What a difference three months makes.
At the close of 2023 and into early 2024, it seemed the U.S. was on a seamless trajectory toward what I dubbed "economic nirvana": a condition where growth would maintain its steady pace—albeit unspectacular—as inflation subsided to more manageable levels. This ideal scenario would not only prolong America's four-year economic upturn but also potentially allow the Federal Reserve to relax its tight grip on economic controls, perhaps even reducing interest rates.
However, recent data have prompted a reevaluation of this optimistic forecast, particularly regarding its timing. Indicators now point to an inflationary surge, with the economy heating up as inflation rates rebound. The job market remains robust, with employment figures consistently surpassing expectations, and the Employment Cost Index, a key barometer of wage growth, showing increased momentum.
Most notably, the persistent rise in inflation has taken economists, market analysts, and crucially, Federal Reserve members by surprise. The core personal consumption expenditures index— the Fed's preferred measure of inflation, which excludes volatile items like food and energy—has shown an unexpected acceleration, reversing much of the progress achieved in the latter half of the previous year. This resurgence in inflation has delayed expectations for rate reductions, prompted some analysts to warn of impending high inflation, and led to speculation about possible rate hikes by the Fed.
Reassessing forecasts in light of new data is essential and prudent. Rigidly clinging to an initial projection to avoid error is a hallmark of poor analysis. Upon thorough examination of the underlying inflationary dynamics recently alarming the markets, I find these concerns to be overstated.
As we approached 2024, the rate of price increases was reverting to normal levels—ideally to the Fed's target of 2% annually. Core PCE had increased at an annualized rate of 1.9% by the end of December, signaling a seemingly successful moderation. Yet, in the first quarter of the year, this figure jumped to 4.4%. Such rapid acceleration in core inflation is uncommon and was difficult to explain purely by fundamental economic indicators.
Inflation dynamics can be visualized as a triangle, where each side represents a critical component: expectations, aggregate demand, and supply shocks. Surveys on inflation expectations remain anchored around the Fed's 2% target. The modest increase in the unemployment rate over the past year does not suggest a surge in consumer demand. Moreover, there are no significant supply chain disruptions currently evident. The smooth functioning of supply chains is reflected in stable delivery times reported in the ISM vendor-deliveries index.
On a deeper level, the recent spike in inflation seems somewhat arbitrary, driven more by sector-specific factors than by overarching economic conditions. For instance, adjustments in government healthcare policies have led to a spike in Medicaid payments, significantly influencing the overall inflation index. Similarly, an increase in financial service fees— a delayed reaction to the robust stock market performance at the end of 2023—reflects higher portfolio values rather than an intrinsic increase in service costs.
These isolated factors have disproportionately influenced the overall inflation landscape. Before 2024, non-cyclical components had minimal impact on core inflation. In the past three months, however, their contribution has surged to 4.4%. In contrast, the influence of cyclical components—those directly linked to the economy's overall health—has slightly declined since last year.
Considering the recent sharp rise in inflation, the fundamental argument for a return to the path toward economic nirvana remains strong. Economic growth has not spiraled out of control. If it had, it would amplify the inflationary pressure as Americans increased spending. Instead, real GDP grew at a 1.6% annual rate in the first quarter, with private demand (excluding inventories, government spending, and net exports) rising by 3.1%. This indicates that rather than a sudden economic resurgence, the U.S. is settling into a stable economic state.
Investment in residential real estate notably boosted GDP in the first quarter, though this is unlikely to continue with rising borrowing rates and falling building permits. Moreover, recent increases in consumer spending have been largely driven by decreases in the savings rate—a trend unlikely to sustain, especially as wage growth continues to moderate. The Indeed Wage Tracker, which precedes the more widely recognized Atlanta Fed Wage Growth Tracker by about eight months, shows a slowdown to 3.1% annual growth in wage and salary listings.
Equity markets have quickly overlooked the inflation news, underestimating its potential to constrain economic growth. Persistent inflation could diminish real incomes, curbing household spending and corporate profits. Unlike the previous year, labor market dynamics have shifted, implying that higher inflation now poses greater risks to the economy.
Encouragingly, there are robust reasons to anticipate a decline in recent U.S. inflation trends. Inflation expectations remain stable, labor-market turnover is low, and inflation is moderating in many developed nations.
Looking ahead, if my analysis proves correct, the anticipated slowdown in core inflation coupled with stable economic growth should reignite optimism for a smooth economic adjustment. In this scenario, I would favor bonds over stocks for now, though both could fare well if economic conditions align as expected.
