Inflation is slowing, but still high. What you need to know

After reaching 40-year highs over the summer, price increases in the U.S. are now steadily easing.

Consumer inflation slowed to 7.1% in November from a year earlier and to 0.1% from October, the government said Tuesday. Stripping out volatile food and energy prices, so-called core inflation rose 6% over the past 12 months and 0.2% from October.

Though inflation is slowing, prices remain steep, especially for food and many services.

Here’s what you need to know:

WHAT’S GOING ON WITH INFLATION?

In recent months, there’s been a shift in inflation from goods to services.

In general, that means prices for goods and gas are rising more slowly than prices for things like dining out, travel, health care, financial services and hospitality. Prices for used cars, furniture, and appliances have moderated.

Food prices are an exception, driven by more expensive eggs, vegetables, and chicken.

Kathy Bostjancic, chief economist at Nationwide, noted that core goods prices — once you exclude food and energy — have been slowing dramatically. But services prices, excluding energy, have stayed near a 40-year high.

WHAT IS CONTRIBUTING TO THE SLOWING OF INFLATION?

Average gas prices have tumbled from $5 a gallon in June to as low as $3.26 a gallon, according to AAA, below their average a year ago.

Supply chain snarls are also coming to an end. Ports have cleared ship backlogs. And the cost of shipping a cargo container from Asia has returned to its pre-pandemic price.

The Federal Reserve’s series of aggressive interest rate hikes have also created downward pressure on prices by making borrowing steadily more expensive.

WHY ARE SERVICES PRICES RISING MORE THAN GOODS PRICES?

Some of it is the ongoing shift from the pandemic era, when millions of Americans stayed away from restaurants, postponed vacations and stopped going to concerts or movie theaters. Now, as COVID-19 fades, people are making up for lost time by traveling and dining out again.

At the same time, spending on goods like exercise bikes, furniture, and cars spiked during the pandemic but is now declining.

Some economists point to rising wages as a primary cause of increasing service costs, as employers pass on the higher cost of labor to consumers.

Others say companies have seens that consumers are willing to absorb increasingly higher prices in recent months. As costs for things like shipping have eased, corporations have not always passed those savings on to consumers.

“If companies don’t feel the pressure and need to discount, they won’t,” Bostjancic said. “They’ve achieved some pricing power, and it’s been good for the bottom line. They’ve profited quite nicely, and they want to hold on to that pricing power as long as possible. As long as the consumer withstands those prices, they won’t change that.”

WHAT DOES ALL THIS MEAN FOR INTEREST RATES?

In some ways, the Fed is better suited to combat goods inflation than services inflation. When people buy expensive items like appliances, cars, or furniture, they often borrow money to do so. A high interest rate increases the cost of borrowing, thereby slowing those purchases. The Fed has a less clear pathway to affecting the price of services.

So while inflation in the goods sector is slowing, inflation in the services sector could prove more stubborn. As people spend down savings they built up during the pandemic, demand may slow. But until those savings are meaningfully depleted, or debt reaches unmanageable levels, spending may continue.

That said, the Fed’s benchmark short-term rate affects loan rates throughout the economy. The central bank has already weakened the housing market significantly with its tightened monetary policy.

Chair Jerome Powell has made clear that the Fed will raise its key rate by a smaller increment when it meets Wednesday. Investors foresee a half-point Fed hike, after four straight three-quarter-point increases.

WHERE DOES INFLATION GO FROM HERE?

Powell has suggested that housing costs, which have been a major driver of inflation, should start to slow next year — including rent.

And Gregory Daco, chief economist at EY-Parthenon, suggested that the momentum behind inflation will continue to ease in 2023.

“We expect to see ongoing downward pressure on the goods front and energy-prices front in the next 12 months,” Daco said. “On the services side, we expect to see some abating pressures, with less demand for travel and leisure over time.”

Daco predicted there will be downward pressure on housing costs, too.

SO HOW LOW COULD INFLATION GO?

The Fed sets a target to keep annual inflation averaging around 2 percent. Before the pandemic struck, inflation was so persistently low that the central bank struggled to even raise it to 2%. (Too-low inflation can slow economic growth by causing people to delay purchases if they think they can buy a product for a lower price later.)

Some economists are now suggesting that the Fed won’t be able to get inflation down to 2% again anytime soon — and might conclude instead that a somewhat higher inflation target is more realistic.

IF INFLATION IS SLOWING, WHY DOES IT STILL FEEL PAINFUL?

Wages haven’t kept up with prices, and lower-income households, which spend disproportionately more on housing, fuel and food, have been hit hardest.

“We’re not equal in the face of inflation,” Daco said. “If anything, inflation tends to exacerbate inequalities.”

These factors can lead to a “K-shaped” recovery, in which the performance of different parts of the economy diverges like the arms of the letter “K.” In this scenario, some parts of the economy may experience strong growth while others continue to decline.

“There’s a wealth effect,” said Nationwide’s Bostjancic. “Upper- and middle-income households have more pandemic-related savings. They always have more of a buffer to withstand downturns than other income groups.”

Low- and middle-income households may have already exhausted their reserves, Bostjancic noted, and now lack the savings to cope with both higher prices and higher borrowing rates.

“Even though they’ve seen wage gains, it’s lagged behind inflation,” she said. “So we’ve seen more people turning to credit. We’re not seeing outright delinquencies, but people are falling behind on payments, which indicates there’s stress on the consumer.”

IS THERE STILL RISK OF A RECESSION?

Daco indicated that a recession is not looming large on the near horizon.

“We’ve seen resilience both on the part of the U.S. consumer and business executives,” he said. “Companies haven’t proceeded with broad-based layoffs. As of now, we’re not in a recession, but we’re seeing more hesitance and discretion when it comes to hiring and buying decisions.”