Why We Expect Inflation to Fall in 2024

Summary

• Overall PCE inflation was 2.3% year over year as of August 2024, with core PCE inflation at 2.7%.
• After soaring to 6.5% in 2022 and 3.7% in 2023, PCE inflation should post an annual average of 2.4% in 2024. We project a further drop to an average 1.8% over 2025-28, just under the Fed’s 2% target.
• Supply chain improvements will continue to weigh on inflation, while housing component has further to fall.
• A coming deceleration in GDP growth should also cool off prices across the economy.

When peak inflation was raging in 2022, many economists thought that it would take a recession (perhaps a severe one) to bring inflation back to the Fed’s 2% target.

But the US economy has defied those pessimistic predictions. Inflation fell from 6.5% in 2022 to 3.7% in 2023, despite economic growth accelerating. We project inflation to continue to fall, averaging 2.4% in 2024 and then averaging just 1.8% over 2025 to 2028.

To be more precise about the timing, we expect core PCE to hit 2.0% year over year sometime in the first quarter of 2025, declining from 2.7% as of August 2024.

Even while inflation normalizes, we expect the economy to avoid a recession, though we do expect a period of slightly weaker GDP growth (troughing in 2025). See our latest Economic Outlook for further details.

To be sure, a recession is still possible. It could happen if the Fed fails to loosen monetary policy sufficiently, or if another black swan-type event hits the economy or financial markets. But the key point is that we now know a recession is not necessary to normalize inflation.

How Did Inflation Fall Without a Recession?

Admittedly, the inflation pessimists had history on their side when they argued a recession would be needed to tame inflation. For example, to beat the Great Inflation of the 1970s, the Fed had to engineer a sharp recession in the early 1980s. Why have things turned out differently this time?

Like any economic phenomenon, inflation is explainable by supply and demand. Too much demand chasing too little supply of goods causes prices to rise.

When inflation peaked in 2022, demand certainly played a contributing role, but probably the biggest driver was on the supply side. The pandemic caused disruptions to the supply of energy, durable goods, and other areas, and that’s where prices rose the most.

These supply disruptions took longer to resolve than expected, but they did eventually resolve to a great degree. As the supply side recovered in 2023, we saw inflation come down fastest for the same kinds of goods where prices had risen fastest in 2022. This process is ongoing as of the second half of 2024.

The pessimists had assumed that the supply side wouldn’t recover in this manner, but instead the disruptions would be more enduring (akin to the oil price shocks of the 1970s). If supply hadn’t improved, the onus would’ve been on falling demand to reduce inflation. And the requisite drop in aggregate demand would’ve been consistent with a sharp recession.

What Is the Current Inflation Rate in the United States?

The Personal Consumption Expenditures Price Index, or PCE Index, which is our (and the Fed’s) preferred inflation measure, has dropped from a peak of 7.1% year-over-year growth in June 2022 to 2.3% as of August 2024 (our estimates for August derive from the Consumer Price Index data).

Core PCE inflation stood at 2.7% as of August. Core inflation’s rise and fall was somewhat less dramatic than overall inflation because core inflation doesn’t include food and energy prices. Economists prefer core inflation as a better gauge of inflation’s underlying trend, which can be obscured by the volatility of food and energy prices.

Consumer Price Index inflation, which has some methodological differences with PCE, has fallen even more dramatically. It peaked at a higher rate (8.9%) owing to a higher weighting in energy. CPI inflation data posted 2.6% year-over-year growth in August 2024. It’s still running a bit higher than PCE inflation owing to its larger weight to housing, where inflation has been running hottest among major categories.

Zooming into the monthly data for core PCE inflation, we experienced a scare with renewed high inflation in early 2024. After posting a 1.9% annualized rate in the final six months of 2023, core PCE inflation jumped to a 4.5% annualized rate in the three months ended in March 2024. But it dropped back quickly and stands at a 2.0% rate as of the three months ended in August 2024.

Core PCE Inflation Components, 3-Month % Change (Annualized)

The spike in core services excluding housing (especially driven by financial services) has receded. Likewise, core goods have returned to deflation, reflecting the ongoing impact of improved supply conditions. We’ve seen particularly strong price reductions in vehicles, but also in other areas.

Housing inflation remains stubbornly high, at 5.4% year over year as of August and a 4.7% annualized rate in the past three months.

