Inflation Remains Key Threat despite Strong U.S. Economic Outlook

The U.S. economy is in the throes of a virulent bout of inflation. In January 2022, the consumer price index (CPI) was up 7.5% from a year earlier, the largest increase in nearly 40 years. This inflation surge was unexpected by most forecasters, financial market participants and monetary policymakers. Now, however, cognizant of the dangers posed by high inflation to the health and stability of the U.S. economy, the Federal Open Market Committee (FOMC) is poised to begin raising its policy rate at the conclusion of the March 15-16 meeting. Given that inflation is far above the FOMC’s 2% target,The personal consumption expenditures price index (PCEPI) is the FOMC’s preferred measure of inflation. January's headline PCEPI rose 6.1% from a year ago. the number and pace of rate hikes by the FOMC will depend importantly on the actual and expected path of the inflation rate this year. Hearteningly, the broader economy and labor markets are performing well: The consensus of most forecasters is that economic conditions will remain strong in 2022. As always, though, there is uncertainty about the near-term outlook—and perhaps more so now than usual given the large inflation shock and recent geopolitical developments in Eastern Europe.

Inflation is High and the Outlook is Uncertain

In February 2021, the Philadelphia Fed’s Survey of Professional Forecasters (SPF) projected that the headline and “core” (excluding food and energy prices) personal consumption expenditures price indexes (PCEPI)—which are the Fed’s preferred measures of inflation—would increase by 2% and 1.8%, respectively, in 2021 (Q4/Q4). Instead, headline inflation measured 5.5% and the core 4.6%. Inflation forecast errors of this magnitude are rare. Now, a year later, the consensus of the SPF is that both the headline and the core PCEPI will increase by 3.1% in 2022 (Q4/Q4).

Headline PCEPI and CPI Have Been Trending Higher

Some important indicators of current and projected inflation suggest there are a few key reasons why inflation will stay above the FOMC’s 2% inflation target in 2022:

• Rising nonlabor input costs. An important measure of input price inflation faced by firms is the producer price index (PPI) for final demand for goods and services, which increased by nearly 10% in January 2022 from a year earlier. Anecdotal reports from recent Beige Books and the financial press indicate that firms have had little difficulty in passing along higher material input costs that have arisen from supply-chain disruptions or material shortages.
• Rising labor costs. Robust demand for goods and services in 2021 has fueled a strong demand for labor. Firms in many industries continue to report a near-record number of unfilled job openings, and the number of individuals quitting their job was near an all-time high. In response, firms have been aggressively raising wages in an effort to fill job openings and retain existing workers to increase sales. In January 2021, average hourly earnings for private-sector workers were up by 5.7% from a year earlier.
• Rising commodity prices. Following the Russian invasion of Ukraine on Feb. 23, spot crude oil prices briefly surpassed $100 per barrel for the first time since August 2014, and other commodity prices jumped sharply. Some energy analysts expect prices to rise further. Crude oil and commodity prices are often a significant driver of higher inflation over the near term, although their impact must eventually wane because prices will not rise indefinitely.
• Rising inflation expectations. Some measures of inflation expectations over the next one to three years are more than double the 2% inflation target. However, various measures of longer-run inflation expectations (5-10 years) have not risen much, if at all, relative to their pre-pandemic level.

A key element of the Fed’s new monetary policy framework is to keep long-run inflation expectations anchored at 2%; a steady rise in longer-run inflation expectations would be troubling. If inflation remains well above the Fed’s 2% inflation target for the second straight year, this could begin to boost longer-run inflation expectations. Fed policymakers would risk an unwelcome erosion in their credibility if such a development occurred.

The Near-Term Outlook for the Economy and Labor Markets Is Good

The pace of economic activity ended 2021 on a strong note, as real gross domestic product (GDP) increased at a nearly 7% annual rate. However, more than two-thirds of this growth stemmed from a surge in business inventory investment. Still, there was good growth in consumer expenditures and exports. A key question going forward is whether firms’ inventory investment was unplanned or whether they ramped up production in anticipation of faster growth in 2022 with the waning of the omicron wave. Some support for the latter view was seen in the January retail sales report, as the nation’s retailers reported that sales of goods jumped by nearly 4%. Currently, though, most forecasters expect a marked slowing in real GDP growth in the first quarter—but a sizable increase in final sales (GDP less inventory investment)—because firms plan to meet existing demand for goods from the previous quarter’s inventory investment bulge.

Labor market performance also finished 2021 on a strong note and began 2022 on an ever stronger note. Nonfarm payroll employment increased by a 467,000 in January—much stronger than anticipated given the expectation that the omicron wave dented hiring in the services-providing sectors. Although the unemployment rate rose by 0.1 percentage point to 4%, this was mostly because of a sizable increase in the labor force, which is a positive development.

In sum, the most probable outcome for 2022 is 3% to 4% real GDP growth, which would be in excess of the U.S. economy’s longer-run potential rate of growth (something around 2% to 2.25%). This development would likely trigger further declines in the unemployment rate, perhaps ending the year at around 3%. If the pandemic fades into the background, there could be a surge in spending on consumer services, which would buoy growth in other areas. But it might also trigger further increase in services price inflation.

Devin Werner, a research associate at the Bank, provided research assistance.

Endnotes

1. The personal consumption expenditures price index (PCEPI) is the FOMC’s preferred measure of inflation. January's headline PCEPI rose 6.1% from a year ago.