Inflation’s Final Stretch: Why 3% Feels Harder Than 9%

For everyday Americans, ongoing inflation continues to negatively impact purchasing power and daily expenses. Businesses struggle with rising costs and difficult pricing decisions and investors need to understand how persistent inflation influences both monetary policy and market performance.

Following the re-opening of the economy in 2021, pent up demand combined with supply chain problems led to a rapid spike of inflation rising all the way to 9.06%.

Since its peak of 9.06% in June of 2022, the CPI has dropped significantly, falling all the way down to 2.97% in June of 2023. This was a drop of 6.09% in just 12 months, however, progress has stalled since then, oscillating around 3% for the past 21 months and currently sitting at 2.82%.

This raises a couple of important questions: Why has it been so much more difficult to bring inflation from 3% to 2% than it was to bring it down from 9% to 3%? And are we entering a period where 3% will be the new normal rate of rising prices? These answers are important since the Federal Reserve’s Target rate of inflation is 2% and they have made it clear that they will need to have confidence that prices are on track to this target in order to resume cuts in interest rates.

Why Getting Inflation Down to 2% Has Been Such a Challenge

The U.S. Federal Reserve has faced persistent challenges in achieving its 2% inflation target. Despite an aggressive cycle of monetary tightening and keeping interest rates at elevated levels, inflation has remained stubbornly above target. There are several key factors that are contributing to the stickiness in the CPI. 

1. Wages

Facing elevated interest rates over the past few years, employment has continued to be robust, with unemployment staying at relatively low historical levels, around 4.1% as of the latest Employment Situation Report. This has resulted in employers competing for scarce labor resources, leading to higher wages. The most recent report indicated average hourly earnings grew at an annualized rate of approximately 4.02%. While we have been seeing a normalization here, rates are still significantly above historical norms. Rising wages, while beneficial for workers, have contributed to sustained consumer spending, thereby putting upward pressure on prices.

Additionally, demographic shifts, such as retiring baby boomers, have contributed to labor shortages, intensifying wage pressures. The resultant higher labor costs have compelled businesses to increase prices to maintain profitability, fueling inflation further.

Moreover, the mismatch between available jobs and workforce skills has amplified the labor market tightness. The latest Job Openings and Labor Turnover Survey (JOLTS) reported approximately 7.57 million job openings, substantially higher than historical average levels, highlighting this ongoing labor scarcity. Industries like healthcare, technology, and skilled trades have reported prolonged hiring challenges, exacerbating wage pressures in these critical areas. 

Ultimately, addressing structural labor market issues, such as improving workforce training and education programs may be necessary alongside monetary policy interventions to sustainably achieve the Fed’s 2% inflation goal. Without some structural adjustments, persistent tightness in the labor market is likely to remain a significant barrier to stabilizing inflation at desired levels.

2. Consumer Spending Strength

Over the past two years, the U.S. consumer has exhibited notable resilience, supporting economic growth despite elevated inflation and high interest rates. Driven by robust employment markets, wage growth, and accumulated savings from earlier economic stimuli, consumer spending has maintained positive momentum.

In 2023, consumer spending proved to be a significant engine of the U.S. economy, with personal consumption expenditures increasing by 2.7%, supported by steady employment figures and strong wage gains. The labor market remained remarkably tight, with unemployment rates hovering near historic lows of around 3.5%, empowering consumers to maintain or even elevate spending levels, particularly in sectors such as travel, leisure, and hospitality. Retail sales in 2023 grew by approximately 5.0%, driven by strong demand during peak shopping seasons. Despite elevated inflation early in that year, consumers leveraged savings accumulated during the pandemic era, bolstering discretionary spending.

This resiliency continued through 2024, despite sustaining higher interest rates. Spending shifted somewhat towards services rather than goods, reflecting changing preferences and adaptation to higher prices. Retail sales increased 4.36% year-over-year in 2024 and is currently at 3.11% YoY, demonstrating the consumer's continued willingness to spend despite economic uncertainties.

3. Shelter Costs (housing & rents)

Shelter costs represent the largest single portion of CPI, at over 1/3 of the index, and have been slow to come down. YoY shelter costs have increased 4.2% and for the month of February 2025, shelter prices rose by 0.3%, making up almost half of the monthly increase in the all-items index. 

Shelter (housing) costs take time to adjust, leading to a lag in the inflation calculations. Even if new rental agreements reflect current market conditions, existing contracts and housing shortages keep overall shelter inflation high.

These shelter costs, particularly owner's equivalent rent (OER), have continued to pose a significant challenge to bring down overall inflation. Despite broad economic indicators showing moderation in several sectors, shelter costs remain stubbornly high, complicating efforts by policymakers to achieve inflation targets.

Owner's equivalent rent, the theoretical rent homeowners would pay if they rented their own homes, is heavily weighted in the CPI, comprising approximately 25% of the total index. Specifically, as of December 2024, OER accounted for 26.2% of the CPI, while rent of primary residence made up 7.47%. This outsized influence means that even minor increases in housing prices or rents can have disproportionate effects on the overall inflation picture.

Several factors explain why shelter prices are resistant to declines:

• Elevated Mortgage Rates: Higher mortgage rates reduce affordability for homebuyers, pushing many into already strained rental markets. 30-year fixed mortgage rates have been hovering around 6.5% - 7.0%, significantly impacting buyers' purchasing power. Increased demand for rentals then leads landlords to raise rents, sustaining the upward pressure on shelter costs.
• Housing Shortages: The U.S. faces a housing deficit with estimates suggesting that shortages have ranged between 1.5 million and 5.5 million units in recent years. Using data from the 2023 (2024 data has not been released yet) American Community Survey and the Housing Vacancy Survey, the U.S. housing market was estimated to be short 4.9 million units at the end of 2023 and expectations are similar for 2024. This limited housing supply further inflates both purchase and rental prices.
• Sticky Prices: Housing prices and rental rates are notoriously slow to decrease due to long-term lease agreements and the gradual pace at which landlords and homeowners adjust expectations and prices. This stickiness means that even when economic conditions begin to moderate, shelter costs typically lag behind other sectors in responding.
  
