Stubborn Inflation, Reluctant Fed

Episode Summary

Executive Summary: The panel argues U.S. inflation is still easing toward the Fed’s 2% target, with housing and owners’ equivalent rent (OER) the main remaining obstacle. Chris and Marissa explain that rent inflation is cooling as new supply and softer demand work through the system, while Marissa shows non-housing inflation is mixed but mostly moderating. The team’s baseline: a soft landing, rate cuts starting around September, and inflation near target by next year.

Main Topics: Inflation’s post-peak disinflation path (Priority: 5/5): The discussion opens with the view that inflation has been moderating since its 2022 peak and is expected to return to the Fed’s 2% target by next year, barring a renewed shock. Housing, rents, and owners’ equivalent rent (OER) (Priority: 5/5): Chris explains that shelter costs—especially rent and OER—remain the biggest reason measured inflation is still above target, but market rent data suggest further moderation ahead. Why OER is controversial (Priority: 4/5): The speakers review why the CPI uses OER, its conceptual strengths, and its practical weaknesses compared with alternative housing-cost measures and harmonized inflation indices that exclude it. Other inflation components beyond housing (Priority: 4/5): Marissa breaks down CPI/PCE differences and shows that many service categories remain elevated, while goods inflation has softened or turned negative in several areas. Autos, insurance, and sticky service inflation (Priority: 4/5): Auto insurance, vehicle maintenance, and related services are highlighted as lagged, sticky categories still reflecting earlier vehicle-price surges and supply-chain disruptions. Fed policy, mortgage transmission, and rate cuts (Priority: 5/5): The group argues the Fed’s tightening has had limited direct impact because most U.S. mortgages are fixed rate; the baseline forecast is for the first cut in September and a gradual easing path afterward. Consumer resilience, wages, and productivity (Priority: 3/5): Mark ties the inflation outlook to real wage gains, strong consumer spending, and a possible productivity revival that could help keep inflation and growth in balance.

Key Arguments: Inflation’s original surge was driven first by demand (reopening, fiscal stimulus) and then by supply shocks (pandemic disruptions, war in Ukraine), but those forces are fading. Housing is the key remaining driver of above-target inflation; if rent and OER continue to cool, overall inflation should reach 2% on schedule. New lease data already show rent growth flattening or turning negative in some markets, while the official CPI/PCE shelter measures should follow with a lag. OER is conceptually intended to measure the service value of owner-occupied housing, but in practice it may be noisy and biased because owner-occupied and rental stock often differ substantially. The CPI and PCE differ materially in housing weighting; the PCE assigns a much smaller share to housing, which is one reason it runs below CPI. Outside housing, many goods categories are flat or falling, and several service categories are still elevated but appear to be moderating rather than accelerating. Auto insurance and vehicle repair costs remain elevated because they are lagging responses to earlier spikes in vehicle prices and supply shortages. The Fed’s policy transmission is muted because about 95% of outstanding mortgages are fixed-rate, so households have not felt much direct payment pressure from rate hikes. Consumer spending remains supported by rising real wages, strong employment, high asset prices, and accumulated savings, helping avoid recession. A return to productivity growth would be supportive for inflation, wages, and broader economic growth, though the panel remains cautious about how durable the improvement is.

Data Points: Core PCE inflation: 2.8% - Current year-over-year reading cited as still above the Fed’s 2% target. Headline PCE inflation: 2.7% - Current year-over-year reading including food and energy. Core CPI housing weight: 34%-35% - Rent plus owners’ equivalent rent share of the CPI basket. PCE housing weight: about 14% - Housing weight in the PCE basket, much lower than in CPI. Inflation peak (headline PCE): 7% in June 2022 - Peak referenced as the high point of the post-pandemic inflation surge. CPI-PCE gap pre-pandemic: 0.3 percentage points - Average difference before the pandemic, with CPI above PCE. CPI-PCE gap since 2020: 0.7 percentage points - Average difference after 2020, showing a wider gap. Motor vehicle insurance increase: up about 25% in the past year - Used as an example of sticky service inflation. Motor vehicle insurance since start of 2020: up over 45% - Shows cumulative inflation in the category. Vehicle maintenance and repairs since start of 2020: up 49% - Another sticky auto-related inflation component. Real motor vehicle insurance price increase since 2020: over 45% - Marissa’s chart showing sustained auto-related inflation pressure. Personal care services since Dec. 2019: up over 30% - Examples include salons, haircuts, and dry cleaners. U.S. oil production: 13 million barrels per day - Record-high output, cited as helping keep oil prices contained. Share of mortgages that are fixed rate: about 95% - Explains why Fed rate hikes have had limited immediate impact on households. Share of mortgages below 6%: about 87% - Shows how many borrowers locked in low pandemic-era rates. First Fed cut forecast: September - The panel’s baseline expectation for the first quarter-point cut. Long-run policy rate forecast: about 3% - Estimated neutral/equilibrium rate by the mid-to-late decade. 10-year Treasury yield forecast range: 4% to 4.5% - Expected long-run range cited for the benchmark bond yield. Immigration flows (CBO figures cited): 2.6 million in 2022; 3.3 million in 2023; 3.3 million in 2024 (forecast) - Used to explain added labor supply and housing demand. Mortgage rate lock-in period: below 3% to under 6% for most borrowers - Illustrates reduced sensitivity to current higher rates.

Pivotal Quotes: "If inflation comes in based on the script that I just described, getting back to the Fed's target by this time next year ... then we're golden. We'll have a soft landing." — Mark: Summarizing the baseline macro outlook and why the inflation path matters. "The key to getting overall inflation down ... is the outlook for rents and owners' equivalent rent." — Chris: Stating why shelter inflation is the central issue in the forecast. "Maybe if we're not able to estimate the OER ... perhaps best just to leave it out and focus on the prices that we can observe." — Chris: Critiquing OER as a measurement tool and motivating harmonized inflation measures.

Implications: If shelter inflation keeps cooling, the Fed likely gains confidence to cut rates, supporting a soft landing. Persistent service inflation or a new shock would delay easing and raise recession risk.