Has inflation truly peaked? You couldn’t blame some Americans for thinking so. In the summer of 2022, a gallon of gasoline cost over $5. By December, prices had dropped to below $3.75 and seemed poised to dip significantly lower. Local groceries began posting reduced prices. Even used-car prices started drifting downward. Meanwhile, on November 30, investors went on a short-lived stock-buying binge after Federal Reserve (Fed) chair Jerome Powell suggested the Fed would soon begin “moderating the pace of rate increases.” For some, it seemed, peak inflation had finally arrived.

Or maybe not. Two days after Powell’s public comment, the US Labor Department’s monthly jobs report showed that average hourly earnings had jumped by an annual rate of 5.1% versus expectations of a 4.6% increase.¹ Other recent Consumer Price Index (CPI)² data show that rental costs have also stayed stubbornly high, as have prices charged by restaurants, car repair shops, home-furnishing firms, and many other businesses. 

Unfortunately, it turns out that only 30% of the CPI basket categories fall into the flexible bucket. The other 70% are considered sticky (FIGURE 2). Flexible prices are more likely to be buffeted by factors such as supply shortages, transportation snafus, bad weather, foreign wars (looking at you, Russia-Ukraine), or unemployment.

Many items on the sticky side of the inflation ledger are not especially beholden to supply-chain challenges. Evidence suggests that strong demand probably holds the most influence on sticky-price categories—the same strong demand that the Fed’s campaign of interest-rate hikes is trying to cool off.

Economists often link the prevalence of sticky inflation to the notion of inflation expectations.

Sticky Inflation and Inflation Expectations

Sticky prices are seen as efforts by price setters (i.e., business entities) to stay one step ahead of rising costs by setting their prices at a high level for as long as possible.⁶ That’s why economists often link the prevalence of sticky inflation to the notion of inflation expectations—the idea that rising prices create expectations that the general level of all wages and prices will continue to rise until inflation embeds itself in consumer psychology and morphs into a self-fulfilling prophecy (as happened during the 1970s and early 1980s). 

Two important factors are thought to be decisive drivers of sticky inflation: wages and housing costs.

Sticky Wages

Although the Atlanta Fed’s flexible-vs.-sticky breakdown doesn’t include wages, economists regard them as particularly sticky. As the double-digit inflation of the 1970s illustrates, stronger wages can prompt businesses to raise prices, which in turn prompts consumers to demand still higher wages, and so on. Sticky-wage theory further states that employee pay is resistant to decline, even under deteriorating economic conditions, and that workers will resist pay cuts—motivating managements to reduce costs elsewhere, including layoffs, if profitability falls.⁷ 

Evidence suggests that wages are indeed rising, and that job creation has defied the Fed’s efforts to engineer an economic slowdown. In addition to November’s surprise jump in wages, job-growth figures for the same period showed that nonfarm payrolls increased to 263,000—well above the expected 200,000 estimate (FIGURE 3). Some analysts have suggested that the US labor market may still be about 7 million workers short of pre-pandemic levels and that early retirements and resignations are likely causing further labor shortages.⁸

Rents rarely decline. Instead, they tend to stay the same or increase with each new lease agreement.

The majority of landlords said they would continue increasing rents in 2023. Most renters are locked into leases lasting a year or more. Besides, rents rarely decline; instead, they tend to stay the same or increase with each new lease agreement.

Homeowners’ costs are measured as if their mortgage payments were rental payments—what the CPI and similar measures call owners’ equivalent rent (OER). Together, rents and OER comprise nearly two-thirds of each month’s CPI report. Data from the rent and OER components are collected biannually; consequently, the housing-inflation numbers you read about today usually reflect what renters and homeowners were paying six months ago.

This could present a dilemma for the Fed’s inflation-fighting campaign—and for renters, too. Rents may be poised to drift down sometime in 2023, but the more the Fed raises rates, the more it could discourage rental construction, which, in addition to reducing overall growth, is likely to take new homes off the market and contribute to a housing shortage that keeps rents elevated.¹⁰

Investments for a Sticky-Inflation Era

What’s an investor to do during an era of persistent, sticky inflation? During much of the time since the Global Financial Crisis, interest rates were sitting near zero while growth-oriented companies were raking in profits. Investing in growth stocks during this time was an easy call. In recessions, fixed income often does a star turn as the asset class of choice. But now, many economists believe the era of accommodative central-bank monetary policies may be over and that interest rates are likely to stay higher as the Fed tries to make good on its promise of crushing inflation.

No asset class can offer complete protection. That said, financial professionals generally suggest taking a look at the following range of options for building a diversified portfolio that can offer the potential for either modest growth or protection from persistent inflation (FIGURE 4).

¹ CNBC, “Payrolls and Wages Blow Past Expectations, Flying in the Face of Fed Rate Hikes,” 12/2/22.

² The Consumer Price Index in the US is defined by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

³ US Bureau of Labor Statistics.

⁴ US Bureau of Labor Statistics.

⁵ Federal Reserve Bank of Atlanta, 11/10/22.

⁶ Federal Reserve Bank of Cleveland, “Economic Commentary: Are Some Prices in the CPI More Forward Looking Than Others? We Think So,” Michael F. Bryan and Brent Meyer, 5/19/10.

⁷ Investopedia, “Sticky Wage Theory: Definition and Importance in Economics,” 11/30/20.

⁸ Barron’s, “Inflation Is Sticky, Structural, and Hard to Solve,” 8/12/22.

⁹ CNBC, “Rent Growth Slows to the Lowest Level in 18 Months,” 11/17/22.

¹⁰ The Atlantic, “Why the Rent Inflation Is So Damn High,” 8/18/22.

Important Risks: Investing involves risk, including the possible loss of principal. • Investments in the commodities market may increase liquidity risk, volatility, and risk of loss if adverse developments occur. • Small-cap securities can have greater risks, including liquidity risk, and volatility than large-cap securities. • Different investment styles may go in and out of favor, which may cause a fund to underperform the broader stock market. • Fixed income security risks include credit, liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • The value of inflation-protected securities (IPS) generally fluctuates with changes in real interest rates, and the market for IPS may be less developed or liquid, and more volatile, than other securities markets. • Obligations of U.S. Government agencies are supported by varying degrees of credit but are generally not backed by the full faith and credit of the U.S. Government. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets.

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