Both halves of the US's inflation nightmare are starting to look better

• Today's sky-high inflation comes from a clash between extraordinary demand and inadequate supply.
• Recent reports indicate the gap between the two is closing, signaling price growth will soon start to cool.

The US inflation problem is a two-pronged one. New data suggest the price surge is cooling down on both fronts.

The latest print from the Consumer Price Index capped a year of unrelenting price hikes. Inflation accelerated to a year-over-year pace of 7% in December, the fastest rate since 1982. Price hikes have been even larger for some popular goods like gas, beef, and furniture.

The elevated rate underscores the cavernous gap between shoppers' demand and strained supply. Vaccine rollouts in early 2021 paved the way for Americans to unleash pent-up demand and stimulus dollars at reopened businesses. Yet supply chains haven't fully healed, leaving firms struggling to keep their inventories intact. The Delta wave worsened the situation as key manufacturing hubs in the Asia Pacific region were forced to slow production.

But both of those problems could be coming to an end and ease the last months' sky-high price hikes on their own. The world's supply-chain mess is on the mend, and Americans' spending is shifting into a lower gear.

Consumer demand is falling back to earth

After several months of record spending, shoppers are taking a step back. Data out Friday showed retail sales — a proxy for overall spending — tumbling 1.9% in December, the largest one-month decline since February and a major deceleration from the 0.2% gain seen just one month prior. Economists had expected only a mild drop of 0.1%.

Recent readings of Americans' attitudes about the economy similarly hint at declining demand. The University of Michigan's Consumer Sentiment Index reversed its upward trend and slid to 68.8 in a preliminary January report, marking the second-lowest level in a decade. Three-quarters of surveyed adults ranked soaring prices as a bigger economic problem than unemployment. And although this month's full report isn't yet published, recent months have seen Americans grow more pessimistic toward purchases of durable goods like furniture and appliances, cars, and homes.

The demand cooldown already seems to be pulling inflation to more palatable levels. Prices paid to US producers — a closely watched forward indicator for inflation — rose just 0.2% in December, missing the average economist estimate of a 0.4% bounce and sharply slowing from November's 1.0% leap.

Americans' inflation fears are also easing. Surveyed adults' expected year-ahead inflation rate held flat in December, according to the New York Fed's Survey of Consumer Expectations, reflecting the first time since October 2020 that the measure didn't increase. Since inflation can be influenced by peoples' expectations, snapping the years-long streak of increases offers yet another hopeful sign of the inflation surge peaking.

The Fed will also do its part to rein in Americans' demand. The central bank announced in December it would taper its emergency asset purchases at twice the speed it previously planned, setting the program up to end in March. Economic projections published alongside the announcement show officials expecting three interest rate hikes in 2022 and another three in 2023. By raising borrowing costs, the central bank will gradually wean the country off of the easy-money conditions of the last two years.

Supply is on the rebound

Weaker demand is only one half of the inflation puzzle. Matching supply with demand is key to staving off more extraordinary price hikes, and various signs point to improvement on that front, too.

Jefferies economists in October were among the first to say the global supply-chain crisis had peaked, and data since has supported their call. The Institute for Supply Management's Chicago Business Barometer — a popular gauge of national business activity — saw inventories climb for a third straight month in December while order backlogs sank to the lowest level of 2021. Key ports have also seen their bottlenecks ease in recent months, helping alleviate pressure further down the supply chain.

The bottlenecks that prevented businesses from shoring up supply are now "easing in all the right places," JPMorgan economists Joseph Lupton and Bruce Kasman said in a note. The bank doesn't expect the Omicron variant to power the same level of supply-chain pain as previous waves, and instead sees manufacturers continuing to ramp up production through 2022.

"The sharp bounce-back in global industry last quarter supports our key near-term call that these supply constraints are now easing," the team said.

The Fed holds a similarly encouraging outlook. Powell said in a congressional hearing last week he expects "some help" from the supply side to fight inflation, adding the shipping bottlenecks are a big reason why inflation soared so high in the first place. After months of saying that inflation would prove to be transitory, the Fed chair laid out a simpler explanation for the price surge.

"What we have now is a mismatch between demand and supply."