Despite Rhetoric, Inflation Remains a Major Problem

The good news is that the annual inflation rate has fallen from a peak of 9.1% in June 2022 to 3.2% last month. The bad news is that inflation will likely not fall further and could increase in 2024.

Much of the rise in the inflation numbers in 2021 and 2022 was due to rapidly rising food and energy prices. Much of the decrease in the inflation rate this year is due to declining energy prices and stabilizing or slightly declining food prices. While both food and energy prices tend to have large variations, what would the inflation rate be if those two were not fluctuating?

Economists tend to focus on this “core” number. If energy and food prices were constant, the core inflation rate could be calculated. The core rate has varied much less than the CPI. In October, the core annual inflation rate was 4%. That’s about the same as it has been for the past year or so.

That means it was primarily the reduction in the price of energy that brought the CPI to its current 3.2%. The Fed, through its aggressive interest rate hikes, has brought down the CPI, but it has had a much smaller impact on the core rate.

Predicting the price of energy is very difficult. In the last few months worldwide demand for energy has fallen mostly because many countries in the world are in or near a recession. While the US economy grew at a 5% rate in the third quarter of this year, most other countries are seeing small growth or even no growth.

At the same time worldwide production has increased. In the US 12.5 million barrels of oil were produced daily at the end of 2020. Because of the current administration’s desire to use less fossil fuel, daily production fell to 11 million barrels by mid-2021.

But rising prices encouraged oil companies to produce more from existing wells so that currently the US produces 13.7 million barrels per day. Had the Keystone pipeline not been canceled and the permits to drill on federal land not revoked, the US would be producing more than 15 million barrels daily.

The worldwide reduction in demand coupled with the increase in supply from the US and others, resulted in falling energy prices. Still, the core inflation rate remains at 4%.

The Federal Reserve has paused its interest rate increases, leading many in the business community to believe that the inflation problem is being resolved so that future rate increases will not be needed. Many believe that the Fed will actually begin to reduce interest rates sometime next year.

However, that may not be the case.

About 70% of total demand in the US comes from consumer spending. Another 25% comes from government spending. Business makes up about 10% and since the US imports far more than it exports, the foreign sector reduces total US demand by about 5%.

Mostly because wage increases seen by consumers are averaging nearly 7% this year and the government continues to deficit spend more than $2 trillion annually, total demand in the economy will rise significantly next year, creating excess demand.

Many labor contracts are multi-year, meaning the large wage increases will continue well into the future. Since productivity is in the 2% range, labor cost for business will rise. That puts upward pressure on prices.

Worse yet, the economy could go into recession. While most economists have been forecasting a recession for some time, next year looks like a recession could finally come. In the current quarter of this year, it looks like consumer spending will finally slow, despite the large wage increases, which could signal the beginning of a recession.

Inflationary pressures are still present. The large wage increases, the continuing large government spending deficits and the potential for increases in energy prices due to geo-political events all point to future inflation. If the Fed reduces interest rates too soon, inflation will flare up again.

The inflation battle won’t be won until the federal government reduces the annual deficit, wage increases moderate, and the US continues to increase energy production.

Let’s hope that happens.

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