July 08, 2021
There have been many warnings, most notably from former Treasury Secretary Larry Summers, that President Biden’s robust recovery package would lead to spiraling inflation. I have written several times that I don’t think the inflation hawks are right, but their warnings deserve to be taken seriously. The most recent evidence supports the view that, for the moment, we can put aside our inflation fears.
To add some context to the debate, we all knew that there would be some disruptions as the economy reopened. Large segments of the economy, most visibly hotels and restaurants, were running at a fraction of their capacity until the last few months. Now that most pandemic restrictions have been removed, businesses in these sectors are rushing to add staff and get fully up to speed.
But this is a process that takes time. (That’s why some of us supported measures like work sharing or the paycheck protection program, that kept workers tied to their employers.) During this adjustment process, there will be shortages in various sectors. There also will be problems for many employers trying to attract workers. In many cases they will have to offer higher wages, which is not a bad thing, but may require some adjustment on the part of businesses who are not used to competing for workers.
The difference between the view that the adjustment process will be difficult, and involve some inflation, and the inflation hawks’ view, that we are on a path to spiraling inflation and the return of 1970s stagflation, is whether the inflationary pressures are likely to be enduring. The latest evidence is supporting the temporary disruption story. (See, Preview: What to Look for in the June Consumer Price Index)
To take the most visible case, lumber prices having fallen by roughly 50 percent from the peak hit in early May. They are still high, but the soaring prices of the winter and early spring have proven to be temporary.
There also has been a very visible price surge in used cars. This is the result of both temporary supply problems for new cars (a fire temporarily reduced capacity in the semi-conductor industry) and a huge surge in demand as rental car companies sought to rebuild their fleets. The price surge now appears to be slowing, if not actually going into reverse. New car production is starting to catch up with demand, but it will likely be several more months, perhaps not until 2022, until the car market returns to something resembling normal.
Oil is another area where we have seen a price surge. As people may recall, the price for oil futures actually turned negative briefly last spring, as people were effectively looking to be paid to store oil. With the economy picking up steam in the U.S. and around the world, oil consumption is bouncing back to more normal levels. However, production has not kept pace.
Part of this is by design, as OPEC moved to restrain production during the pandemic and is still targeting a level of production well below pre-pandemic output. When it failed to reach a deal on higher production quotas earlier this week, the price of oil spiked to over $77 a barrel. While this is at least temporarily bad news on the inflation front (good news on the climate front), the impact of this decision is not likely to be long-lasting.
Historically, it has been difficult for cartels to maintain their limits on output because there is an enormous incentive to cheat. Each producer stands to benefit if they can sell additional oil at near the cartel price, while the other producers stick to their quota. This has been an ongoing problem with OPEC, so it would not be surprising if countries soon begin to exceed the agreed upon quotas. As of July 8th, the price of oil had fallen to $72 a barrel.
Unfortunately, high oil prices still mean bad news in the short-term for the economy and also politically for the person in the White House. Higher oil prices not only show up directly as higher inflation in gas and heating oil prices, they also show up in items like air fares and rents, which often include the cost of utilities. Surging oil prices would contribute to inflationary pressures, so from that standpoint, moderation of oil prices is a good thing.
The Labor Market
We have been seeing strong wage growth the last few months, especially at the bottom end of the labor market. Many of us see this as a good thing. After all, anyone who supported a $15 an hour minimum wage for 2026 has to want to see substantial wage increases in sectors like retail and restaurants, where the average hourly wage for production and non-supervisory workers is $18.57 and $16.21, respectively. Thus far in 2021 the pattern of wage increases has been very progressive with rapid wage growth in sectors with low pay, and much less rapid wage growth in industries with higher average pay. With wages overall increasing at annual rate of just over 4.0 percent, it is not clear that there is much to worry about with inflation.
We got important news today on the labor shortage story. The Labor Department’s Job Openings and Labor Turnover Survey showed a drop in the quit rate from 2.8 percent in April to 2.5 percent in May. This should not be that big a deal, except that when we saw a rise from 2.5 percent in March to 2.8 percent in April, it was treated as a very big deal. This was the highest rate ever reported in this survey, which goes back to 2000. It was taken as evidence that workers were so confident of their labor market prospects, they would freely quit jobs in search of a better one.
The 2.5 percent level reported for May is still high, but it is comparable to what we have seen in prior years. The recovery package was good news for workers, as is the rapid growth in employment that we have been seeing this year, but Biden has not yet created a worker’s paradise.
The Bond Market
In a series of tweets this morning, Paul Krugman noted the interest rate on 10-year Treasury bonds had fallen to under 1.3 percent. It had been over 1.7 percent as recently as March. This is interesting from the standpoint of inflation forecasts, since it doesn’t seem likely that many investors would be holding long-term bonds at a 1.3 percent interest rate if they expected inflation in the range of 3-4 percent, and possibly higher. In other words, the bond markets don’t seem to agree with Larry Summers’ view on inflation risks.
Markets are often wrong (just look at the price of Bitcoin), but it is striking that people with lots of money on the line clearly are not acting as though they anticipate a large uptick in the inflation rate. They apparently are not taking the warnings of the inflation hawks very seriously.
There is a great irony in this story. The deficit hawks always told us that the bond market was the big enforcer. Clinton Treasury Secretary Robert Rubin used the term “bond market vigilantes,” for the investors in the bond market who would send interest rates soaring in response to deficits they perceived as too large. We are now looking at far larger deficits, even relative to the size of the economy, than anything we were looking at during the Clinton years. Yet, the bond market vigilantes seem to be asleep at the wheel.
At the end of the day, the bond market may or may not prove to be right on this one, but it sure is nice to see that bond investors are not supporting the people with their actions, who claim to be speaking on their behalf.