The likelihood of U.S. inflation dropping to 2% next year is very low, but the Federal Reserve may stick to its rate-cutting path

According to Zhitong Finance APP, the likelihood of U.S. inflation falling to the Federal Reserve's annual target of 2% by 2025 is very low, but this is unlikely to change the Fed's current interest rate cut path.

Inflation has been one of the main challenges for the Federal Reserve over the past four years. However, there has been significant improvement in inflation. The preferred inflation measure of the Fed—the year-on-year increase in the Personal Consumption Expenditures (PCE) price index—peaked at over 7% in June 2022. At that time, the Fed had just begun to raise interest rates from nearly zero to address the rapid rebound in prices following the economic freeze caused by the COVID-19 pandemic.

The initial progress was quite rapid: by June 2023, the annual increase in the PCE price index had fallen to 3.3%. In the following month, the federal funds rate reached its highest level in twenty years, with a target range of 5.25% to 5.5%.

However, since then, inflation has experienced fluctuations. After further slowing at the end of 2023, it rebounded again at the beginning of 2024. Following a decline in inflation during the summer, progress stalled again at the end of 2024. The core PCE price index (which excludes volatile food and energy prices) has remained around 2.7% over the past six months.

The Fed's Optimism

Federal Reserve Chairman Jerome Powell stated on November 14, "I expect inflation to continue to move toward our 2% target, although the path may be somewhat bumpy."

So, why do policymakers seem to "declare victory" when inflation is still above target? This requires a deeper understanding of the components of the inflation index.

First, the 2% inflation target does not mean that the prices of all goods and services in the economy will grow at a rate of 2% simultaneously. The Consumer Price Index (CPI) basket includes about 80,000 goods and services, some of which have price increases exceeding 2%, while others are below 2%.

Three Categories of Inflation

Inflation can be divided into three main categories: goods, housing, and non-housing services. During the peak of inflation post-pandemic in 2022, prices in all three categories experienced rapid increases. Supply chain disruptions and a surge in online shopping drove up goods prices; rents and home prices soared as people reassessed housing needs in the era of remote work; and service prices were driven up by rising wages and labor shortages.

Today, goods inflation has been brought under control, and service inflation has eased with a cooling labor market, but housing price inflation remains a problem.

The housing category includes rent paid to landlords and "owner's equivalent rent" (the estimated cost a homeowner would need to charge if renting out their home). This category may also include utility costs such as water and electricity. In the CPI, housing accounts for about one-third, while its weight in the PCE price index is about 16%.

As of September 2024, housing and utility costs in the PCE price index rose by 5% year-on-year, down from a peak of over 8% in mid-2022. During the same period, non-housing service prices increased by 3.3%, while goods prices fell by 1.2%.

The Challenge of Housing Inflation

Housing inflation is essentially a slowly changing area, and the Federal Reserve cannot significantly accelerate its pace of change by altering interest rates. Lease contracts are typically renewed only once a year, and the frequency of home sales is also low. The central bank cannot directly build more housing to increase supply, nor can it expedite the renewal of leases for individuals.

As a result, Federal Reserve officials have shifted their focus to changes in rents for new lease contracts rather than changes in rents for existing leases. Progress in this area is more encouraging, but it will still take a considerable amount of time to reflect in the inflation index.

Boston Fed President Susan Collins stated on November 20, "The high level of housing inflation is due to existing tenants' rents still catching up with past increases. Although this catch-up process may be slow and uneven, as long as the rent increases for new tenants remain subdued and overall inflation expectations are stable, I am not concerned about the sustainability of inflation returning to the 2% trajectory."

Researchers at the Cleveland Fed recently conducted a study showing that housing rent inflation still has a long way to go to complete this catch-up process. Their model predicts that rent inflation will not fall below the pre-2020 average level of 3.5% until mid-2026.

Policy Outlook and Future Prospects

This does not yet take into account the new growth policies that the new Congress and government in the United States may adopt. These policies could increase goods inflation through tariffs, drive service inflation through labor shortages, or stimulate demand through tax cuts, thereby increasing overall inflationary pressures.

The October PCE price index, set to be released this Wednesday, is expected to rise 0.2% month-on-month, with the core index rising 0.3%, consistent with the increase in September. The annual PCE inflation rate is expected to reach 2.3%, with the core inflation rate at 2.8%.

Nevertheless, the outcome of the Federal Reserve's meeting on December 17-18 may not be significantly affected. Before that, there are only two key data points left: the November employment report on December 6 and the November CPI on December 11. If the inflation report is significantly higher than expected, it may prompt the Fed to pause interest rate cuts; conversely, if the employment data is weak, it may support further rate cuts.

Federal Reserve officials believe that the current level of interest rates is sufficient to restrict economic activity, and they hope to gradually approach the neutral rate without harming the economy. Although it may be necessary to endure a period of inflation above the target, as long as the inflation progress is concentrated in the housing sector and new lease inflation continues to decline, they seem to have accepted the reality that achieving the 2% target by 2025 may not be feasible