Since the end of last year, US inflation has been driven in part by sharply rising healthcare spending. Annual growth in this component has rebounded from 0.5%, its lowest level since 1962, and is now running higher than core inflation (see chart below). This article examines why healthcare spending declined so much after the financial crisis and how strong the recent bounce could be. Healthcare inflation accounts for a whopping 17% of the US consumer price index, so a large, long-term increase would put the pressure on the central bank.
The Personal Consumption Expenditures (PCE) - Healthcare subindex does not only include the medical expenses paid for by US households but also healthcare-related reimbursements by the government and insurance companies. Healthcare spending can be divided into three categories: services, such as hospital care and visits to the doctor; products, such as drugs; and insurance premiums (see left-hand chart below).
As explained below, it is the government that has put downside pressure on healthcare prices, much more than the private sector (see right-hand chart above).
a. In 2013 the sequester mechanism of across-the-board budget cuts was triggered to reduce the US federal deficit, mainly affecting hospitals and government health insurance subsidies for the poor and elderly (under Medicaid/Medicare).
b. Since the criteria for eligibility to Medicaid services were broadened, many households replaced their private healthcare insurance with this government programme. However, because Medicaid reimbursements to service providers are less generous, and because less-insured people spend less on medical services and products, healthcare prices declined generally.
c. Reforms unique in American history were implemented under the Affordable Care Act ("Obamacare") aimed at cutting public expenditure. For example, reimbursements to doctors were reduced along with the indexing of rates charged by other care providers. 2610 hospitals that failed to meet quality standards were fined, further reducing their cost to the government.
d. Technological progress, one of the main factors behind rising medical costs in the previous decade, was slowed. As an example, the use of stents, expandable tubes that keep arteries open, registered double-digit growth between 1990 and 2000 but levelled out subsequently.
Now, however, most of the government's regulatory restrictions have been relaxed, allowing more scope for a rise in prices. Healthcare inflation already bottomed out last year and we think their intervening upturn will prove sustainable for the following reasons:
a. At end-2015 the cap imposed by the federal sequester was raised by $80 billion for two years. This move will relieve the squeeze on reimbursements and allocations under the Medicaid/Medicare programmes, thereby encouraging the poor and elderly to use healthcare benefits more and pushing prices upward again.
b. Job creation and wage growth in the medical services sphere have already risen sharply in the past two years (see left-hand chart below). This wage pressure will flow through into prices, since medical services represent nearly 75% of overall healthcare spending (see left-hand chart on previous page).
c. The number of Americans with health insurance coverage is growing rapidly, creating more consumption. Population ageing is also a factor in the rising use of medical services and products. As a consequence health insurance premiums are expected to go up 7.5% from 2016 compared with 2% increases in recent years (according to forecasts by Capital Economics).
d. Finally, high drug prices will continue to fuel inflation. Their current decline was orchestrated by producers, mainly to prevent a price scandal ahead of this year's elections and in anticipation of possible reforms by the new president. Still, their annual rate of increase is about 3%, far higher than other components of inflation (see right-hand chart above).
Conclusion: The rebound in healthcare inflation is sustainable, but it will continue at a slower pace than at the beginning of the year.
- The price decline observed until last year was mainly due to sweeping changes in public healthcare policy and this downside pressure has abated.
- Medical costs will therefore remain on an upward path. The annual rate of increase surged at the beginning of 2016 to offset the extraordinary repercussions of changes to Obamacare that came into force a year earlier. Prices will continue to go up more gradually throughout 2016.
- Rising healthcare costs will stoke total inflation. However, we do not believe the increase will be unduly rapid for structural reasons, including the slowdown in technological progress and the long-term impact of certain Obamacare provisions (cf. lower price-indexing). If the US Federal Reserve finds itself face to face with a much-feared surprise jump in inflation, it won't be because healthcare costs have risen too quickly.