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02. rates
some prices cool, others simmer
There has been no shortage of discussion on inflation in recent years. The attention is warranted; it is the defining economic issue of our times. But while headlines show inflation still above target, its composition has substantially changed.
Traditional CPI readings can be broken down into four components that together show its cumulative effect on prices. March's 2.8% headline figure, for example, comprised 1.5% from shelter, 1.0% from services, and 0.3% from food and energy. Examining today’s components yields interesting insights. Shelter costs, which are circularly impacted by Federal Reserve rate decisions, are now the largest contributor to inflation, and by themselves would already account for most of the Fed's 2% inflation “budget”.
Looking at these components historically is just as telling. During the peak period from 2021-2023, inflation was overwhelmingly dominated by increases in food and energy and in core goods—two components that are nearly non-existent today and in some cases even deflationary. For example, at its height in March 2022, changes in food and energy prices contributed well over three percentage points to headline inflation by themselves.
These differences in composition have important implications for how much progress we can expect moving forward. Shelter costs tend to move slowly simply due to the nature of leases and the natural illiquidity of housing markets. Services inflation, the other remaining major component, will only cool as wage growth softens, which is underway, but not yet sufficiently. And if high import tariffs remain in place, inflation in core goods and in food and energy will return. Consequently, the interest rate normalization path will likely be longer than anticipated. In the next section, we will examine just how prolonged this journey might be.
The composition of today’s inflation show us why the recent past has been the most difficult stretch for the Federal Reserve in three years.
HOW THE INFLATION CAKE IS BAKED
DATA: COMPONENTS OF HEADLINE CPI INFLATION (MONTHLY ANNUALIZED, NOT SEASONALLY-ADJUSTED)
SOURCE: BUREAU OF LABOR STATISTICS, FEDERAL RESERVE BANK OF SAN FRANCISCO
this time it’s different
There are many reasons to believe the current rate loosening cycle will not be like previous ones. It will be more gradual, and will require patience from market participants.
For the Federal Reserve, the fight against inflation is not a glamorous one, but rather often a thankless task. Nobody likes rate increases, and the Fed is perpetually either jumping the gun or missing the boat entirely when it comes to rate cuts. But regardless of how you feel about its timing, the current loosening cycle is well underway, and there is a wealth of historical examples to draw from to see where we are.
In the past three rate-loosening cycles, the Federal Reserve took on average one year to reach the bottom of interest rates. Given the Federal Reserve delivered the first cut in September 2024, we are eight months into the current cycle as of time of writing. This suggests we should be just past the mid-point if historical patterns hold.
But there are a number of reasons to believe that this round will take much longer. The Federal Reserve, to date, has delivered just 100 basis points in cuts, when historically past cycles have averaged 200 basis points by this point. Further, both the Federal Reserve’s own forecast and the market-implied expectations for the rate path show a very protracted descent—notably slower than in previous eras. By the end of year, only 50 basis points in additional cuts are expected, and a total of 100 basis points by the end of 2026.
CUT FROM A DIFFERENT CLOTH
DATA: PERCENTAGE-POINT REDUCTION IN FEDERAL RESERVE TARGET RATE, MONTHS FROM START OF LOOSENING CYCLE, INTEREST RATE PROJECTIONS AS IMPLIED BY FOMC DOT PLOT AND FEDERAL FUNDS FUTURES
SOURCE: FEDERAL RESERVE BANK OF ST. LOUIS, FEDERAL OPEN MARKET COMMITTEE PROJECTIONS, CHICAGO MERCANTILE EXCHANGE GROUP
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