The Big Idea

Medical care poses an inflation challenge for the Fed

| September 30, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The two largest components of core inflation by far are shelter costs and medical care. And both categories have been accelerating this year.  Recent work by the Dallas Fed, paralleling work done there on shelter costs, indicates that upward pressure on wages in health care will drive inflation in this industry higher for the foreseeable future. With momentum in shelter costs also pushing up inflation, the Fed will need to work harder on other components of core to hit their inflation targets.

Key pieces of core inflation

Shelter costs and medical care together account for 51% of core CPI, shelter costs accounting for about 40% with medical care for almost 11%.  The two account for nearly 35% of the core PCE deflator, with the weights more balanced. Shelter costs accounts for 16.9% and health care for 17.8%.

The main reason for the massive difference in weighting, especially for medical care, is that the CPI measures only out-of-pocket expenses, while the PCE deflator accounts for all medical care expenditures made on behalf of households, including those by insurance companies and federal government programs.

Health care inflation

The Dallas Fed has recently turned its attention to the dynamics of health care inflation, coming in the wake of earlier work there on shelter cost inflation, a topic I explored in a recent piece, Researchers at the Dallas Fed have taken a close look at the link between the wages of health care workers and medical care inflation.  Their work found a strong correlation between the wage gains of hospital workers and PCE health care inflation, with a lag of about a year.

As an aside, in discussions of hospital workers, highly skilled and well-paid doctors may come to mind first. But hospitals employ a wide array of workers that covers nearly all points along the wage scale, including professionals such as doctors and nurses as well as a myriad of support staff.  In short, hospitals are a labor-intensive sector of the economy, incorporating workers across the span of the wage scale. So, it stands to reason that prices in the sector would track wages with a lag.

In any case, the tight link between wages and prices in health care represents bad news for the inflation outlook. The Dallas Fed work shows the strong correlation historically, as well as the recent run-up in wages, as measured by the Employment Cost Index (Exhibit 1).

Exhibit 1: A clear link between wage growth and inflation in health care

Note: PCE is personal consumption expenditures.
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics.

Dallas Fed researchers developed a regression model to predict the health care component of the PCE deflator.  Through June this year, health care inflation was quite benign in the PCE deflator, running just above 2% on a year-over-year basis.  However, the Dallas Fed model suggests health care inflation is likely to surge to roughly 4% by mid-2023.  Perhaps even more troubling, the model points to scant deceleration in 2024, with the largest component of the core CPE deflator still running at a 3.5% year-over-year clip by the end of 2024 (Exhibit 2).

Exhibit 2: Dallas Fed projected PCE health care inflation rises

Notes: Forecasts are based on authors’ estimation of a quarterly vector autoregressive model with eight lags and and intercept including the three variables: year-over-year percent change in employment cost index wages and salaries for hospital workers, personal consumption expenditures (PCE) hospital services inflation and PCE health care inflation. Dashed lines indicate a 90 percent prediction interval.
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics.

Given the weight of health care in the PCE deflator, a 3.9% annual inflation rate for the category would contribute about 0.7 percentage points to core inflation, a little over three tenths more than the contribution in the second quarter this year.

Stubborn core inflation

Previous work from the Dallas Fed showed, similarly, that shelter costs are likely to accelerate until around the middle of 2023.  If the two largest components of core inflation are both accelerating for the better part of a year, it is difficult to see how core inflation will cool as much and as fast as consensus forecasts project.

In particular, the FOMC median projection for the year-over-year advance of the core PCE deflator issued last week showed a moderation from the current pace of nearly 5% to around 3% by the end of next year.  If the largest component roughly doubles between now and then, and shelter costs are equal to or higher than they are now, as the Dallas Fed researchers projected earlier this summer, then the balance of the index would have to slow sharply to achieve anything close to the moderation envisioned by the Fed.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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