June 6, 2023

America has been in abnormally high inflation for two years now – and while the country appears to be past the worst of the worst spike in price increases in half a century, the road back to normal is a long and uncertain one.

The rise in prices during the 24 months ending March eroded wage increases, strained consumers and spurred a response from the Federal Reserve that could trigger a recession.

What caused the painful inflation and what comes next? A look through the data reveals a situation that came from pandemic disruptions and government response, which was exacerbated by the war in Ukraine and is now cooling as supply problems subside and the economy slows. But it also illustrates that US inflation today is drastically different from the price increases that first appeared in 2021, driven by persistent price increases for services such as airline tickets and childcare rather than the cost of goods.

New wage and price data to be released on Friday is expected to show continued signs of slow and steady moderation in March. Now Fed officials must assess whether the cooling is happening fast enough to assure them that inflation will soon return to normal — a focus when the central bank issues its next interest rate decision on Wednesday.

The Fed is aiming for an average inflation rate of 2 percent over time using the Personal Consumption Expenditures Index, to be released Friday. That figure takes some of its data from the Consumer Price Index report, which was released two weeks ago and gave a clear picture of the recent inflation trajectory.

Before the pandemic, inflation hovered around 2 percent, as measured by the general consumer price index and by a “core” measure that excludes food and fuel prices to provide a clearer picture of the underlying trends. It fell sharply at the onset of the pandemic in early 2020 as people stayed home and stopped spending money, and recovered from March 2021.

Part of that initial pop was due to a “base effect.” New inflation data was measured against numbers from the previous year that had fallen due to the pandemic, making the new numbers look high. But by the end of summer 2021, it was clear that something more fundamental was going on with prices.

Demand for goods was unusually high: families had more money than usual after months at home and repeated stimulus checks, and they spent it on cars, sofas and patio furniture. At the same time, the pandemic had shut down many factories, limiting the supply the world’s companies could produce. Shipping costs rose, goods shortages increased, and the prices of physical purchases from appliances to cars rose.

At the end of 2021, a second trend also started. Service costs, which include non-physical purchases such as tutoring and tax filing, began to rise rapidly.

As with commodity prices, this was linked to strong demand. The ability of households to spend well allowed landlords, day care centers and restaurants to charge more without losing customers.

Across the economy, companies seized the opportunity to improve their bottom line; profit margins rose at the end of 2021 before moderating at the end of last year.

Companies also covered their growing costs. Wages began to rise faster than normal, which meant that companies’ labor bills rose.

Fed officials had expected goods shortages to ease, but the combination of faster inflation for services and accelerating wage growth caught their attention.

Even if wage increases had not been the original cause of inflation, policymakers feared it would be difficult for price increases to return to a normal pace with wages rising rapidly. Companies, they believed, would continue to raise prices to pass on those labor costs.

Concerned central bankers began raising interest rates in March 2022 to curb growth by making it more expensive to borrow to buy a car or house or expand a business. The aim was to slow down the labor market and make it more difficult for companies to raise prices. In just over a year, they raised interest rates to nearly 5 percent — the fastest adjustment since the 1980s.

But in early 2022, Fed policy began battling yet another force fueling inflation. The Russian invasion of Ukraine in February sent food and fuel prices soaring. Between that and the cost increases of goods and services, headline inflation hit its highest peak since the 1980s: about 9 percent in July.

In the following months, inflation slowed as energy and goods cost increases cooled. But food prices are still rising rapidly, and – crucially – cost increases in services remain rapid.

In fact, services prices are now the center of the inflation story.

They could quickly begin to fade in an important area. Housing costs have been rising rapidly for months, but rent increases have slowed recently in real-time data from the private sector. This is expected to be factored into the official inflation figures later this year.

That has led policymakers to focus on other services, which span a range of purchases, including medical care, car repairs and many holiday expenses. How quickly those prices – often referred to as “core services ex-housing” – can fall will determine if and when inflation can return to normal.

Now Fed officials will have to assess whether the economy is ready to slow enough to lower the cost of those critical services.

Between the central bank’s interest rate moves and the recent banking turmoil, some officials believe this is possible. Policymakers in March predicted they would hike rates just once more in 2023, a move widely expected at their meeting next week.

But market watchers will listen closely as Fed Chairman Jerome H. Powell gives his post-meeting press conference. He could hint at whether officials think the inflationary saga is headed for a quick end — or another chapter.

Ben Casselman reporting contributed.