The inflation roller coaster

Inflation has been one of the most important factors for investors to watch over the past several years.

In 2022, U.S. consumer inflation’s climb to a peak rate of 9% ignited concerns that the Federal Reserve would be forced to hike interest rates to extreme levels in order to tame inflation, causing both stock and bond prices to drop sharply.

In 2023, inflation’s downward march eased concerns about Fed policy, helping stocks to post strong returns, particularly in the latter part of the year.

So far in 2024, inflation has yet to show a clear direction. Inflation reports for January through March brought unwelcome upside surprises, but April and May results were more favorable. This has left many investors wondering what will come next for Fed policy.

The transition from goods to services inflation

When analyzing the direction that inflation could take, it’s important to recognize that there are two types: services inflation and goods inflation. Services inflation tends to move more gradually. Goods inflation, on the other hand, can be volatile.

The initial surge in inflation following the COVID pandemic was driven by goods prices. This was because the demand for goods surged while supply chains remained clogged.

In 2023, that dynamic shifted.  Goods inflation dropped sharply as supply chain issues were resolved and consumers shifted their spending away from goods and toward services. But services inflation has remained stubbornly high and is now driving almost all of the rise in the U.S. consumer price index.

This pattern raises two big questions: When will services inflation ease? And will goods inflation remain benign?

Question 1: When will services inflation ease?

Services inflation has two broad categories: shelter and non-shelter. Both currently are elevated relative to recent past trends. Both historically have tended to be sticky.

Shelter inflation is largely a reflection of home prices. It tends to move in the same direction as home prices but with a 12-to- 18-month lag.

Shelter inflation is currently elevated, rising 5.4% year over year through the end of May. But it has been trending lower for more than a year. This is right in line with what home prices were doing a year ago.

However, home prices bottomed in May of 2023 and have been rising since then. So shelter inflation also appears likely to accelerate over the coming 12 months.

Inflation in non-shelter services tends to reflect wage growth, although there can be a fair amount of statistical noise in the relationship.

Wage growth has been slowing for nearly two years now, but only gradually. As tracked by the Atlanta Fed, U.S. annual wage growth peaked at 6.7% in June 2022 but was still at 4.7% as of the end of March. Meanwhile, non-shelter services inflation peaked at 8.2% in September 2022 but still stood at 5.0% at the end of May.

Based on labor market data we’ve collected, we think it’s reasonable to assume that the downward trend in wage growth will continue over the near to medium term. So, we expect inflation in non-shelter services to trend down as well.

With shelter categories pulling upward and non-shelter categories potentially trending downward, we think services inflation overall is likely to continue moving sideways until housing prices start to slow again.

Question 2: Will goods inflation remain benign?

Goods inflation is much harder to predict than services inflation. It can be affected by a wide variety of factors, including geopolitics, weather, supply chain disruptions, the strength of the Chinese housing market, and the pricing policies of the major oil-exporting countries.

Over the past year, goods prices have risen only modestly. This may continue to be the case over the near term. But too many variables are at work to have a high-conviction view about the direction of goods prices in the next few years.

Over the long run, emerging macro trends such as deglobalization, decarbonization, and artificial intelligence have the potential to boost demand for key commodities. This could result in persistently higher goods inflation than was seen over the past decade.

The bottom line is that goods inflation will remain a wild card for the foreseeable future. We need to account for the risk that it will not remain as benign as it is now.

Conclusion

Services inflation remains elevated and is unlikely to decline rapidly over the next year.  Goods inflation has been benign for the past year but could resurface at any time.

As a result, T. Rowe Price’s Asset Allocation Committee currently holds an overweight position in asset classes that have tended to benefit in rising inflation environments. This includes an allocation to Treasury inflation protected securities, commonly known as TIPS, and to real assets equities.

January 2019 to May 2024
Source: U.S. Bureau of Labor Statistics/Haver Analytics.
Past results are not a reliable indicator of future results.

January 2001 to May 2024
Sources: U.S. Bureau of Labor Statistics, S&P CoreLogic Case-Shiller Home Price Index / Haver Analytics.
Past results are not a reliable indicator of future results.