Source: Jin10 Data

Federal Reserve officials expect inflation to continue to ease over the next two years and may return to the target level of 2% in 2026. However, Randall Verbrugge, senior research economist at the Cleveland Fed, warned that it may take longer to actually reach the target because inflation has some inherent characteristics that make it unlikely to fall to 2% in a timely manner.

According to the model developed by Verbrugge, the inflation rate will reach 2.7% in the second quarter of 2025, which is still above the target. By mid-2027, the inflation rate will be close to but slightly above 2%.

Market participants are expecting the personal consumption expenditure price index (PCE) to confirm a slowdown in U.S. inflation on Friday. Economists' median forecast is for PCE to fall from 2.7% in April to 2.6%, while the core PCE, which does not include food and energy prices, is expected to fall from 2.8% in April to 2.6%.

Although Powell has made it clear that policymakers do not need to wait for inflation to return to the target level before starting to cut interest rates, in the median forecast released on June 12th, PCE and core PCE are expected to fall to 2% by 2026.

Verbrugge further explained in a paper he wrote in May why the 'last mile' of inflation is so stubborn. He pointed out that there are three major factors that drive price fluctuations: recession, overheated economy, and supply chain pressures.

"If none of the three factors mentioned above are driving inflation, then you will be stuck in the inherent persistence of inflation. How fast does it move to 2% when inflation develops naturally without shocks? This paper shows that the speed is not that fast." said Verbrugge.

According to the consensus forecast of top analysts reflected in the Blue Chip economic indicator, PCE inflation will be close to 2% in 2025, which is earlier than Verbrugge's model prediction.

Verbrugge said his model suggests that most forecasters underestimate the persistence of inflation relative to the average level predicted by the Blue Chip economic indicators. He added, "Of course, I could be wrong. No model is perfect."

Verbrugge explained why corporations may continue to raise prices even when they expect inflation to decline: "Since April 2023, inflation has fallen relatively quickly, but because inflation is positive, most of the adjustments are also positive. Wages are part of these adjustments. If you suddenly have to pay higher wages, this will erode your profit margin, and you may try to raise prices to avoid being squeezed."

Excluding the average removes the fastest growing and slowest growing components each month and provides another way to observe core inflation. Historically, it took about six years for 12-month PCE excluding average to move half a percentage point from 2012 to 2019.

Verbrugge developed a mathematical formula that describes all the factors that make up inflation. One of these factors is expected inflation, which is people's views on inflation in the coming year or years. The second factor is recent past inflation, which is particularly important for businesses that have not yet had the opportunity to adjust prices to make up for squeezed profit margins. The third factor is external forces, such as a recession, overheated economy, or disrupted supply chains. The fourth factor is "one-time" shocks, such as sudden increases or decreases in natural gas prices.

"The statistical link between inflation, interest rates, and wages is difficult to discern," Verbrugge said.

Verbrugge's model suggests, "Without further supply chain improvement, the only thing that could put downward pressure on inflation is a recession. If there is no recession, then patience is needed, because this will take time."

Editor/Lambor