Best predictions point to decline---supply chain resolution, rate hikes, and spending normalization.

Inflation in 2022 reached the highest level in over 40 years. But we expect inflation to fall dramatically over the next year.

Understanding why inflation will fall requires understanding why inflation became so bad in the first place. Over 2021 and 2022, strong consumer demand ran into a brick wall of supply constraints, causing prices to explode in many industries, especially food, energy, and durable goods.

But demand is cooling off, thanks greatly to the Federal Reserve’s interest-rate hikes. Just as importantly, supply constraints are disappearing. With the main causes of high inflation now running in reverse gear, the economy is set to receive a large deflationary impulse.

After peaking at 6.2% in 2022, we expect inflation to fall to 3.5% for 2023. Over 2024 to 2027, we expect inflation to average just 1.8%—below the Fed’s 2% target.

Inflation Still Heavily Driven by a Few Categories

Inflation (PCE) has fallen from a peak of 7% year-over-year in June 2022 to 4.2% as of March 2023. That’s encouraging progress, though it’s still much too high.

Digging deeper into the data, we continue to see inflation being heavily driven by a handful of categories subject to supply disruption. The spike in prices in these categories should unwind as supply issues resolve. This chart measures the contribution to excess inflation—or the cumulative deviation of inflation above its prepandemic trend.

Of the 8.8 percentage points in excess inflation since the start of the pandemic, well over half (4.9 percentage points) is accounted for by energy, food, and durable goods. These categories account for 22% of total personal consumption. Admittedly, the inflation problem has broadened out significantly since late 2021, when these categories accounted for three fourths of excess inflation. But the resolution of supply issues in these categories should go a long way to bringing inflation back to normal.

We Forecast Inflation for 2023-27 From a Bottom-Up Perspective

Given the role of industry-specific shocks, we forecast inflation using a bottom-up methodology.

We’re projecting large deflation in prices for durable goods, food, and energy over 2023-27.

For durable goods, resolution of the semiconductor shortage should play a large role in expanding supply. A normalization of consumer spending mix will also shift demand away from durables (and other goods) and back into services.

For food and energy, prices should subside as these industries adjust to disruption from the Russia-Ukraine conflict and other factors.

We don’t expect the price spikes in energy and durables to be replaced by new problems elsewhere in the economy. We expect moderate wage growth and the absence of any long-lasting supply disruptions to keep general inflation at restrained levels. Inflation expectations (which can fuel high inflation in a self-fulfilling prophecy) also look restrained.

Fed tightening will cool off the overall economy substantially in 2023 and 2024, extinguishing the inflationary fire before it gets out of control.

Supply Chains Are Healing as Demand Normalizes and Capacity Expands

A broad array of production and logistical disruptions have contributed to inflation in durables and other parts of the economy. But supply chains are healing as demand normalizes and capacity catches up. The New York Fed’s Global Supply Chain Pressure Index (which captures ocean shipping costs and delivery times, among other indicators) is now, stunningly, showing looser supply chain conditions than before the pandemic.

here’s more help on the way. As one indicator on the logistics side, there are enough container ships set to be delivered over the next several years to expand the current fleet by 30%. On the manufacturing side, capacity is also expanding in the U.S. and other major economies (most notably China).

Beyond these broad supply-chain disruptions, perhaps one half of the runup in durable goods prices looks to be a result of the semiconductor shortage alone. Semiconductor manufacturing capacity is frantically expanding, with 2022 capital expenditures having soared 90% above prepandemic levels. It takes a while to ramp up capacity, but it is now a question of when—not if—the semiconductor shortage will be cleared.