Prices quickly increase on the way up but are sticky on the way back down.
During an era like today, when the economy is less sensitive to changes in interest rates, this kind of inflation creates challenges for central banks looking to maintain price stability.
For Kevin Warsh, who just took over as chair of the Federal Reserve, the recent increase in prices has created a challenge that few expected even a few months ago. He was nominated by the executive branch with a mandate to cut rates, but the recent rise in prices, if it proves sticky, could instead force the Fed into a rate-hiking cycle.
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The key question is whether top-line inflation bleeds into the core inflation rate, which excludes the more volatile food and energy sectors but includes service sector pricing that has recently proven to be sticky.
And since sticky prices do not respond quickly to changes in monetary policy, that lag can erode the credibility of a central bank’s ability to meet its mandate on inflation, which in turn can result in rising inflation breakevens and inflation expectations.
The duration of any tightening cycle will be driven by how long inflation remains elevated and determine the trajectory of real rates and sector-specific pricing power.
The current environment is not looking promising for rate cuts. Demand for services has continued to be robust in a trend that began before the war in Iran. That rising demand has resulted in higher prices—service-sector inflation rose by 0.6% in April and by 3.4% from a year ago.
Recent examples include rents, housing and transportation. But it’s not just those sectors. Technology, electronics, utilities, health care, education, recreation, food service and accommodation as well as subscription-based services like streaming media have been increasing, and those prices tend not to decline once they go up.
As those prices rise, there is a ripple effect. Once consumers start paying those higher costs, they start to agitate for higher wages and salaries in their jobs, which then forces businesses to raise their prices. The result? A cycle of persistent inflation.
Should inflation remain elevated, the Fed will have to delay rate cuts, which will feed back into bond yields, credit spreads, and equity and foreign exchange valuations.
Bond investors in particular tend to be sensitive to sticky inflation as it erodes real yields over time as nominal rates fail to keep pace.
Flexible vs. sticky prices
Using the three-month annualized rates for flexible and sticky groups of prices compiled by the Federal Reserve Bank of Atlanta, we can see that spikes in flexible-priced items have often coincided with insufficient supplies of oil.
Examples were the hurricanes of 2005 that shut down Gulf Coast refineries and then the bottlenecks before the financial crisis. More recently, the 2022 and 2026 spikes were because of the shutoff of supplies in the Ukraine war and the Iran war.
The Atlanta Fed reported that the flexible portion of the consumer price index, which it defines as a weighted basket of items that change price relatively frequently, increased at a three-month annualized 19.3% rate in April and by 5.6% on an annual basis.
The Atlanta Fed’s sticky-price consumer price index, which is a weighted basket of items that change price relatively slowly, rose by 4.6% in April on an annualized basis, following a 2.4% increase in March.
On a three-month annualized basis, sticky-priced items increased by 3.2% in April and by 3.1% annually.
The takeaway
Both sticky and flexible inflation increases are well above the Federal Reserve’s 2% target for inflation, as they have been for more than five years, which we think is causing many investors to reset their expectations higher and demand a greater risk premium.
This implies lower rates of real, or inflation-adjusted, wages and income growth and, in turn, lower rates of household spending and diffused quality of life for most Americans.
The Fed will soon have to make a policy decision on whether the supply shock is transitory or will require near-term policy action.