  

Is a 3% inflation rate the new normal?

Inflation has long been targeted by central banks at around 2%, a rate historically considered optimal for balancing economic growth and price stability. However, recent economic developments have prompted economists and policymakers to reconsider if a higher target around 3% might be more realistic and sustainable moving forward.

Since the COVID-19 pandemic, the global economy has experienced persistent disruptions, from supply chain bottlenecks to labor market imbalances, pushing inflation rates notably higher. Although initially viewed as temporary, some of these pressures seem structurally embedded, suggesting inflation might settle at levels above pre-pandemic targets.

Comparative data highlights this potential shift. From 2008 to 2020, the U.S. Consumer Price Index (CPI) averaged approximately 1.54%, frequently remaining below the 2% threshold traditionally targeted by central banks. 

However, more recent CPI data from mid-2023 to early 2025 shows inflation stabilizing at an average rate of around 3.07%, with peaks approaching 3.70%. 

This clear rise compared to the earlier period raises concerns that the higher inflation environment could persist, becoming a structural feature of the post-pandemic economy.

Many of the challenges we discussed will continue to put upward pressure on prices, however, as we move into 2025 new tariff policies will be adding some additional pressures. 

In summary, President Trump's administration has started imposing new tariffs on imports from key trading partners, including Canada, Mexico, and China. These tariffs target a wide array of imported goods such as automobiles, steel & aluminum and other general products.

The introduction of these tariffs is expected to have several inflationary effects:

• Increased Consumer Prices: Tariffs function as taxes on imported goods, leading to higher costs for businesses that often pass these increases on to consumers. This scenario is particularly impactful to industries reliant on global supply chains, such as automotive and electronics. 
• Elevated Inflation Expectations: The University of Michigan reported that expected inflation 1 year out rose up to 5.0% and long-term inflation expectations rose to 4.1% in February 2025. This was a big spike up from the year end expectations of 2.8% and 3.0% respectively.  

• Higher for Longer interest rates: The Federal Reserve has adopted a more cautious stance on interest rates. Officials have shifted to a more hawkish position and are weighing the potential need for rate adjustments to manage the economic impact of rising prices. 

The goal of these measures is to achieve outcomes such as reigning in illegal immigration, reducing drug trafficking and bolstering domestic manufacturing. However, the economic impact is likely to be additional challenges to achieving the 2% inflation target.

Supporters of a revised inflation target argue that this adjustment better reflects contemporary economic realities. Technological advancements and globalization, historically strong deflationary forces, may no longer sufficiently offset rising prices. Additionally, demographic shifts, notably aging populations in developed nations, are expected to exacerbate labor shortages, further embedding higher inflation rates into the economy.

Conversely, critics warn that a shift toward accepting higher inflation could diminish central banks' credibility, potentially destabilizing inflation expectations and creating a more volatile economic environment. They caution that a seemingly modest increase in the inflation target could gradually escalate, risking a repeat of the inflation volatility characteristic of the 1970s and 1980s.

It’s hard to predict whether 3% will be the new normal permanently, however there is a high probability that over the next year or two, 2% will be extremely difficult to achieve particularly with the added pressures of incoming tariffs. 

Potential Winners and Losers in a 3% World

Persistent inflation around 3% affects different economic sectors in varied ways, creating groups of "winners" and "losers" based on their ability to navigate rising costs and maintain profitability.

Potential winners: companies with pricing power

Companies in the technology and AI sectors often possess significant pricing power due to the inelastic demand for their innovative products and services. This allows them to pass on increased costs to consumers without substantially affecting demand. 

Established brands in the consumer staples sector continue to demonstrate robust pricing power. Their essential products and strong brand loyalty enable them to implement price increases with minimal impact on consumer demand, thereby preserving profit margins even as input costs rise.

The energy sector, particularly oil and gas producers, often benefits in inflationary environments. As commodity prices rise, these companies can pass on higher costs to consumers, leading to increased revenues and profitability. 

Potential losers: margin-squeezed sectors

Mid-tier retailers face significant challenges as consumers become more price-sensitive and opt for discount alternatives during inflationary periods. This shift in consumer behavior pressures these retailers' profit margins, as they struggle to balance rising costs with competitive pricing. 

As the housing sector contends with higher mortgage rates, the sector will face reduced affordability and dampened demand. Elevated interest rates increase borrowing costs, making home purchases less accessible for many consumers. This scenario leads to reduced sales volumes and pressures on housing prices, as observed in recent market analyses.

Small businesses often lack the financial resilience to absorb rising input and wage costs compared to larger firms. Their limited pricing power makes it challenging to pass on increased expenses to consumers, resulting in compressed profit margins.

Investment Implications and Looking Forward

In this potentially higher inflation environment, investors should position portfolios toward sectors with pricing power like technology, consumer staples, and energy. Consider diversification across inflation-resistant assets including commodities, TIPS, and select real estate investments.

While the Federal Reserve works toward its 2% target, practical investors should prepare for a scenario where 3% inflation persists longer than expected. Understanding which sectors may benefit or struggle helps investors make informed decisions in this challenging landscape. The coming months will show whether higher inflation represents a temporary phase or a more permanent shift in economic fundamentals.