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Economist: ‘I would expect inflation to gradually cool’ over the second half of 2022

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Greg Daco, chief economist at EY-Parthenon, weighs in on the March CPI data and where he sees inflation heading.

Video Transcript

[MUSIC PLAYING]

RACHELLE AKUFFO: Welcome back to "Yahoo Finance Live," everyone. A painful punch in the gut is how our next guest described this headline inflation number that came out at 8.5%. Let's get right to it with Greg Daco, EY-Parthenon's Chief Economist. So as we look at this headline number then, break down the main culprits and some of the sectors that are also cooling off as we look at what's within these numbers.

GREG DACO: That's right. I think it's important to look at the different components of the latest inflation print. We have, on the one hand, international factors related to the war in Ukraine to the renewed lockdowns in China that are putting additional upward pressure on the energy front and on the supply front, which we know are two key culprits of the higher inflation that we've seen in recent months.

But there's also signs that there was stronger activity on the services side with leisure and hospitality sectors, and prices for these sectors rising faster. But we also saw some declines in used car prices, which we know was a key driver of inflation up until now. So there's really a rotation in the spending mix and in the price mix that is influencing inflation and will likely continue to influence inflation in the coming months.

- Expectation from the FOMC is that inflation is still going to begin to come down during the second half of this year. When in the second half of this year would you forecast inflation starting to subside?

GREG DACO: Well, I think we're not too far from a peak. I think it's always difficult to call a peak in inflation, especially in the given context that we have today on the international front. But I think we're not too far from a peak. I would expect inflation to gradually cool over the second half of the year.

But I think from a Fed perspective, gone is the perspective that this passive moderation in inflation from cooler demand from a rotation in the spending mix and from stronger supply is going to ease inflation on its own. The Fed really wants to take control of the inflation narrative. It wants to tighten monetary policy, bring the Fed funds rate closer to a neutral stance, and normalize the size of its balance sheet in an effort to cool demand and to tighten financial conditions to be able to bring inflation back down under control. So there's going to be that passive element but, also and very importantly, that active Fed element to try to regain control over inflation.

DAVE BRIGGS: And you expect two 50 basis point rate hikes the next two meetings. But on that note that you just mentioned the balance sheet reduction, what are your expectations there? And how key is that going to be in the Fed getting down this number and somehow avoiding a recession?

GREG DACO: Well, I think that's a very delicate balancing act from a Fed's perspective. The Fed is bringing out its full arsenal in terms of combating inflation, which it sees as a key threat to the longevity of this economic expansion. So it will want to tighten monetary policy fairly rapidly. Doing so will involve faster rate hikes, and we do expect to see back-to-back 50 basis point increases in the Fed funds rate over the next two FOMC meetings.

But the balance sheet normalization process is going to be a key part of the Fed's normalization program. And the idea there is to try to tighten financial conditions to try to essentially reduce economic momentum via that channel as well as the credit channel and by pushing on both levers, trying to exert a certain form of policy break to cool inflation on top of the passive cooling that I just mentioned.

RACHELLE AKUFFO: And keeping an eye on what we're seeing with mortgage rates as a result, making it even harder for a lot of home buyers to get out of renting. But for renters who are hoping for some reprieve as wage is still on keeping pace with inflation, break down your expectations for the rent in real estate markets.

GREG DACO: Well, I think what we're seeing on the real estate front is a couple of developments that are going to be quite interesting. There are certainly going to be still some pass-through from higher housing prices into the CPI components for rents and owner equivalent rent. So we're going to see some upward pressure on that front.

But as you stated correctly, the higher cost of credit with mortgage rates rising rapidly will put a damper on housing activity. And I would expect that as we look into the latter, the very latter part of 2022 and into 2023, we're going to see cooler housing activity, which will put likely downward pressure on prices going forward.

So there's going to be a two-motion step here in terms of the real estate activity. Initially, still some upward momentum through the end of the year on the housing price front. But I would expect that as we look into 2023, the cooler activity from the latter part of 2022 will weigh on prices over the course of next year.

BRAD SMITH: Greg, ahead of the summer travel season where we know that there's going to be a ton of demand to get back on the roads, the president, of course, in the White House announcing today the EPA administrator planning to allow E15 gasoline to the extent that you've been able to really parse through the details of this. What effect, net effect, do you believe that it will have in curbing some of the higher costs for fuel that Americans have been seeing right now at the pump?

GREG DACO: Well, I think the rise in gasoline prices is certainly a key element driving up inflation. We know that gasoline prices are up about 50% relative to last year just in this past month alone. The 1.2% increase in the headline CPI index came-- nearly 2/3 of that came from higher gasoline prices, so certainly an area of concern.

I have my reservations as to whether the plan that was suggested by the administration will work to really significantly curb gasoline prices. But what will likely weigh down on gasoline prices is the fact that crude oil prices have come back down from their recent highs in March. That will take some time to filter through the gasoline prices. But I think we should not be expecting some further significant increases in gasoline prices. And that, in itself, will act as some form of relief for households across the US.

DAVE BRIGGS: Some good news for the American consumer. Greg Daco, EY-Parthenon Chief Economist, thank you, sir. Appreciate it.