It’s Sticky! Inflationary Trends

Michael Normyle – Nasdaq’s US Economist joins IBKR’s Jeff Praissman to discuss current inflationary trends and how consumers of different income levels are affected.

Summary – IBKR Podcasts Ep. 175

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi, my name is Jeff Praissman with Interactive Brokers, and it’s my pleasure to welcome back NASDAQ’s U. S. Economist, Michael Normyle. Michael, how are you?  

Michael Normyle 

Hi, doing well. Thanks. Glad to be back.  

Jeff Praissman 

It’s great to have you back for our monthly podcast on the economy. And, currently in this year so far, we’ve discussed the labor market, consumer spending, supply chains, among other economic subjects. Today, I want to talk about inflation over the past six months. 

I keep hearing the term sticky inflation.What exactly does that mean? And do you agree that we’re experiencing it?  

Michael Normyle 

Yeah, I think it’s definitely something that we’ve been experiencing the last couple years, actually. And it’s pretty much what it sounds like. It’s prices that don’t tend to change quickly, particularly in response to changing market conditions. So this is often categories that are wage related or things like health insurance or car insurance, where prices are often fixed for a period. 

Jeff Praissman 

So, is sticky inflation considered bad?  

Michael Normyle 

I don’t think it’s necessarily bad, especially when inflation overall is around the Fed’s target, but in the situation we’ve faced over the last couple years where the Fed desperately wants to get inflation back to that target, sticky inflation is a big reason why we’ve seen this pivot to higher for longer rates and why this process has been so drawn out. 

Jeff Praissman 

So, that’s a good point that you just made. The Fed’s target. You hear that a lot in the news. According to the Fed, I guess, what is the ideal inflation level that they want? what exactly is their target? And I guess maybe what’s the logic behind it?  

Michael Normyle 

Well, so the official target is a 2% annual inflation rate based on the Personal Consumption Expenditures Price Index, which is called PCE for short.  

And so as of the May data point, headline PCE inflation is 2.6 % year over year. So that’s pretty close to the 2% target considering that it peaked at 7.1% percent earlier in the cycle back in mid 2022. 

And the idea really is that you want a little bit of inflation in the economy because if there’s deflation, then people are actually incentivized to not spend money because then prices are just going to keep falling in the future. And so things will just get cheaper in that sense. 

So, it disincentivizes spending, but with a little bit of inflation, that means that people should spend, but it’s not so much inflation that people are really losing their spending power so quickly. But, 2%, there’s no kind of perfect number, but that’s kind of where they landed. 

Jeff Praissman 

So, really, that target’s considered just a healthy number where it kind of keeps things moving. But doesn’t jump ahead too fast and really leave people unable to afford anything or vice versa. Just kind of stagnates and nothing seems to go anywhere. And we’re sort of just in a rut for lack of a better word.  

Michael Normyle

Yeah, exactly.  

Jeff Praissman 

So what are the major contributors to inflation? And how are each of them affecting it?  

Michael Normyle 

So there are two big drivers of inflation currently. One is housing and the other is core services, ex housing. The rest of inflation, core goods, food and energy, they’ve been relatively minimal drivers of inflation in the last year or so. Since we have June data for CPI and only May for PCE, I’ll focus on CPI. 

In June, headline inflation fell to 3.0% percent in year over year terms. And housing and core services x housing account for essentially all of that 3.0% headline rate. 

Jeff Praissman 

So, what’s going on within those categories that’s making these differences between them and I guess, the core inflation?  

Michael Normyle 

So one of the big themes that we’ve seen for actually a while now is the lagged effects of COVID are still contributing to inflation, particularly in car insurance, healthcare, and housing. So those three categories alone account for 2.5% points of that headline, 3.0% annual rate. 

And that’s almost double their average contribution in the five years prior to the pandemic, which was a time when inflation was pretty well behaved.  

It was a little bit below that 2% target, but pretty close on average over that period. So taking these one by one, car insurance is still rising in response to the earlier increase in new and used car prices during the pandemic. 

And really that earlier increase was a function of, if you remember early on, the pandemic, people were flushed with cash with their stimulus checks. Rates were zero. So there was a lot of demand to buy new cars at that time. But there was also a chip shortage. So the supply of cars was restrained. 

And so that resulted in new car prices rising. And then with that, demand for new cars and the lack of supply and the rising prices that push people into the used car market since a car that’s only one or two years old is a pretty good substitute for a new car. So that pushed up used car prices. 

So the CPI price level, not the inflation rate, peaked a couple years ago for new and used cars. Up about 30% from the pre pandemic level. So meaning your average car is 30% more expensive than it was pre pandemic versus that peak a couple years ago. Since then, car prices have actually declined a little bit. 

They’re now 24% higher than their pre pandemic level, but car insurance is increasing at an annual 20% rate. That’s its inflation rate. And that’s because insurance is typically fixed for six or twelve months. And so those car insurance policies, they need to reset and catch up to that higher car price by resetting to a higher premium. But that takes time for all those old policies to roll off and reset to higher rates.  

For medical costs, it’s a similar story. The industry was hit hard by COVID, which led to strong wage gains, which have added to all sorts of costs for care. But again, the costs of medical procedures, they can be negotiated rates that take time to reset. 

And it’s the same story with your medical insurance, where your premium is often locked for a year. So it takes time for those prices to reset to reflect higher labor costs and other input costs. 

