Lag effects from the past are driving inflation today

It has been three long years since inflation first ripped upward. But the inflation data in 2024 is, in important ways, being driven by that initial series of economic disruptions that took place in 2021 and 2022.

Why it matters: In one sense, this is good news — it implies that once these lag effects have worked through the system, inflation should settle lower without much additional economic pain.

• As Goldman Sachs economist Ronnie Walker writes in a recent note, “the remaining hot inflation appears to be lagged catch-up inflation, not reheating inflation.”

Yes, but: The bad news is that it implies the inflation of the last few years has, cumulatively, been worse than earlier data implied.

• And the longer high inflation persists, the more likely it is to trigger lasting changes in household and business decisions.

State of play: The biggest driver of elevated inflation so far in 2024 is from shelter — rents and homeowners’ equivalent rent — which has risen at a 6.1% annual rate in the first three months of the year, according to the Consumer Price Index.

• Many measures of market rents for new leases have stabilized or even come down, but landlords have moved slowly in bringing existing tenants’ rents up to current market rates.
• In that sense, surging rents in current government data reflect a delayed effect of the surge in market rents that began three years ago.
• As Federal Reserve chair Jerome Powell put it last week, “essentially there are a number of places in the economy where there are just lag structures built into the inflation process, and housing is one of them.”

Housing isn’t the only sector where these dynamics apply. Motor vehicle insurance prices are up 22.2% over the last 12 months, according to CPI data.

• The supply disruptions and labor shortages of the 2021-2022 period made auto repairs much more expensive, so insurers need to charge higher prices to cover their outlays for damaged vehicles.
• But as a highly regulated industry, it has taken time for state agencies to authorize those rate hikes, hence higher prices in 2024 due to economic shifts that took place in the past.

Zoom in: Lags are evident in wages, as well. Inflation-adjusted compensation costs for state and local government are up 1.3% over the last year, according to the Employment Cost Index, more than double the 0.6% rise in the private sector.

• But this reflects the fact that the private sector reacted more quickly to the tight labor market in 2021 and 2022, raising pay in order to keep up with the market at a time state and local governments fell behind on wages — and are now playing catch-up.