Core CPI Could Reach 3.5% Next Year
Driven by Housing Costs and Wages
Tariff Effects Expected to Peak in Q2 Next Year
"As we head toward 2026, signs are increasingly clear that the U.S. economy is moving into a 'lite' stagflation phase."
According to Business Insider on December 4 (local time), Royal Bank of Canada (RBC) stated in a recent report that the U.S. economy is likely to experience stagflation-rising prices amid below-trend growth-next year. RBC warned that inflation will remain worryingly high even as growth slows, and projected that the core Consumer Price Index (Core CPI) will exceed 3% year-over-year for most of 2026.
Even a 'lite' form of stagflation would place a significant burden on the U.S. economy. In such an environment, growth slows while inflation remains elevated, making it difficult for the Federal Reserve to stimulate the economy by cutting interest rates. This makes monetary policy management extremely challenging.
The first reason RBC cited for the risk of stagflation is high housing costs. The core services inflation rate, which excludes goods and the volatile food and energy sectors,
recently rose by about 3.5% year-over-year. Core services inflation is made up of sticky price components such as wages and housing costs. The increase in this measure indicates that there are persistent factors driving inflation, suggesting that prices are likely to remain structurally high.
In fact, while the pace of home price increases in the U.S. has slowed somewhat, prices have already surged significantly over the past five years and continue to rise. The Owners' Equivalent Rent (OER), which reflects the average housing costs in U.S. cities, also rose by 3.7% year-over-year as of September.
RBC explained, "OER is a concept that assumes homeowners pay rent to themselves, and it exerts persistent upward pressure on core CPI," adding, "It is unlikely that OER will help bring inflation back down to the Federal Reserve's 2% target in 2026."
The second factor is entrenched wage growth. In September, the average hourly wage for private-sector workers increased by 3.8% year-over-year. Notably, core services inflation excluding housing costs has never turned negative in the past 40 years. The structural upward pressure on this measure is mainly driven by wages. RBC emphasized, "Unless the trend of wage increases is broken, it will be difficult for core services inflation excluding housing costs to fall meaningfully."
RBC also noted that goods prices are rising. Goods inflation has steadily climbed over the past year, reaching an annualized rate of 1.8% in September. RBC stated that it had already anticipated goods prices would rise again as supply chains and demand normalized after the pandemic. In addition, the reciprocal tariffs introduced by President Donald Trump are adding further upward pressure on goods prices.
RBC reaffirmed its existing view that reciprocal tariffs will fuel inflation, stating, "The full impact of tariffs has not yet been passed on to consumer goods prices, and the effect of tariffs on prices is expected to peak in the second quarter of next year."
Finally, RBC pointed out that excessive government spending could constrain U.S. economic growth next year. While government spending typically stimulates the economy, expansion of the public sector can lead to lower productivity, becoming a drag on growth in the medium term. As the share of the public sector increases, less productive areas expand relative to the private sector, and increased government spending leads to higher government bond issuance, which in turn pushes up interest rates and dampens private investment.
RBC also noted that massive government debt will fuel inflation and intensify stagflationary pressures. The expansion of government debt leads to increased fiscal spending and interest costs, which add to inflationary pressures and, through various channels such as reduced private investment due to higher government bond issuance, raise the risk of stagflation. According to the Congressional Budget Office (CBO), the U.S. is expected to record a cumulative fiscal deficit of about 21 trillion dollars over the next 10 years.
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