The rate of U.S. inflation has slowed considerably from a 40-year peak of 9.1% in mid-2022 and it’s gotten an assist from a surprising source: falling medical costs.
But that’s about to end — to a large degree because of the complex way the federal government tries to figure the rise of medical costs. And a re-acceleration in health-care costs could complicate the Federal Reserve’s job to get inflation back down to pre-pandemic levels of 2% or less.
“Unfortunately, the bill is about to become due” said economist Omair Sharif, founder of research firm Inflation Insights. “It’s going to be more of a headache for the Fed.”
Ever-rising medical costs
Rising medical costs have long been one of the biggest sources of inflation, even in times when overall U.S. prices were growing slowly. Medical costs rose an average of 3% a year in the decade prior to the pandemic and even faster in the early 2000s.
Expensive health care was one the chief drivers of former President Barack Obama’s attempt to create a national health care system more than a decade ago.
Yet medical costs began to decelerate sharply about one year ago, and in July, they turned negative for the first time since Word War Two. At least according to the complicated formula by which the federal government measures these expenses.
The consumer price index, the nation’s main inflation gauge, showed that the annual cost of medical care fell by 1% in the 12 months ended in August. Less than a year before, they were rising at a 6% pace.
Now, no one really believes medical costs are falling. Historically prices rise every year. And just this week The Wall Street Journal reported that health insurance could post the biggest price increase in 2024 in more than a decade.
So what’s going on?
Well, the government’s method for determining health-care prices has always been flawed — and the pandemic only made the problem worse. Far worse.
The cost of health care is almost impossible to measure accurately, economists say. It’s easy to determine the price of gas or a loaf of bread. Not so the cost of a trip to the emergency room or even a routine visit to one’s doctor.
Prices charged by doctors and hospitals are opaque, for one thing, and differ sharply even in the same city. It’s also difficult to gauge patient outcomes. And payments for services rendered are split by businesses, consumers and government (Medicare and Medicaid).
“How do you measure outcomes? Is it an hour in the hospital? Is it making a patient healthy,” said Stephen Stanley, chief economist at Santander Capital Markets. “How do you measure any of this?”
Then came the pandemic
The government had to come up with a workaround, and it did.
Basically the CPI formula subtracts the cost of benefits paid by health insurers on behalf of customers from the amount of premiums they pay. Whatever profits are leftover each year — known as retained earnings — are used to determine how much health-care prices are rising.
The formula works all right in normal times, but the coronavirus threw a huge curve ball.
Americans stopped going to the hospital or doctor’s office during Covid for fear of catching the virus. Health insurers paid out far less in benefits and profits soared.
As the pandemic faded and Americans went back to their doctors, health insurers had to pay much more in benefits and profits sank.
The result: Health-care costs as measured by the CPI have shown unprecedented ups and downs since the pandemic, especially since the government only updates its math for the medical index once a year in October.
Just how big are these swings?
The annual cost of health insurance in the CPI soared by a reported 28% as of September 2022, only to sink by 33% as of August.
Now here comes another swing. Health insurance costs are set to rise sharply starting in October after the government’s next update to its CPI formula.
That could spell trouble for the Fed.
The ‘core’ of the problem
The goal of the central bank is to get inflation back down to 2%, especially the core rate that strips out volatile food and energy costs.
The core rate of the CPI already slowed considerably in the past year, decelerating to a yearly pace of 4.3% last month from a four-decade peak of 6.6% in mid-2022.
The supposed plunge in health-insurance costs helped pave the way.
At Inflation Insights, Shariff estimates the core CPI would have slowed to only 5.1% — not 4.3% — if health-care costs had risen in the past 11 months as fast as they were rising in September 2022.
What about in the year ahead, when health insurance costs accelerate in the CPI? Medical care is the third biggest category in the index after housing and groceries.
Economists are split how much it could impede the Fed in its effort to get inflation down to 2%.
Shariff, for his part, thinks rising medical costs could add three-tenths or more to core CPI by next spring.
“It’s going to start adding back to core inflation,” he said.
At Santander Capital Markets, Stanley was one of the first Wall Street DJIA economists to warn about high inflation a few years ago. He is less sure rising medical costs will undermine the Fed’s inflation fight. “It is a really important category, but it’s probably not getting worked up about.”
Other economists believe inflation is likely to continue to slow toward 2% largely because of easing price pressures in many other major categories such as food and especially shelter.
Rents have come off a boil, for example, and housing prices aren’t rising rapidly anymore. Shelter accounts for more than one-third of the CPI versus a little over 8% for medical costs.
“CPI only barely starting 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’s better to focus on a separate measure of health-care costs preferred by the Fed that shows more stability.
The health-service gauge found in the so-called PCE index shows that costs are rising about about 2.5% a year.
“The PCE is the best measure to look at,” Amemiya said. “It’s designed to capture the total cost of health care.”
The PCE tries to take into account total health-care spending, including business contributions to employee health insurance as well as Medicaid and Medicare reimbursement rates.
As of July, the core PCE was up at an annual rate of 4.2%, almost the same as core CPI.
Whatever the case, the cost of health care and its impact on inflation still bear watching.
The massive ups and downs in the CPI health-insurers index has even forced the Bureau of Labor Statistics to rejigger its once-a-year formula to try to be more timely and accurate.
Whether it can truly capture the changes in medical costs is still an open question.
“I don’t think there is an easy answer on this,” Stanley said.