I have written about inflation a couple of times in the past, most recently on May 26th in an article you can find here: “Inflation: Transient or Persistent, Lessons from the 1970s”. In that article, I concluded – based on the last period of sustained inflation in the US in the 1970s/early 1980s – that current higher-than-target inflation would be transitory. The reason I concluded this is that the Federal Reserve could shut down inflation by acting decisively once the primary objective of (pre-pandemic) full employment is achieved. I also mentioned that, in my opinion, the risk of persistent inflation is less than the risk of the Federal Reserve mismanaging its shift towards a more hawkish stance, which could easily tip the US economy into recession. The success of a shift to less accommodative policy will ultimately require a combination of skilful and perfectly timed execution (and some luck). Let me get back to the purpose of this article though.
I believe that inflation will be transitory because above-target inflation was, in the initial stages, caused by excess stimulus-fuelled demand, especially demand for services as people returned to some semblance of normality post-pandemic. This demand-pull inflation has been heavily influenced by aggressive, pandemic-inspired fiscal and monetary stimulus. Fiscal stimulus directly related to the pandemic has more or less run its course, whilst accommodative monetary policy looks set to be gradually curtailed over the coming months and years. Demand seems to be slowly waning. Nevertheless, inflation remains stubbornly high, not easing as quickly as the Fed would have liked. A key reason for this is that there are a series of supply-push inflationary factors in play over which the Federal Reserve has no control. These factors, listed below, are affecting headline CPI and PPI and will likely continue to do so for several more months.
Supply chain issues: The first factor is ongoing and broadening supply chain interruptions / shortages, which are pushing up the prices of inputs, thereby putting pressure on end prices as companies seek to protect operating margins. This is likely to persist but improve in the coming three to six months.
Price of oil: The second factor is the steady escalation in the price of oil, which seems to reflect the combination of OPEC+ sticking to its production quota increases and the reluctance of alternative providers (like US fracking companies) to re-enter the market even as oil prices increase. Oil has its on boom-and-bust cycle. When prices are too low, strong demand for petroleum and petroleum derivatives pushes oil prices higher assuming that supply is “controlled” or held in check. When oil prices are too high, consumers curtail demand and look for alternative sources. Higher prices also attract new production which becomes economical at higher price points, increasing supply. Predicting oil prices can be a fool’s game because there are so many factors at play, so I am not going to go there.
Labour market friction: A final factor that is leading to cost-push inflation is labour market friction. Service industries in particular have come back on-line with a vengeance to meet rapidly increasing demand as the world learns to live with COVID-19. However, hiring qualified employees quickly enough is proving difficult. The reasons are that not all employees are qualified, and many qualified employees are not in the “right place” (where they are needed). Some pundits have even argued that there is a contingent of unemployed workers that are not in a rush to return to work because they don’t need the money due to excess savings funded by pandemic fiscal stimulus measures, meaning that they can hold out for even higher wages. There is also a contingent of unemployed workers that simply fear returning to work due to concerns about catching the virus. Regardless of the reasons, there is troubling wage pressure in some service industries in particular. It is this third category of supply-push inflation that is most likely to be sticky. Although labour markets will slowly adjust and wage pressures will ease, I doubt that employers will take back increases that are occurring at the moment, so these will be permanent.
The Federal Reserve has no ability to directly influence the first two supply-push inflationary factors, both of which – as an aside – are global and are not purely US matters. The third factor is more indigenous to each country, but even this sort of friction is not directly addressable by a country’s monetary policies.
How long these factors might persist is hard to say. I suspect the first and third factors are pandemic-remnants and will – with the passage of time – be addressed as economies continue to return to normal. However, as I mentioned, wage increases that have occurred already will in essence become permanent. Oil prices are another matter altogether. Although it is impossible to predict the price of oil over time with high confidence, the effect of higher oil prices on inflation is predictable. According to a 2017 study by the IMF, a 10% increase in the price of oil leads to a 0.4% increase in domestic inflation in most countries, an inflationary influence that dissipates over a period of two years or so.
Even with these supply-push inflationary pressures, I believe that inflation will be transitory. The Federal Reserve has telegraphed its tapering plan and is starting to crystallise a plan for a series of rate rises. The approach of the Fed seems to be undeterred by these supply-push inflationary factors, so I believe that current above-target inflation will be relatively short-lived, meaning extending into 1Q22 but gradually subsiding over the coming months. The worst possible outcome, which I do not think will occur, is stagflation, meaning stubbornly high inflation and – at the same time – weakening demand. Let’s hope we don’t go there!