Inflation Is Still High. What’s Driving It Has Changed.

America is now two years into abnormally high inflation — and while the nation appears to be past the worst phase of the biggest spike in price increases in half a century, the road back to normal is a long and uncertain one.

The pop in prices over the 24 months that ended in March eroded wage gains, burdened consumers and spurred a Federal Reserve response that has the potential to cause a recession.

What generated the painful inflation, and what comes next? A look through the data reveals a situation that arose from pandemic disruptions and the government’s response, was worsened by the war in Ukraine and is now cooling as supply problems clear up and the economy slows. But it also illustrates that U.S. inflation today is drastically different from the price increases that first appeared in 2021, driven by stubborn price increases for services like airfare and child care instead of by the cost of goods.

Fresh wage and price data set for release on Friday are expected to show continued evidence of slow and steady moderation in March. Now Fed officials must judge whether the cool-down is happening fast enough to assure them that inflation will promptly return to normal — a focus when the central bank releases its next interest rate decision on Wednesday.

The Fed aims for 2 percent inflation on average over time using the Personal Consumption Expenditures index, which will be released on Friday. That figure pulls some of its data from the Consumer Price Index report, which was released two weeks ago and offered a clear picture of the recent inflation trajectory.

Before the pandemic, inflation hovered around 2 percent as measured by the overall Consumer Price Index and by a “core” measure that strips out food and fuel prices to get a clearer sense of the underlying trend. It dropped sharply at the pandemic’s start in early 2020 as people stayed home and stopped spending money, then rebounded starting in March 2021.

Some of that initial pop was due to a “base effect.” Fresh inflation data were being measured against pandemic-depressed numbers from the year before, which made the new figures look elevated. But by the end of summer 2021, it was clear that something more fundamental was happening with prices.

Demand for goods was unusually high: Families had more money than usual after months at home and repeated stimulus checks, and they were spending it on cars, couches and deck furniture. At the same time, the pandemic had shut down many factories, limiting how much supply the world’s companies could churn out. Shipping costs surged, goods shortages mounted, and the prices of physical purchases from appliances to cars jumped.

By late 2021, a second trend was also getting started. Services costs, which include nonphysical purchases like tutoring and tax preparation, had begun to climb quickly.

As with goods prices, that tied back to the strong demand. Because households were in good spending shape, landlords, child care providers and restaurants could charge more without losing customers.

Across the economy, firms seized the moment to pad their bottom lines; profit margins soared in late 2021 before moderating late last year.

Businesses were also covering their growing costs. Wages had started to climb more quickly than usual, which meant that corporate labor bills were swelling.

Fed officials had expected goods shortages to fade, but the combination of faster inflation for services and accelerating wage growth captured their attention.

Even if pay gains had not been the original cause of inflation, policymakers were concerned that it would be difficult for price increases to return to a normal pace with pay rates rising briskly. Companies, they thought, would keep raising prices to pass on those labor expenses.

Worried central bankers started raising interest rates in March 2022 to hit the brakes on growth by making it more expensive to borrow to buy a car or house or expand a business. The goal was to slow the labor market and make it harder for firms to raise prices. In just over a year, they lifted rates to nearly 5 percent — the fastest adjustment since the 1980s.

Yet in early 2022, Fed policy started fighting yet another force stoking inflation. Russia’s invasion of Ukraine that February caused food and fuel prices to surge. Between that and the cost increases in goods and services, overall inflation reached its highest peak since the 1980s: about 9 percent in July.

In the months since, inflation has slowed as cost increases for energy and goods have cooled. But food prices are still climbing swiftly, and — crucially — cost increases in services remain rapid.

In fact, services prices are now the very center of the inflation story.

They could soon start to fade in one key area. Housing costs have been picking up quickly for months, but rent increases have recently slowed in real-time private sector data. That is expected to feed into official inflation numbers by later this year.

That has left policymakers focused on other services, which span an array of purchases including medical care, car repairs and many vacation expenses. How quickly those prices — often called “core services ex-housing” — can retreat will determine whether and when inflation can return to normal.

Now, Fed officials will have to assess whether the economy is poised to slow enough to bring down the cost of those critical services.

Between the central bank’s rate moves and recent banking turmoil, some officials think that it may be. Policymakers projected in March that they would raise interest rates just once more in 2023, a move that is widely expected at their meeting next week.

But market watchers will listen intently when Jerome H. Powell, the Fed chair, gives his postmeeting news conference. He could offer hints at whether officials think the inflation saga is heading for a speedy conclusion — or another chapter.

Ben Casselman contributed reporting.

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