The pace of U.S. inflation has slowed significantly from a 40-year peak of 9.1% in mid-2022, gaining support from a surprising source: falling medical costs.
But that’s coming to an end — in large part because of the complex way the federal government is trying to calculate increases in medical costs. And another acceleration in health care costs could complicate the Federal Reserve’s task of returning inflation to pre-pandemic levels of 2% or less.
“Unfortunately, the bill is about to expire,” said economist Omair Sharif, founder of research firm Inflation Insights. “It will cause even more headaches for the Fed.”
Ever-increasing medical costs
Rising medical costs have long been one of the biggest sources of inflation, even during times when overall U.S. prices have been growing slowly. Medical costs rose an average of 3% per year in the decade leading up to the pandemic, and even faster in the early 2000s.
Expensive health care was one of the main drivers behind former President Barack Obama’s attempt to create a national health care system more than a decade ago.
Still, medical costs started to slow sharply about a year ago, and in July they turned negative for the first time since World War II. At least according to the complicated formula with which the federal government measures these expenditures.
The Consumer Price Index, the country’s main inflation gauge, shows annual medical care costs fell 1% in the 12 months ending in August. Less than a year earlier, they rose 6%.
Now no one really believes that medical costs are going down. Historically, prices rise every year. And just this week, The Wall Street Journal reported that health insurance could experience the biggest price increase in more than a decade by 2024.
So what’s going on?
Well, the government’s method of setting health care prices has always been flawed — and the pandemic has only made the problem worse. Much worse.
Health care costs are nearly impossible to measure accurately, economists say. It is easy to determine the price of gasoline or a loaf of bread. This does not include the cost of an emergency room visit or even a routine visit to the doctor.
For example, the prices charged by doctors and hospitals are opaque and vary widely even within the same city. It is also difficult to measure patient outcomes. And payments for services provided are distributed among businesses, consumers, and the government (Medicare and Medicaid).
“How do you measure the results? Is it an hour in the hospital? Does it make a patient healthy,” said Stephen Stanley, chief economist at Santander Capital Markets. “How do you measure all this?”
Then came the pandemic
The government had to come up with a solution, and it did.
Basically, the CPI formula subtracts the cost of benefits that health insurers pay on behalf of customers from the amount of premiums they pay. The profit left over each year – also called retained earnings – is used to determine how much healthcare prices will rise.
In normal times the formula works fine, but the coronavirus threw a huge curveball.
Americans stopped going to the hospital or doctor’s office during Covid for fear of contracting the virus. Health insurers paid out much less in benefits and profits increased enormously.
When the pandemic subsided and Americans went back to their doctors, health insurers had to pay far more benefits and profits fell.
The result: Healthcare costs as measured by the CPI have seen unprecedented ups and downs since the pandemic, especially since the government only updates its medical index calculations once a year in October.
How big are these fluctuations?
The annual cost of health insurance in the CPI rose a reported 28% from September 2022, before falling 33% from August.
Now there’s another swing. Health insurance costs are expected to rise sharply from October, following the government’s next update to the CPI formula.
That could spell trouble for the Fed.
The ‘core’ of the problem
The central bank’s goal is to reduce inflation to 2%, especially the core interest rate that ignores volatile food and energy costs.
The core CPI figure has already slowed significantly over the past year, from a peak of 6.6% in mid-2022 to an annual pace of 4.3% last month.
The supposed decline in health insurance helped pave the way.
At Inflation Insights, Shariff estimates that the core CPI would have slowed to just 5.1% – not 4.3% – if health care costs had risen as quickly over the past eleven months as they did in September 2022.
What about next year, when the cost of health insurance increases in the CPI? Medical care is the third largest category in the index, after housing and groceries.
Economists are divided on the extent to which this could hinder the Fed’s efforts to bring inflation back to 2%.
For his part, Shariff thinks rising medical costs could add three-tenths or more to the core CPI next spring.
“It will increase core inflation again,” he said.
At Santander Capital Markets, Stanley was one of the first Wall Street DJIA economists to warn of high inflation a few years ago. He is less certain that rising medical costs will undermine the Fed’s inflation fight. “It’s a very important category, but we’re probably not worried about it.”
Other economists believe inflation will likely continue to slow toward 2%, largely due to easing price pressures in many other key categories, such as food and especially shelter.
For example, rents have fallen and house prices are no longer rising quickly. Shelter accounts for over a third of the CPI, compared to just over 8% for medical costs.
“The CPI has barely begun to show the slowdown in shelter costs,” said Simona Mocuta, chief economist at State Street Global Advisors.
An alternative approach
Senior economist Aichi Amemiya at Nomura said it is better to focus on a separate measure of health care costs, which the Fed prefers and which shows more stability.
The health care meter in the so-called PCE index shows that costs are rising by approximately 2.5% per year.
“The PCE is the best metric to look at,” Amemiya said. “It is designed to identify the total cost of healthcare.”
The PCE attempts to take into account total health care spending, including company contributions to employee health insurance and Medicaid and Medicare reimbursement rates.
As of July, the core PCE rose 4.2% year over year, almost the same as the core CPI.
Be that as it may, the cost of healthcare and its impact on inflation is still a concern.
The dramatic increases and decreases in the CPI index for health insurers have even forced the Bureau of Labor Statistics to revise its annual formula to try to be more current and accurate.
Whether it can actually absorb changes in medical costs is still an open question.
“I don’t think there’s an easy answer to this,” Stanley said.