March 11, 2022
The jump in the Consumer Price Index (CPI) we saw in February was bad news. The overall CPI rose by 0.8 percent for the month, while the core rate increased 0.5 percent. This brought the year-over-year inflation rate to 7.9 percent overall and 6.4 percent in the core.
However, the report was disappointing even beyond the bottom line numbers. Many of us have been banking on the idea that we would soon see a reversal in the prices of items where prices have been driven up by supply chain issues. The idea is that if a clogged supply chain was responsible for the rise in prices, then prices should come back down when the supply chain becomes unclogged.
But, I’ve been saying this for a while, prices in most areas have not started to come down. In fact, the prices of many of these items are continuing to rise. After being flat in January, new vehicle prices rose by 0.3 percent in February, bringing their increase since the pandemic began to 13.7 percent. Apparel prices rose by 0.7 percent for the month and are now up 6.6 percent over the last year. The price of appliances also went up 0.7 percent, bringing their rise since the pandemic began to 15.2 percent.
So, should Jerome Powell put on his Paul Volcker outfit and push interest rates through the roof? I would argue that, while modest rate hikes are appropriate, it is too soon to bring out the heavy artillery.
Why I Still Believe Inflation Will Fall
There are three main reasons why inflation is likely to be falling in the months ahead. Just to be clear, I’m focusing on monthly rates of inflation, not year-over-year rates. We don’t know how to change the past.
A Shift in Income Shares Back from Profits to Wages
In the 1970s inflation, there was a very plausible story of a wage-price spiral where companies were raising prices in response to higher wages to protect their profit margins. Profit shares were in fact lower than in the 1960s.
The opposite has happened in the pandemic. The profit share of national income for 2021 was 1.1 percentage points higher than in 2020, this is an 8.5 percent increase in the profit share. There is a plausible explanation for this rise in the context of shortages faced during the pandemic. Higher prices ration excess demand. But if we envision that the shortages will end at some point, it is reasonable to believe that this shift from wages to profits will be reversed, unless we think that conditions of competition in the economy have been permanently changed as a result of the pandemic.
This issue gets to the claim that monopoly power has been a major factor in the inflation we have seen in the last year. If companies have been able to take advantage of the pandemic to use their market power to increase their profits, then we may expect that the profit share will stay near its current level. By contrast, if we think that prices rose in the pandemic because of real shortages, and not especially due to market power, then we would expect the profit share to fall back to the pre-pandemic level when the shortages are alleviated.
There are two points worth noting here. First, overall demand in the economy is not out of line with longer term trends. Real personal consumption expenditures in January were 4.6 percent higher than in January of 2019. This translates into growth of 2.3 percent annually. That is a level of demand that the economy should be easily able to meet without the disruptions of the pandemic.
The major problem in meeting demand has been a shift in consumption from services to goods. Goods consumption was 16.9 percent higher in January than two years ago, and durable goods consumption was 24.3 percent higher. By contrast, consumption of services was still 0.8 percent lower than in January of 2019. The basic story is that the pandemic prevented people from spending money on restaurants, travel, and other services. Instead they bought cars, new refrigerators, and other types of goods.
This created strains on the production and delivery systems that we would have not seen if demand had been more balanced. (This is the distinction between blaming “supply chains” as opposed to simply too much demand.) These strains are likely to be alleviated as demand shifts back to services and the manufacturing and distribution networks are able to work through bottlenecks. It also helps that companies will not have to deal with widespread absences due to illness if the pandemic remains relatively contained.
Therefore, it is still reasonable to believe that the strains on supply chains will be alleviated in the not too distant future. (I know, I said that last fall too.) If we believe that our manufacturing and distribution systems have not been permanently damaged by the pandemic, we should be able to meet future demand without excessive strains on our production networks. That should mean prices falling in many areas.
Just to repeat an example I have used before, the price of apparel is up 6.6 percent from its year ago level. The vast majority of the apparel we buy is imported. The index for imported apparel prices (which does not include shipping costs) has risen by less than 2.0 percent over the last year. This implies that most of the jump in apparel prices is due to higher shipping costs. If our supply system gets back to normal, we should expect shipping costs to decline, and presumably domestic apparel prices will fall back in line with import prices. This is a story that we are likely to see with cars, refrigerators, and a wide variety of other items.
The other item worth noting is that beef prices are up 23.9 percent from February 2020 to February 2022. This is striking because demand for beef has fallen back to pre-pandemic levels. This jump is clearly not due to excessive demand for beef. (Demand had risen sharply in 2020 as people stopped going to restaurants and bought more food at home. Real restaurant spending is now slightly above its pre-pandemic level.)
The continued high price of beef reflects either continuing problems in the supply chain, which are raising shipping costs, or a change in the state of competition in the industry. If it’s the former, we should expect beef prices to come down over the course of the year. In the latter case, high beef prices may persist, unless stronger antitrust measures are taken.
We have seen an uptick in productivity growth the last three years, with growth averaging 2.3 percent annually since the fourth quarter of 2018, compared to a rate of just 0.8 percent over the prior eight years. This is the opposite of the 1970s, where we saw productivity growth fall from an average of 2.5 percent over the prior quarter century to just 1.0 percent in the years from 1973 to 1980.
In the seventies, workers had been accustomed to seeing real wage growth roughly in line with productivity growth. Real wage growth in excess of 2.0 percent annually was no longer possible in an economy with annual productivity growth of just 1.0 percent. This was a major factor in the wage-price spiral we saw in the decade.
