Will high inflation stick this year?

The prices of food and energy come to mind quite readily as supply issues such as crop failures or OPEC clampdowns can make food and oil prices very volatile.

If it does, then even if actual inflation rates come down from the currently lofty levels, it still seems likely that prices will rise much faster than target for some time, necessitating determined and long-lived rate hikes. Alternatively, if high inflation does not stick, central banks might be able to get away with a relatively modest amount of tightening and can stop their actions before any adverse consequences emerge. It seems from market pricing and the way the central banks are talking that the latter view predominates. But we are not at all sure that this is correct.

In any country there are prices that are very flexible and move around a lot. There are also more stable or ‘sticky’ prices that don’t move very quickly or by much. In the former group, the prices of food and energy come to mind quite readily as supply issues such as crop failures or OPEC clampdowns can make food and oil prices very volatile. But it is not just about food and energy, as that would just leave us with the typical non-food, non-energy ‘core’ rate that countries already calculate. Other commodities that are integral to the production of goods can also imply a lot of flexibility in finished prices given that most commodities are volatile. The supply of chips used in car manufacturing is just one example of how we might describe new and used car prices as being in the flexible camp. Work undertaken by the Atlanta Fed suggests that these ‘flexible’ prices account for around 30% of the CPI. The rest comes from prices that don’t move very often or quite so much – the sticky prices. Included here are things such as rents (which tend to be adjusted periodically), medical costs, public transportation costs and more. When the pandemic led to supply chain pressures it was mainly the ‘flexible’ prices that shot up.

Besides energy prices, we saw annual used car prices rise by nearly 50% at one stage and even today they are still 37% above year ago levels. Central bank governors, led by Fed Chair Powell argued that these increases were transitory and, as they unwound, so inflation would come back towards the target. But the problem, as we’ve just highlighted with car prices, is that flexible price inflation has stayed high. A second, and far more worrying concern is that ‘sticky’ price inflation has stated to rise at a much faster pace as well. So, while the Atlanta Fed’s flexible CPI stands at 18% right now, which is the highest it has even been, and is up from zero a year ago, sticky price inflation has been no slouch as it is up to 3.7%, or double the rate it was a year ago and the highest in 30-years.

So, while it’s the flexible prices like energy and cars that might have grabbed all the headlines, the real concern lies in sticky prices. This is because sticky prices behave exactly as their name suggests; they are sticky, meaning that it is going to be tougher to get them back down. They do fall sharply when there’s a recession, as we saw with Covid or the global financial crisis but, the rest of the time it is hard to break the back of increases in sticky prices. But this is what the Fed and other central banks have to do, and to do it without creating the recession that will not just unwind sticky price inflation but bring significant economic damage. As it has become clearer to the Fed and other central banks that inflation is proving stickier than they first envisaged, so they have moved on policy, either in words (like the ECB and Fed) or in deeds (as the BoE has done with rate hikes).

But despite these moves it still seems that central bankers – and the market – believe that either flexible price inflation will unwind so much that it lowers overall CPI prices significantly or, more likely, that sticky inflation won’t actually stick for long. But we find it hard to be comfortable with this assumption, perhaps especially given things like the tightness of labour markets in the US and UK, pent-up demand as Omicron departs, high savings levels thanks to government support and limit ed opportunities to spend during the height of the Covid crisis. All these, and more suggest to us that sticky inflation will live up to its name.