Is Inflation Making a Comeback in 2025?

The final reading of the Consumer Price Index (CPI) for 2024 comes out tomorrow. The consensus forecast predicts an increase of 2.9% year-over-year for prices in December 2024. Although this uptick is far below the peak inflation rate of 8.9% in June 2022, it is still higher than the Federal Reserve’s goal of 2% annual growth. In addition, the inflation rate  is moving in the wrong direction. In year-over-year terms, inflation has been rising since its low of 2.4% in September 2024. 

In order to bring inflation down, the Federal Reserve began its tightening cycle in March 2022 by increasing interest rates. At the time, topline inflation was 8.5%. When the Fed was done with its increases in August 2023, the federal funds effective rate stood at 5.3% and inflation was 3.7%. The Fed has a dual mandate of price stability and maximum employment. On the labor front, the U.S. economy in this period moved from a hot labor market to a cooling one.

As inflation approached the Fed’s 2% goal and the labor market (at least according to some indicators) began sounding alarm bells, the Fed began its easing cycle in September 2024 and lowered rates by a total of 100 basis points by the end of 2024. The final unemployment rate for 2024 was released on January 10, 2025 and better than expected figures pushed out the already lowered prospects for further interest rate cuts for 2025 (with some market watchers even bringing up prospects of interest rate hikes.)

Although the Fed bases its interest rate decisions on government data that has already been released, the Fed Board committee members have voiced risks related to changes to trade policies and immigration policies. The incoming Trump administration has campaigned on sweeping tariffs as well as deporting undocumented workers. Both of these policies – if implemented – could push the inflation rate higher, the former through higher prices that American consumers would pay for imported goods and the latter through downsizing the available labor pool – especially lower-wage workers – that maintain and provide the goods and services consumed.  An additional early 2025 inflation risk seems to already have been averted, with the International Longshoremen’s Association (ILA) and the U.S. Maritime Alliance (USMX) announcing a tentative 6 year-deal that would prevent the closure of East and Gulf coast ports. While supply of goods — in aggregate terms – has not been a contributor to price pressures lately, the absence of this deal, coupled with increased shipments ahead of possible tariffs could have altered that dynamic.

Where to in 2025?

Risks are clearly pointing up for inflation. Although inflation is growing at a lower rate relative to the last three years, price levels are still high. High price levels are painful for U.S. consumers – especially for those whose wages have not kept up with the pace of price increases – it is particularly difficult to afford essential purchases. In the face of high prices, consumers may choose to delay certain purchases, seek a cheaper option or even in some cases walk away from a purchase, which is typically more common for discretionary goods and services. However, for the case of essentials, such as housing or food, walking away is a harder task.

At Morning Consult, we aim to quantify changes in decision making when consumers are faced with prices different than their expectations. Our monthly survey reaching 11,000 consumers asks whether consumers considered making a purchase for select categories. Then we ask if they simply did or did not complete the purchase or alternatively purchased a similar product or service at a lower price. We turn the responses into indexes, including the substitutability index -- one of our demand indexes that helps us understand consumer behavior in light of price changes. 

Trading down on essentials

For essential purchases that are difficult to forgo, changes in the Substitutability index would demonstrate to goods and service providers whether there is not as much room in consumers’ budget for their goods or services. Certain products or even services are easier to substitute or trade down: generic instead of brand name goods, economy “light” plane tickets instead economy price tickets, etc. For some other purchases, substitution is harder, especially for housing. 

For those who are considering purchasing a home, substitution can come in many shapes and forms, such as lower square footage or a different location among other tradeoffs. It is important to note that many people that we survey are not even considering a house or apartment purchase due to unaffordability. We released a report on U.S. housing affordability last quarter and many dynamics that were present then continue to be a challenge now, namely lower supply, high prices and high mortgage rates among other factors.

Among the different cohorts that we track at Morning Consult, for parents housing affordability is more of an issue. As families grow, they need more space. They may opt to still rent (and many do, according to our ongoing daily survey over the course of 2024). However, for those with kids, buying a home happens at a higher frequency.

Among those who are buying a home, substitution is on the rise, especially for parents. In contrast to non-parents and all respondents, the substitution index scores for parents have been negative. For the first time since February 2023, they have passed into positive territory – meaning a higher share of parents are choosing to trade down in some shape or form. For parents, trading down can be harder, as they are more likely to need the space or proximity to schools. Although ways of substitution are not limited to these two examples, the data shows that even in harder-to-substitute categories, high price levels are pushing consumers towards more money saving measures and tradeoffs. 

As risks mount for higher inflation in 2025, and higher for longer interest rates continue to negatively affect households’ finances, we will likely see higher substitution in essential categories as well as higher price sensitivity (walking away) for discretionary items.