Health Care Inflation: What s the Prognosis?

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1 Economics Group Special Commentary Sarah House, Economist (704) Ariana Vaisey, Economic Analyst (704) Health Care Inflation: What s the Prognosis? Executive Summary With much of the discussion about weak inflation in recent years centering around lower commodity prices, a strong dollar, pressures from e-commerce and, more recently, cell phone services, it has been easy to overlook price developments in the health care sector. Yet at 23 percent of the core PCE deflator, health care commands sizeable influence on inflation. Like many categories, health care inflation has been weak over the current expansion, but the slowdown marks a more significant departure from its historic trend. Given the sector s large size, health care services accounts for about 70 percent of core inflation s current shortfall from its pre-recession trend. The outlook for health care inflation therefore has great bearing on when or whether the Fed will meet its inflation goal. The health care sector has undergone tremendous changes over the past decade due to public policy reform and an aging population, but cyclical pressures on utilization and input costs appear to be building. That suggests that the downward pressure on medical inflation stemming from structural changes, like changes in the private insurance market and Medicare reimbursements, will need to intensify in order to keep health care inflation and therefore broader core inflation from edging up over the next year or two. Health Care Services a Downer for Core PCE Inflation Inflation has persistently missed the Fed s 2 percent target over the course of the current economic expansion. The core PCE price index, the Fed s preferred gauge of trend inflation, has averaged just 1.53 percent year-over-year growth since the Great Recession, compared to 1.93 percent during the expansion. Over the same period, inflation for health care services, which accounts for roughly 19 percent of the core index based on spending, has been growing near the slowest pace on record (Figure 1). Figure 1 Figure 2 Health care services accounts for about 70 percent of core inflation s current shortfall from its prerecession trend. 1 1 PCE Deflator: Health Care PCE Price Index, Year-Over-Year Percent Change Core PCE: 1. Health Care Services PCE: Health Care Inflation Percentage Point Contribution to Core PCE Inflation Health Care Services: 0.2 (Left Axis) Health Care Goods: 0.1 (Right Axis) Source: U.S. Department of Commerce and Wells Fargo Securities This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 Health care services have contributed much less to inflation over the past decade than historically. After increasing ahead of core inflation for most of the past five decades, the cost of health care services has grown closely in line with other prices since As a result, health care services have contributed much less to inflation over the past decade than historically. The PCE price index for health care services is currently up 1.3 percent on a 12-month basis, significantly below the average 3.5 percent rate recorded over From 2003 to 2007, health care services contributed an average of 0.60 percentage points to 12-month core PCE inflation. This average contribution has dropped by almost half to 0.33 percentage points since 2008 (Figure 2). Medical goods such as prescription drugs, on the other hand, have seen little change on trend in their average contribution to core PCE. In fact, compared to the period, health care goods have contributed slightly more to core inflation since 2008, at 0.12 percentage points on average versus 0.09 in the prior period. Therefore we focus on the slowdown in health care services inflation more specifically. One way to parse out the effect of health care services on the core PCE price index is to compare changes in inflation over time with and without health care services included. Since health care services PCE inflation has typically run higher than the core index, the average 12-month PCE inflation ex-food and energy is 1.57 percent since 2008, versus 1.24 percent when health care services are also excluded. The story flips, however, when looking at deviations from long-term inflation rates. As shown in Figure 3, core PCE inflation when measured on a year-over-year basis is running about 0.5 percentage points below its long-term pre-recession average ( ), but when removing health care services this gap narrows to 0.15 percentage points. In other words, health care services accounts for about 70 percent of core inflation s current shortfall from its pre-recession trend. Therefore, current core inflation would be much closer to longer-term average levels were it not for disinflation in health care services prices. Figure 3 Figure Core Inflation ex Health Care Services Year-Over-Year Percent Change Minus Avg PCE, ex Food & Energy: -0.5 PCE, ex Food, Energy & Health Care Services: Components of Health Care Services Inflation Pctage Pt. Contributions to Yr/Yr Health Care Services PCE Inflation Physician Services: 0.1 Dental Services: 0.1 Paramedical Services: 0.3 Hospitals: 0.6 Nursing Homes: 0.1 Health Care Services PCE: Much of the decline in the inflation rate is due to slower cost growth for physician services and hospitals Source: U.S. Department of Commerce and Wells Fargo Securities Breaking out health care services by its components, we can see that much of the decline in the inflation rate is due to slower cost growth for physician services and hospitals. Compared to , physician services have on average contributed 0.44 percentage points less to yearover-year health care services inflation post-2008, while hospitals have contributed 0.71 percentage points less (Figure 4). Together, these two components make up almost 70 percent of the drop in average health care services PCE inflation. All other components dental services, paramedical services and nursing homes also grew more slowly since 2008, and contributed the remainder of the decline. What s Behind the Slowdown in Health Care Inflation? Slower health care inflation in recent years can be traced to the weak economic expansion as well as significant changes in the health care industry. From the cyclical side, use of health care slowed - 2

