
Not everyone agrees with this view that inflation will continue to decline and interest rates will normalize. The big caveat, say skeptics, is that the fall in inflation so far could stall because of services inflation: A tight labor market keeps wages inflation high, leading to sticky, high inflation overall.
At first glance, this “wage-price spiral” narrative makes sense. Labor is roughly 60% of total value added in the U.S. and therefore should be key to production costs; higher wages also tend to mean higher rents. However, investors who fear that inflation will be higher for longer should consider the bigger picture of what’s behind these numbers.
Core goods inflation, which excludes food and energy price, has been negative for a couple of months now, and we expect this trend to continue. Moreover, most consumer goods are imported, so a tighter U.S. labor market isn’t as relevant.
As for rents – which constitute 40% of the core Consumer Price Index (CPI)– inflation in new leases has already fallen sharply, so the CPI component of shelter inflation will almost mechanically come down. And of course, rents are charged for existing units, so there is no “production function” with labor as an input driving up the price.
This means that any wage inflation fears need to focus on “other” services, which represent roughly 25% of core CPI. Federal Reserve Chair Powell has emphasized this component, noting that it is a function of the labor market and is likely to take a substantial period to come down.
It’s a fair point, but there are several reasons why we don’t worry about this segment of inflation—one of the biggest being the outsized influence of transportation.
- Other services inflation went from about 1% annualized in January 2021 to roughly 6% annualized in December 2022, but roughly 4 percentage points of the increase is explained by transportation.
- Within transportation, airline fares are the key component, but the recent surge in fares was more a function of fuel prices and pent-up demand for travel amid capacity restrictions—not a rise in wages.
- Moreover, nominal wage acceleration has been widespread across services industries, but only transportation CPI inflation has increased.
Certainly, there is still some connection between wages and other services, with historical data showing that other services are the most likely of all CPI components to have higher wages result in higher prices.
The recent upswing in wages might boost inflation in other services by 140 basis points in the next year, with all else being equal. But with other services representing a relatively low share of the overall index, the boost to core CPI inflation is only 35 to 50 basis points.
True, this could mean that wringing out the last bit of inflation could be hard, but it’s not enough to stall the trajectory of lower inflation. As a result, Morgan Stanley is predicting US headline inflation of 3.6% this year, below the consensus of 3.8%.