Why is Inflation so Stubborn?

The August inflation report released by the U.S. Bureau of Labor Statistics indicated that although the annualized rate of inflation declined slightly, inflation remained at a relatively high rate. The Consumer Price Index (CPI) increased 8.2 percent (seasonally adjusted) for the 12 months ending in August, down slightly from the July rate of 8.5%. Month over month, inflation rose 0.1% in August after being unchanged in July.

CPI – 12-Month Percent Change

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug
2022	7.5	7.9	8.6	8.2	8.5	9.0	8.5	8.2

CPI – One-Month Percent Change

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug
2022	0.6	0.8	1.2	0.3	1.0	1.3	0.0	0.1

Inflation has decreased, but it has not decreased quickly enough for most Americans, and the financial markets. When the August inflation number was released on Tuesday, September 13 the financial markets fell significantly. The S&P 500 dropped over 4% and the NASDAQ plunged over 5%. The concern in the financial markets was that although inflation is generally declining, it is not declining fast enough. As a result, the Federal Reserve may continue to be aggressive at increasing interest rates, which in turn lowers borrowing and reduces consumer and business spending.  This could make it difficult for an economic “soft landing”. In other words, a recession may result. Many central banks around the world are facing the same challenge. The U.S. Federal Reserve, European Central Bank and Canadian Central Bank have all aggressively raised interest rates in 2022 to temper consumer and business demand and lower high rates of inflation.

However, this round of global inflation is stubborn and particularly challenging for central banks. Part of the reason why inflation has been stubborn and may take some time to bring down is due to the insensitivity of demand to interest rates for products that have experienced the greatest price increases. While the Federal Reserve can increase interest rates to lower borrowing and consumer and business demand, there are some products whose demand isn’t that sensitive to increased interest rates. The table below shows price changes for selected products in August and over the past 12 months. Major product categories include Food, Energy, and all items less Food and Energy (which is also called “core inflation”). Three major products which had substantial price increases in August are listed under the “All Items less Food and Energy” category, including New Vehicles, Shelter, and Medical Care Services.

Product Category	Percent Price Change August 2022	Percent Price Change 12-months Ended August
Food	0.8	11.4
Energy	-5.0	23.8
All Items less Food and Energy	0.6	6.3
New Vehicles	0.8	10.1
Shelter	0.7	6.2
Medical Care Services	0.8	5.6

A primary driver of inflation over the past 12 months has been energy costs, but declining gas prices in August contributed to an overall 5.0% decline in the cost of energy. However, significant price increases occurred in August for Food, New Vehicles, Shelter, and Medical Care Services, which contributed to the stubbornness of continued relatively high inflation. Will increased interest rates by the Federal Reserve contribute to lowering prices in each of these areas?

Food prices increased 0.8 percent in August and 11.4 percent for the 12-month period ending in August. Increased interest rates really don’t affect the demand for food. Food prices have been rising for a myriad of factors. Global fertilizer prices rose to record levels in 2022. According to the USDA, fertilizer prices account for nearly one-fifth of U.S. farm cash costs, with an even greater share for corn and wheat producers. The Russian invasion of Ukraine triggered import-export restrictions that compounded supply problems. Russia is the top exporter of agricultural fertilizer with an estimated 15% of the global market. Although fertilizer prices began increasing in 2021, many farmers were probably able to avoid the increase in fertilizer prices caused by Putin’s invasion of Ukraine as fertilizers for early 2022 plantings were purchased in 2021. However, the Russia-Ukraine war may continue to negatively impact fertilizer prices as the war drags on.

The war has also had a major impact on the price of wheat. Russia and Ukraine combined for 30% of global wheat exports prior to the war. Wheat prices spiked 50% in early 2022, as wheat exports were disrupted by the war. Wheat prices significantly declined in summer aided by a United Nations brokered deal with Ukraine to establish a safe corridor for grain trade, but significant uncertainty over wheat exports remain as the war continues.

Increased energy prices have negatively impacted shipping and growing costs. And while overall energy prices declined in August, there is a lag effect between changing energy costs and product pricing. Food prices have also been impacted by severe weather conditions globally. A variety of factors significantly affect food pricing.  Increased interest rates isn’t one of them. The Federal Reserve increasing interest rates will not have a major impact on food prices.