Altogether, core inflation excluding housing is running very low. Even on a year over year basis (which includes the months from the first quarter 2024 spike), core inflation excluding housing is running at 2.1% year over year. So, it could be said that the inflation problem is essentially solved outside of housing.

What Are Our Inflation Projections for the Next Five Years?

Given the role of industry-specific supply shocks in driving historically high inflation, we take a bottom-up approach to forecasting inflation for the next five years. That is, we start by examining the underlying components and work toward macro trends.

Here are the key categories driving our inflation forecast over the next five years:

• Durables: We expect durables to remain in deflationary territory. Supply-side conditions have healed, with semiconductors and other parts of the supply chain flipping from shortage to glut. But this improvement has only barely been passed on to consumers so far; the unwinding of the spike in prices has much further room to run.
• Food and energy: We expect prices to subside as the industry adjusts to disruption from factors such as the Ukraine war, and one-off events such as the outbreak of Highly Pathogenic Avian Influenza in 2022, which especially elevated egg and poultry prices.
• Housing: Leading-edge data still strongly points to a normalization of housing inflation being around the corner. Assuming market rent growth doesn’t reaccelerate, it’s inevitable that housing inflation will fall back to normal.

In all other components of the Personal Consumption Expenditures Price Index, we expect moderate wage growth and the absence of any long-lasting supply disruptions to keep inflation at restrained levels. And the economy growing well below potential through 2025 will lead to deflation in certain categories of goods and services as well.

PCE Inflation Forecast: Key Components (% Growth)

Will Inflation Go Down as the Global Supply Chain Heals?

Even with a new spate of issues cropping up over the past year (notably the Red Sea disruptions), supply chain conditions remain dramatically improved compared with their deteriorated state in 2021 and 2022. In fact, the New York Fed’s Global Supply Chain Pressure Index is showing supply chain conditions right in line with prepandemic levels.

Supply chains possess a much greater degree of slack compared with 2021 and 2022, so it’s now much less likely that any individual disruption throws a wrench into the whole system. For example, even while global container ship demand is increased by rerouting around the Red Sea, supply has expanded and continues to expand owing to a fast rate of deliveries of new ships. Crucially, while shipping prices have rebounded, incidences of delays and shortages (which are far more important for consumer prices) have been small.

Global Supply Chain Pressure Index (New York Fed)

How Does the Housing Market Affect Inflation Numbers?

Because price indexes like the PCE or CPI capture the cost of living, and most people don’t sign a new lease or buy a new house every year, it takes time for the housing component of the price indexes to capture changing market conditions. As existing tenants are rolled over to prevailing market rates, the housing component of the PCE/CPI catches up to market rents. For this reason, officially measured housing inflation is still running fairly hot owing as a delayed response to the runup in market rents over 2021-22.

Market rent growth decelerated sharply in 2023 in response to expanding supply and weakening demand. It’s remained tepid since then. Rent growth stands at around 2% year over year as of July 2024, down sharply from its peak of 15.6% in February 2022. With PCE/CPI housing close to catching up to market rents, we expect housing inflation to start to decelerate until returning to normal rates (around 3-4%).

We also expect home price growth to remain weak owing to weak demand. We expect home prices to remain nearly flat in nominal terms over the next several years and thus converge much of the way back to the prepandemic trend. This will help return the housing inflation index to normal.

Is Inflation Ever Going to Go Down?

Our base case is that inflation will complete its normalization over the next year, even as real GDP growth remains positive in year-over-year terms. This would meet any economist’s definition of a “soft landing.”

Since mid-2022, inflation has fallen around 400 basis points even as real GDP growth has accelerated. That performance has defied the predictions of those in the stagflation camp who thought that a deep economic slump would be needed to root out entrenched inflation. Instead, the inflation-GDP trade-off has been very kind, thanks to the loosening of supply constraints, as we had long anticipated.

Still, we’ve been surprised by the resiliency of economic growth in the face of aggressive rate hikes from the Fed. This means the “overheating” scenario is a serious possibility, where the economy grows at a rollicking pace and inflation remains stuck around 3%.

We still think that the Fed’s rate hikes executed thus far will eventually slow GDP growth sufficiently such that inflation will drop to 2% (while avoiding an outright recession). The effects of these rate hikes are still accumulating throughout the economy as borrowers roll over to higher interest rates and exhaust their financial cushions.

This article was compiled by Emelia Fredlick