The challenge of sticky prices for the Federal Reserve

Prices increase quickly on the way up but are sticky on the way back down.

During times like these, when the economy is less sensitive to changes in interest rates, rising inflation creates challenges for central banks looking to maintain price stability.

For Kevin Warsh, who just took over as chair of the Federal Reserve, the recent increase in prices has created a challenge that few expected even a few months ago. He was nominated by the executive branch with a mandate to cut rates, but the recent rise in prices, if it proves sticky, could instead force the Fed into a rate-hiking cycle.

The key question is whether top-line inflation bleeds into the core inflation rate, which excludes the more volatile food and energy components but includes service sector pricing that has recently proven sticky.

And since sticky prices do not respond quickly to changes in monetary policy, that lag can erode confidence in a central bank’s ability to fulfill its mandate on inflation, in turn pushing up inflation breakevens and expectations.

The duration of any tightening cycle is driven by how long inflation remains elevated and determines the trajectory of real rates and sector-specific pricing power.

The current environment is not looking promising for rate cuts. Demand for services remains robust, a trend that began before the war in Iran. That demand has pushed prices higher—service sector inflation rose 0.6% in April and 3.4% from a year ago.

Rents, housing and transportation have all recently seen price increases. In technology, electronics, utilities, health care, education, recreation, food service and lodging, as well as subscription-based services like streaming media, prices have also been rising—and once those prices go up, they tend to stay elevated.

Higher prices create a ripple effect. Consumers begin to agitate for higher wages and salaries, which then forces businesses to raise prices. The result? A cycle of persistent inflation. 

Should inflation remain elevated, the Fed will have to delay rate cuts, which will feed back into bond yields, credit spreads, and equity and foreign exchange valuations.

Bond investors, in particular, tend to be sensitive to sticky inflation, because if nominal rates fail to keep pace, real yields erode over time.

Flexible vs. sticky prices

The three-month annualized rates for flexible and sticky groups of prices compiled by the Federal Reserve Bank of Atlanta show that spikes in flexible-priced items have often coincided with insufficient oil supplies.

Examples include the hurricanes of 2005 that shut down Gulf Coast refineries and then the supply bottlenecks before the 2007−09 financial crisis. More recently, the 2022 and 2026 spikes were because of the shutoff of supplies in the Russia-Ukraine war and the Iran war.

The Federal Reserve Bank of Atlanta reported that in April, the flexible component of the consumer price index—which it defines as a weighted basket of items that change prices relatively frequently—increased 19.3% on a three-month annualized basis and 5.6% on an annual basis.

The Atlanta Fed's sticky-price component of the consumer price index—a weighted basket of items that change price relatively slowly—rose 4.6% in April on an annualized basis, following a 2.4% increase in March.