Could inflation come back?

by Collin Crownover, PhD, Fidelity Asset Allocation Research Team, Fidelity Viewpoints

Inflation may be down—but it's not out.

It’s been nearly 2 years since inflation’s dramatic recent peak in June of 2022, when the US inflation rate flirted with double-digit territory for the first time in a generation.

While inflation has come down significantly since then, progress in reducing the rise of prices has slowed.

Viewpoints sat down recently with Collin Crownover, PhD, the lead inflation analyst on Fidelity’s Asset Allocation Research Team, for a candid chat about his outlook. Here are excerpts from our conversation about where inflation goes from here, whether the low-inflation era might be gone for good, and why your coffee runs might get more expensive this year.

Viewpoints: What's your outlook for inflation over the rest of this year and into next?

Crownover: My thesis has long been that a good chunk of the nasty inflation the US experienced in 2022 was going to fade. But there are some remaining drivers of inflation that are proving more persistent. So I actually think the decline in inflation that we’ve seen—or as us geeks call it, “disinflation”—is largely done, and it’s going to be much harder to get inflation down further from here.

To put numbers on that view, I think inflation may get down to around 3% by the middle of this year, but then could actually tick up slightly in the second half of the year. Into next year, I think inflation could stay persistently above 3%.

Viewpoints: What are the key drivers behind that?

Crownover: Not only has the US not seen a recession, we haven’t gotten close to seeing a recession yet. So robust growth is a key factor behind inflation potentially staying higher.

More specifically and perhaps more importantly is that unemployment is still very low by historical standards—even though it’s up slightly from its recent lows. My favorite measure for looking at wage growth—the Atlanta Fed’s Wage Growth Tracker—has still been running at close to 5%. Wages are a huge input cost in many parts of the economy, but particularly in service-based sectors. Companies generally need to pass those higher costs along to consumers in the form of higher prices. Higher wages also mean consumers have more money. All else being equal, if I have more money in my bank account I’m going to spend some of it, so that increases the demand for goods which also pushes up prices.

It’s hard to square the circle of wages going up by 5% but inflation actually coming down to 2%.

Viewpoints: What about 2 of the main inflation pain points for many people: energy and housing?

Crownover: Energy is particularly challenging to forecast because of the role OPEC (Organization of the Petroleum Exporting Countries) has in influencing prices. That said, I've been seeing some increases in inflationary pressures in commodities more broadly. It’s not as bad as what we saw during the height of the pandemic—when supply-chain issues were at their worst—but there seem to be some hot spots due to weather and climate issues. Cocoa and coffee are 2 commodities that have suddenly become in really short supply. So that may turn into higher food prices later in the year, and you might not be happy when you go to buy a coffee.

In housing, the real issue is a lack of supply. The US is about half a million units short of for-sale inventory, relative to where we were pre-pandemic. I’m not seeing a huge swell of new supply coming on the market. In certain cities, yes, but not nationally. And so while I do think we’ll see inflation in home prices come down a bit, I believe it may only come down to about 4% or 5%.

Viewpoints: How has the soft-landing narrative impacted your outlook? A year ago it seemed like a given that a recession was on the way. But now, the consensus seems to be that we have a good shot at avoiding one entirely.

Crownover: It’s definitely influenced the outlook. All else being equal, if demand is higher than expected, that will also push inflation higher.

Now, is the US really going to experience a soft landing? I don’t think that’s settled yet. History has shown that monetary policy actions—especially rate hikes—can take a very long time to impact the real economy. And it hasn’t even been a year yet since the Fed’s last rate hike.

You could make a plausible argument that it’s going to take even longer this time because so many people aren’t affected by higher interest rates in their day to day, because they’ve locked in 30-year mortgages at 3% interest rates.

That’s one of the major questions I’m looking at: Is monetary policy less effective now, because the economy is less sensitive to interest rates than it used to be? Or is it every bit as effective as it has been in the past—it just has longer lags this time?

Viewpoints: So your baseline scenario is inflation might level out later this year at a bit above 3%. What could you imagine throwing that outlook off, and moving the needle higher or lower?

Crownover: If the economy eventually runs into trouble, and the US does see a recession, it could bring inflation lower.

Another issue that could pull inflation lower is what’s happening in China. China has been experiencing a downturn in its property market, which has been a headwind to growth. But it appears that to try to offset that, the country has been pumping up manufacturing—in an aim to increase exports. Now, trade is actually a smaller portion of US gross domestic product (GDP) than you might assume. But all else equal, an increase in the supply of goods from China could create some deflationary pressures.

On the other side, what could lead inflation to be higher than anticipated? There's a lot of evidence from investors’ and consumers’ behavior that financial conditions aren’t actually very restrictive. So that’s the side of the debate where you’re saying, “it’s not that the lags are longer—monetary policy is less effective than it used to be.”

In that case perhaps growth stays robust, and there’s no reason inflation couldn't accelerate from here.

Viewpoints: What about the longer-term view? Is 3% the new normal?

Crownover: There are some inflationary longer-term trends that might keep us at closer to 3%, rather than 2%.

One reason is demographics. The US has an aging population. On the one hand, people generally spend less once they retire, which all else equal should reduce inflation. But that’s more than outweighed by the inflationary impact on wages—because so many people leaving the workforce may create a worker shortage, pushing up wages.

Another issue is productivity. What the US has seen over the last 20-plus years has been steadily declining productivity. The reasons for this are complex. But the end effect is the lower your productivity, the more expensive it is for companies to produce what they produce, and the more those costs get passed on to the end consumer.

A third is peaking globalization. That’s not to say globalization is going in reverse, but it’s really flattened out. Globalization has been a powerful disinflationary force in recent decades, because the US has been able to trade with countries that can make certain goods more efficiently and cheaply. So I'm seeing an end to that disinflationary pressure.

And finally, consumers’ long-run inflation expectations are also higher. Inflation can be a self-fulfilling prophecy. If I expect inflation to be higher I’m going to demand higher wages—if I can. That can create a feedback loop.

That said, it’s important to remember that the US has had 3% inflation before and it’s been fine. In fact, the long-run historical norm has actually been closer to 3% than the 2% experienced for, say, the couple of decades before the pandemic.

But it does require an adjustment for people. You have to start thinking about inflation more when it’s at 3% than you do when it’s 2%.

Viewpoints: What might 3% long-term inflation mean for investors?

Crownover: At 3% inflation, investors may get less diversification benefit from holding a traditional mix of stocks and bonds in their portfolios. The diversification benefit isn’t eliminated, but it is diminished.

This means investors might want to consider assets that provide inflation protection or diversification. Two such examples are commodities and TIPS (Treasury Inflation-Protected Securities). Both of those have historically outperformed during periods of higher inflation. They could potentially help investors better weather an inflationary backdrop that looks different from recent pre-pandemic history.