And lastly for housing, inflation is starting to slow, but again it’s a process. This is particularly evident in rents. If you sign a lease, your rent is typically fixed for one or even two years. The BLS has a series that looks at just new rents at each period and that peaked at a 12% annual rate in mid 2022, as there was strong rental demand with people working from home, so they wanted to find larger spaces. 

Plus, higher housing costs actually priced some people out of buying a house, which kept them renters. But with cooling demand and rental supply actually improving, new rents inflation has fallen to just 0.4% earlier this year, but the CPI for rent is still over 5% annual growth. And that’s because it’s a sample of all rents, not just these new ones. 

And then we need those leases to reset to the lower rates of growth and filter into the sample. So we don’t actually need rents to fall, just to see a slower rate of growth, although I’m sure that’d be welcome news for all the renters out there. 

Jeff Praissman 

The car insurance increase makes sense given the fact that what they’re insuring has gone up in value. And obviously the cause of that, as you just discussed, was increased demand, the shortage of chips, the shortage of supplies, so there’s some scarcity. What really has me a little bit puzzled, though, is, why housing costs have gone up so much? 

Like you would think conventional wisdom would say like, well, okay, higher mortgage rates, so that should potentially drive down the price of housing, but it’s like almost the opposite.  

So like people trying to get into the housing market now they’re paying higher mortgage rates and they’re paying more for the same house that they would have gotten a few years ago at a much lower rate. 

So I find that really interesting and fascinating that these housing rates has gone up so much. I mean, I understand rent going up because the housing is going up, but like, why is housing going up so much?  

Michael Normyle 

Yeah, so I think your logic makes perfect sense, right? But there’s just been an unusual confluence of factors that have meant that home prices have held up despite higher mortgage rates.  

So, a key reason is that the U. S. has mostly long-term fixed rate mortgages. Many other countries, they have short term fixed or even variable rate mortgages. 

But with many people buying a house early in the pandemic or refinancing when rates were historically low, many Americans have locked in those low rates. So about 60% of outstanding mortgages in the U. S. still have a rate under 4%. But with the Fed hiking rates, market rate mortgages are now around 7%. 

So even though a 3% point difference doesn’t sound like that much, it actually makes your monthly mortgage payment about 40% higher.  

So if you have a $350,000 loan on a house the monthly payment would increase from under $1,700 a month at a 4% rate to over 2, 300 a month at a 7% rate.And so that’s made a lot of people not want to change homes because it would increase their monthly housing costs so much if they reset to those higher rates. And so that’s really restricted the supply of homes that are available for sale. Which has then helped keep those home prices from actually falling. 

Jeff Praissman 

I want to I guess kind of go off a little bit of a tangent, but not really cause it’s all interrelated. One of our previous podcasts, Big and Small Tale of Two Labor Markets, we discussed the labor market and it’s contributions, but, is the labor market cooperating with easing inflation to the Fed’s 2% goal? Or is it, not cooperating?  

Michael Normyle 

Yeah, it is. It is because like we spoke earlier in the podcast here, wage related inflation is typically sticky. And so we have seen the labor market cooling over the last couple of years from that peak “great resignation” area where we saw those peak period of wage growth. But with the labor market cooling over the last couple of years, that’s put downward pressure on wage growth and in turn, wage related inflation. 

And so, Chair Powell actually acknowledged in his recent congressional testimony that the labor market has come back into balance and it’s no longer a significant driver of inflation. 

Jeff Praissman 

We’re halfway through the year now. I mean, it’s amazing to think that we’re already into July. What does the second half of 2024 look for inflation? Is it trending up? Is it trending down? Is it staying put?  

Michael Normyle 

Well, I think it’s going to depend on how you look at it, you know, for kind of wonky reasons. 

In month-on-month terms, I think it’s likely that we see more of those cooler inflation readings that we’ve seen the last couple of months. The trouble is that in year over year terms, it’s possible that we see inflation kind of stay put, or maybe even pick up potentially a little bit because inflation slowed so quickly a year ago. 

So there’s a potential that there’s kind of these base effects that distort the year over year number a little bit, because you’re going to be comparing current inflation against a period a year ago that saw inflation falling quite quickly. So that could mess with it a little bit. 

But if you’re focusing on the month on month, I think we’re going to see the kind of recent progress that we’ve seen continuing.  

Jeff Praissman 

Michael, this was great as always. Any final thoughts you’d like to leave our listeners with? 

Michael Normyle 

Yeah, I think it can be hard to believe that COVID related inflation is still impacting the economy. But it makes sense when you consider how these sticky prices work, where a lot of them are just fixed for a period of time. So it makes sense that it kind of takes time for them to reset. 

And then the good news is that we’re starting to see those sticky categories normalized. So overall inflation and rates can start coming down soon too.  

Jeff Praissman 

We are lucky to have Michael Normyle from Nasdaq come in every month and do a podcast on, generally, the U. S. economy, but sometimes also the real economy and any kind of economic events. So tune in. You can go to our website, find past podcasts. You can find them on Spotify, Apple Music. 

On our website, just go to Education, click on Podcasts, you can look for contributors just from NASDAQ, see all our contributors, or just kind of scroll through our episodes. And until next time, Michael, thank you again for stopping by the IBKR Podcast Studio.  

Michael Normyle 

Yeah. Thanks for having me.