In August, new vehicle prices rose 0.8% while for the 12-month period prices were up 10.1 percent. While increased interest rates can make new vehicle financing less attractive, the primary driver of new vehicle price increases has been supply chain issues rather than consumer demand. A previous CBEI blog, “Demand, Supply, and Car Prices” discussed what is driving new car prices. Between April 2021 and July 2022, new vehicle prices increased nearly 16%. Over that same period, vehicle sales declined by over 26% from 18.8 million to 13.8 million. New vehicle sales in July 2022 were lower than at any time between January 2012 and February 2020, before the impact of COVID on the economy. Supply chain issues were driving the price increase, not consumer demand generating increased sales. Since April 2021 vehicle sales have declined and have been volatile, while new vehicle prices increased significantly because of reduced supply.  Since the impact of COVID in 2020, the auto industry has suffered supply chain problems, particularly in the offshore sourcing of semiconductors which in turn significantly limited the supply of new vehicles. Increased interest rates by the Federal Reserve may ripple through to new vehicle financing costs and temper demand, but the primary driver of new vehicle prices has been the supply chain, not consumer demand.

The demand for medical care services is based on the need for medical care, not movements in interest rates. There are a variety of complex reasons that contributed to the increasing price of medical care services, but they don’t include low interest rates. The Federal Reserve increasing interest rates will not have a major impact on the cost of medical care services.

Finally, an area that is impacted by the Federal Reserve raising interest rates is Shelter. Housing and rental prices have risen significantly in many housing markets across the United States, especially since the economic recovery began in 2020. The Federal Reserve reduced the federal funds rate to a record low target range of 0.00-0.25% in March 2020 to foster a return of economic growth as COVID plagued the economy. In 2022, the Federal Reserve began increasing interest rates to fight inflation. Increasing interest rates negatively affects the affordability of housing, and consequently may cool the housing market. However, the increased interest rates and borrowing costs may cause consumers to shift from home ownership to renting. Demand may be reduced for houses but may increase even more for rentals.

The August inflation report released by the U.S. Bureau of Labor Statistics indicated that although the annualized rate of inflation declined slightly, inflation remained at a stubbornly high rate. Financial markets dropped significantly fearing that the Federal Reserve may continue to be aggressive at increasing interest rates, which could result in a recession. The problem for the Federal Reserve is that the demand for some of the products that have experienced the greatest price increases isn’t that sensitive to changes in interest rates. While the Federal Reserve can increase interest rates to lower borrowing and consumer and business demand, there are some products whose demand isn’t that sensitive to increased interest rates. The prices of food, new vehicles, and medical care services are products that had price increases of at least 0.6% in August. The pricing of those items has been significantly driven by a variety of factors, but low interest rates wasn’t one of them. Although raising interest rates can temper consumer and business demand, the current inflationary environment may take some time to resolve. There are many factors beyond the control of the Federal Reserve (and government) that have impacted product and service pricing.

Although the CPI increased by 0.1% in August, there was subsequently some potentially good news for future inflation. The Producer Price Index (PPI) measures the average change over time in the prices received by domestic producers for their goods and services. The PPI is viewed as a wholesale price index and is a leading indicator for the CPI. The changes in costs for producers are often reflected in their selling prices to retailers and consumers. However, changes in the PPI are not perfectly correlated with changes in the CPI, as there are differences between the two indexes. For example, the CPI includes imports; the PPI does not. In August, the PPI declined for the second consecutive month, declining 0.1% in August after dropping 0.4% in July. It was the first back-to-back decline in the PPI since early 2020. The drop in the PPI was driven by the decline in energy prices and improving global supply chains. Monthly increases in the PPI occurred from January through June and ranged from 0.5% to 1.7%.

PPI – One Month Percent Change

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug
2022	1.2	1.1	1.7	0.5	0.8	1.0	-0.4	-0.1

For further information:

1. From the Bureau of Labor Statistics (BLS):
   1. August Inflation
   2. U.S. Inflation
   3. Producer Price Index
2. From the United States Department of Agriculture:
   1. Impacts and Repercussions of Price Increases on the Global Fertilizer Market
3. From Trading Economics:
   1. Wheat Prices