3 in the immediate years following the recession as job losses left many workers without health insurance. The number of inpatient hospital stays for example, fell each consecutive year from The weak labor market also kept wage pressures, a significant share of costs in the health care industry, relatively subdued. The industry has also undergone major changes following the passage of the Affordable Care Act (ACA). Uncertainty surrounding how the new law would affect operations and profitability led to providers restructuring and attempting to rein in costs ahead of implementation. Health care utilization rates jumped in 2014 after the first full year of the ACA helped to expand insurance coverage (Figure 5). However, a shift to high-deductible plans as employers and insurers tried to restrain their own cost growth has kept usage rates from rising wildly. Figure 5 Figure 6 Real Health Care Services Consumption Deflated by Health Care Services Price Index, Yr/Yr Percent Change Real Health Care Services PCE: 2. 1 Hospital Industry PPI By Patient Type, Year-over-Year Percent Change Medicare: 3. Medicaid: 0. Private and Other: Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Securities While the Consumer Price Index zeros-in on consumers direct medical costs, the PCE deflator measures a broader set of health care prices. Rather than measuring the out-of-pocket cost, the PCE deflator measures the price of the goods or services regardless of the ultimate payer, such as private insurance or public health care programs. Therefore, legislated changes in reimbursement rates from public programs bear on PCE health care inflation. Over the past five years, payment rates for Medicare and Medicaid have in general grown more slowly, or even declined, directly contributing to slower health care inflation when measured by the PCE deflator (Figure 6). However, reimbursements rates from public health care programs also influence private payments, leading to an additional indirect link to lowering health care inflation. 1 Will Low Health Care Inflation Continue? Whether these forces will continue to restrain health care prices will shape the path of overall inflation given the sector s size. Research has shown that the pricing cycle for health care tends to lag the economic cycle by about six years. 2 With the recession ending in 2009, broad cyclical pressures would only recently be making their way into health care prices. Some cyclical price pressures look to already be building. Growth in usage continues to rise faster than the early years of the expansion, even as the initial boost from the ACA has wound down (Figure 5). In recent years, the shift to high-deductible plans has helped to curtail demand for health care services, but this phenomenon may have run its course. According to the PWC Health Research - Legislated changes in reimbursement rates from public programs bear on PCE health care inflation. 1 Clemens, Jeffery, Joshua D. Gottlieb, and Adam Hale Shapiro (2016). Medicare Payment Cuts Continue to Restrain Inflation, FRBSF Economic Letter San Francisco: Federal Reserve Bank of San Francisco. 2 Larry, L., Claxton, G., Roehrig, C., and Getzen, T. (Apr. 2013). Assessing the Effects of the Economy on the Recent Slowdown in Health Spending. The Henry J. Kaiser Family Foundation. 3

4 With Medicare covering a growing share of the population as the Baby Boomers age, the program s reimbursement rates, which tend to be lower than the private sector, will take on a greater importance. Institute, the share of employers only offering a high-deductible plan has been flat for three consecutive years now. 3 Input costs are also trending higher. Labor costs account for about half of inputs in the health care sector, and hourly earnings growth has strengthened over the past year. With the industry s job opening rate near record highs, we expect wage costs to pick up in the months ahead (Figure 7). Prescription drugs prices are another area that could lead to higher medical care inflation over the near term. Fewer prescription drugs came off patent in 2016 and Cost savings from generics usually show up 1-2 years after patent expiration, so the impact of fewer patent expirations in the past two years should be felt in That said, there are reasons to believe that health care inflation will remain below historic rates. While wage pressures are rising, they remain muted relative to prior cycles as productivity and broader inflation are still depressed. The Tax Cuts and Jobs Act s repeal of the individual mandate beginning in 2019 may renew pressure on usage growth a little further down the line as well, as some Americans opt out of insurance coverage and others find coverage prohibitively expensive. The Center for Medicare and Medicaid Services (CMS) anticipates price growth for hospital and physician services will strengthen over the next few years, but that the pace will remain slow relative to the past expansion (Figure 8). 5 With Medicare covering a growing share of the population as the Baby Boomers age, the program s reimbursement rates, which tend to be lower than the private sector, will take on a greater importance. Figure 7 Figure 8 Health Avg. Hourly Earnings & Jobs Openings Year-Over-Year Percent Change Health Care Hrly Earnings: 2. (Left Axis) Health & Social Assist. Job Openings Rate: 5. (Right Axis) CMS Market Basket Price Indicies Fixed-Weight Basket, Yr/Yr Percent Change of a 4-Q Moving Avg. Inpatient Hospital: 2. Medicare Economic Index: 1. Forecast A turnaround in health care inflation could go a long way in getting inflation back to 2 percent on a sustained basis. Source: U.S. Dept. of Labor, U.S. Dept. of Health and Human Services and Wells Fargo Securities The FOMC s Prescription Weakening in inflation over the past year has perplexed Fed policy makers and renewed questions over the Committee s ability to reach its inflation target on a sustained basis. PCE inflation briefly reached the FOMC s target last January and February, but core PCE, a more reliable indicator of the trend, has only reached 2.0 percent five of the now 103-month expansion. Disinflation for health care services can explain a significant portion of the prolonged shortfall. Given the sector s size, a turnaround in health care inflation could go a long way in getting inflation back to 2 percent on a sustained basis. Some help looks to be on the way with input costs rising and usage rates strengthening. But medical care inflation looks set to remain somewhat restrained following changes in the way health care is provided and paid for. The fact that the weakness is set to come in part from administered, rather than market, prices won t let the Fed off the hook from 3 Medical Cost Trend: Behind the Numbers PwC Health Research Institute, June Ibid. 5 CMS market basket indices reflect input price inflation facing providers in the provision of medical services, and are used by the CMS to update payments and cost limits. 4

5 reaching its 2 percent target. Therefore, while slower growth in health care costs may be welcome development for many consumers, businesses, and government payers, it remains a challenge for the Fed seeking to maintain credibility on its inflation target and to move interest rates further from the zero lower bound. 5

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