The Inflation Plateau

Just a few months ago, America seemed to have licked the post-pandemic inflation surge for good. Then, in January, prices rose faster than expected. Probably just a blip. The same thing happened in February. Strange, but likely not a big deal. Then March’s inflation report came in hot as well. Okay—is it time to panic?

The short answer is no. Core inflation (the metric that policy makers pay close attention to because it excludes volatile prices such as food and energy) is stuck at about 4 percent, double the Federal Reserve’s 2 percent target. But that’s a long way from the crisis of 2022, when core inflation peaked at nearly 7 percent and the price of almost everything was going up dangerously fast. Instead, we seem to be facing a last-mile problem: Inflation has mostly normalized, but wringing out the final few percentage points in a handful of categories is proving harder than expected. There are two conflicting views of what exactly is going on, each with drastically different implications for how the Federal Reserve should respond. One camp worries that the Fed could lose control of inflation all over again; the other fears that the central bank will—whoops— unnecessarily bring the U.S. economy to its knees.

The “vanishing inflation” view is that today’s still-rising prices reflect a combination of statistical quirks and pandemic ripple effects that will almost surely resolve on their own. This camp points out that basically all of the current excess inflation stems from auto insurance and housing. The auto-insurance story is straightforward: Car prices spiked in 2021 and 2022, and when cars get more expensive, so does insuring them. Car inflation yesterday leads to car-insurance inflation today. That’s frustrating for drivers right now, but it carries a silver lining. Given that car inflation has fallen dramatically over the past year, it should be only a matter of time before insurance prices stabilize as well.

[Annie Lowrey: Inflation is your fault]

Housing, which made up a full two-thirds of excess inflation in March, is a bit more complicated. You might think that housing inflation would be calculated simply by looking at the prices of new homes or apartments. But for the majority of Americans who already own their home, it is calculated using a measure known as “owners’ equivalent rent.” Government statisticians try to determine how much money homeowners would reasonably charge for rent by looking at what people in similar homes are paying. This way of calculating housing prices has all kinds of flaws. One issue is that inflation data are calculated monthly, but most renters have one- or two-year leases, which means the official numbers usually lag the real housing market by a year or more. The housing market has cooled off considerably in the past year and a half, but the inflation data are still reflecting the much-hotter market of early 2023 or late 2022. Sooner or later, they too should fall. “The excess inflation we have left is in a few esoteric areas that reflect past price increases,” Ernie Tedeschi, the director of economics at Yale’s Budget Lab, told me. “I’m not too worried about inflation taking off again.”

The “hot wages” camp tells a very different story. Its members note that even as price increases appeared to be settling back down at the beginning of 2024, wages were still growing much faster than they did before the pandemic. When wages are rising quickly, many employers, especially those in labor-intensive service industries, raise prices to cover higher salary costs. That may show up in the data in different ways—maybe it’s groceries one month, maybe airfares or vehicle-repair costs another month—but the point is that as long as wages are hot, prices will be as well. “The increase in inflation over the last three months is higher than anything we saw from 1992 to 2019,” Jason Furman, the former director of Barack Obama’s Council of Economic advisers, told me. “It’s hard to say that’s just some fluke in the data.”

Adherents of the “vanishing inflation” idea don’t deny the importance of wages in driving up prices; instead, they point to alternative measures that show wage growth closer to pre-pandemic levels. They also emphasize the fact that corporate profits are higher today than they were in 2019, implying that wages have more room to grow without necessarily pushing up prices.

Although this dispute may sound technical, it will inform one of the most pivotal decisions the Federal Reserve has made in decades. Last year, the central bank raised interest rates to their highest levels since 2001, where they have remained even as inflation has fallen dramatically. Raising interest rates makes money more expensive for businesses and consumers to borrow and, thus, to spend, which is thought to reduce inflation but can also raise unemployment. This leaves the Fed with a tough choice to make: Should it keep rates high and risk suffocating the best labor market in decades, or begin cutting rates and risk inflation taking off again?

If you believe that inflation is above all the product of strong wage growth, then cutting interest rates prematurely could cause prices to rise even more. This is the view the Fed appears to hold. “Right now, given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work,” Fed Chair Jerome Powell said in a Q&A session following the release of March’s inflation data. Translation: The economy is still too hot, and we aren’t cutting interest rates any time soon.

[Michael Powell: What the upper-middle class left doesn’t get about inflation]

If, however, you believe that the last mile of inflation is a product of statistical lags, keeping interest rates high makes little sense. In fact, high interest rates may paradoxically be pushing inflation higher than it otherwise would be. Many homeowners, for instance, have responded to spiking interest rates by staying put to preserve the cheap mortgages they secured when rates were lower (why give up a 3 percent mortgage rate for a 7 percent one?). This “lock-in effect” has restricted the supply of available homes, which drives up the prices.

High rates may also be partly responsible for auto-insurance costs. Insurance companies often invest their customers’ premium payments in safe assets, such as government bonds. When interest rates rose, however, the value of government bonds fell dramatically, leaving insurers with huge losses on their balance sheets. As The New York Times’s Talmon Joseph Smith reports, one reason auto-insurance companies have raised their premiums is to help cover those losses. In other words, in the two categories where inflation has been the most persistent, interest rates may be propping up the exact high prices that they are supposed to be lowering.

The Fed’s “wait and see” approach comes with other risks as well. Already, high rates have jacked up the costs of major life purchases, made a dysfunctional housing market even more so, and triggered a banking crisis. They haven’t made a dent in America’s booming labor market—yet. But the longer rates stay high, the greater the chance that the economy begins to buckle under the pressure. Granted, Powell has stated that if unemployment began to rise, the Fed would be willing to cut rates. But lower borrowing costs won’t translate into higher spending overnight. It could take months, even years, for them to have their full effect. A lot of people could lose their jobs in the meantime.

Given where inflation seemed to be headed at the beginning of this year, the fact that the Federal Reserve finds itself in this position at all is frustrating. But given where prices were 18 months ago, it is something of a miracle. Back then, the Fed believed it would be forced to choose between a 1970s-style inflation crisis or a painful recession; today it is deciding between slightly higher-than-typical inflation or a somewhat-less-stellar economy. That doesn’t make the central bank’s decision any easier, but it should perhaps make the rest of us a bit less stressed about it.