At present, we are seeing the opposite story. The increase in productivity growth means that workers can see real wage growth in excess of 2.0 percent annually, without causing inflation. This is in effect the flip side of the shift from wages to profits over the last two years. Real wages have risen in this period, but by far less than the increase in productivity. This leaves plenty of room for real wages to rise without a corresponding increase in prices.
Predictions of productivity growth have a terrible track record, so I won’t try to put forward any here. I will say that there are reasons for believing the uptick seen in the last three years could continue.
First, many companies have been forced to find ways to be more efficient, since they often couldn’t get the workers they needed, and faced major disruptions due to pandemic restrictions. The restaurant industry provides an obvious example. Its real output in the fourth quarter of 2021 was more than 2.0 percent higher than in the fourth quarter of 2019, even though the index of hours worked in the industry was more than 7.0 percent lower.
In the same way that restaurants have been able to find ways to serve more meals with fewer workers, other industries are developing new methods of doing business. We are seeing more use of online services and new technology that can enable businesses to be more efficient. Replacing business travel with Zoom meetings is probably the most obvious and important example of this sort of gain.
It’s also important to realize that many of the gains will not be picked up in conventional measures of GDP and productivity. The increased frequency of work from home is the biggest source of such gains. Workers are seeing tens of billions in savings on work-related expenses, such as commuting, business clothes, and dry cleaning. This is in addition to the hundreds of millions of hours saved commuting.
There are gains in other areas as well. The use of telemedicine has exploded in the pandemic. This not only saves the costs of traveling to and from health care providers, but also the distress that people in poor health may experience from having to endure what can be a difficult trip for them.
Similarly, the spread of online car retailers, which save people from having to endure a trip to a dealership, can be a large gain in well-being for many people. This also would not be picked in measures of GDP or productivity.
These are just some prominent examples of innovations that are taking place across the economy. They provide reason to believe that the uptick in productivity growth over the last three years may continue, but best guesses on productivity growth have proved wrong in the past, so we can’t take faster productivity growth for granted.
Slowing Nominal Wage Growth
The final reason that we don’t seem likely to see the sort of wage-price spiral we had in the 1970s is that wage growth appears to be moderating. It would be foolish to make too much of one month’s data, but the average hourly wage was flat in February. The year-over-year increase in the average hourly wage was 5.1 percent, down from a peak of 5.5 percent in January and 5.4 percent in October.
There has been a sharper slowing in some of lower paying industries that had seen the sharpest gains. For example, the year-over-year wage gains for production and nonsupervisory workers in restaurants were 14.3 percent in February, down from 16.6 percent in December.
Given how erratic the wage data are, especially with the complication of the composition effect from the pandemic shutdowns (it depressed wage growth a great deal in the middle of 2021, less so in more recent months), it would be wrong to make much of this modest evidence of a slowdown in wage growth. However, we do not seem to be seeing evidence of accelerating wage growth, which would be the story of a wage-price spiral.
As many of us have argued previously, it is unlikely that we will see the sort of wage-price spiral we saw in the seventies because of changes in the structure of the labor market. In the 1970s, more than 20 percent of the private sector workforce was unionized. Now, it’s just over 6.0 percent.
We also have a much more globalized economy. This makes its difficult to have sharply higher inflation rates in the United States than in our trading partners. If the price of cars, steel, and other items produced in the United States rises much more than the price of the same items produced Germany, Japan, and China, then we will import much more and buy less of domestically produced goods. That would put serious downward pressure on prices and wages.
A fall in the dollar against the value of other currencies will offset differences in inflation rates. However, contrary to what many inflation hawks predicted, the dollar rose over the last year (even before the Russian invasion of Ukraine). This is clearly inconsistent with the wage-price spiral story.
Conclusion: Don’t Panic Over Inflation
High rates of inflation have definitely persisted for longer than I expected. I still don’t think there is cause for panic about the sort of high and rising inflation we saw in the 1970s.
It is reasonable for the Federal Reserve Board to start on a path of moderate rate hikes. The economy is clearly near full employment, so measures aimed at slowing the pace of economic and job growth are appropriate. At the same time, it does not make sense to try to jack up the rate of unemployment to slow wage and price growth.
It’s worth asking what conditions might be the cause for more concern. First, if we saw more instances like the beef industry, where demand has returned to pre-pandemic levels, but prices remain hugely above pre-pandemic levels. I don’t expect prices to fall back fully to pre-pandemic levels, but if we see supply chain problems resolved, we should see a substantial movement in that direction.
Similarly, if we see a further shift toward profit shares, it would be very concerning. This means both that workers are not getting their share of the gains of economic growth, and also that prices are becoming detached from costs.
If we do see this shift, it would be a strong argument for more aggressive antitrust measures. There already is a strong case, but a further shift to profits would mean that monopoly power is a key source of inflation. We also need to remember that profit data are erratic and subject to large revisions, so one or two quarters of data may not be telling us an accurate story.
Finally, if nominal wage growth accelerates, we should be concerned. It’s great to see workers getting wage gains, but if we see hourly wage growth approach double-digits, it virtually guarantees inflation rates that are uncomfortably high.
In short, there are real grounds for being concerned about the inflation we have been seeing, but we have a long way to go before seeing a 1970s wage-price spiral.