Medical costs are likely to make US inflation stickier

The US consumer price index has been benefiting from a long time lag inherent to the way health-care costs are computed. That benefit is set to wane.

Let’s examine this phenomenon by first inspecting the inflation figures for July. Headline CPI was 3.2 percent. Core CPI, which excludes energy and food prices, was 4.7 percent. As the first chart shows, this broadly follows the softening trend seen through the year.

Next, let’s turn to a heatmap that breaks down current inflationary or deflationary trends in different industries. Which of these eight sectors are having the greatest effect on the CPI?

As the heatmap shows, the “coldest” sectors are transport and medical care. The latter accounts for a weight of almost 8 percent in the CPI, and will be the focus of this blog post.

The CPI’s medical care index can be further divided into medical care services and medical care commodities. Medical care services can be further broken down to (a) professional services, (b) hospital and related services, and (c) health insurance. 

The “cold spell” in that heatmap is at odds with the historic trend. Medical care inflation, led by medical care services (up 114 percent since 2000), has outpaced overall inflation (81 percent) in the economy – as the next chart shows.

The measurement of the health insurance component of the CPI is particularly tricky.

Instead of measuring the change in premium prices directly, an indirect method based partly on health insurers’ profits – rather than the premiums those insurers set – is applied. Thus, the data is lagged by almost a year, and isn’t representative of current price changes.

The Bureau for Labor Statistics’ Retained Earnings Method involves four steps: 1) separating health insurance index weights, 2) calculating the retained earnings ratio, 3) health insurance index aggregation, and 4) reassigning health insurance weights. This implies steep changes, with retained earnings component reset and stepwise changes in the weights.

The calculations in this method can have a lumpy impact on the healthcare insurance index.

The next chart breaks down contributions from medical care index sub-components ranging from hospital services to drug prices. Note how the change in the health insurance component, in green, has shown sharp volatility throughout 2022-23. 

The surge in September 2022 healthcare inflation embedded health insurers’ better margins from the early Covid years, given the lower claims paid during lockdowns. However, returning utilisation implied lower margins, on average, in 2021 and 2022.

This September 2022 index computation and weight redistribution provided a higher base and decreasing inflation prints throughout 2023. Health insurance CPI slowed dramatically -- from an annualised increase of 28.2 percent in September 2022 (the all-time high) to a decrease of 29.5 percent in July 2023. 

The comfort from this moderation is only expected to continue until September 2023. 

Late last year, a report from the Kaiser Family Foundation predicted that employer-sponsored health insurance premiums would rise more steeply in 2023 than they had in recent years.

The steeply negative trend in healthcare insurance inflation will likely reverse beyond the fall season – and coupled with higher wages for medical care workers, the benefits stemming from this negative contribution to overall core CPI will likely abate. 

As our final chart shows, we see core CPI staying in a tight range for the next few months. Base effects will support a marginal softening in headline core inflation prints going into the year-end – but they will stay above the Federal Reserve’s target.