April 26, 2022
Inflation has stayed higher longer than I expected. I got that one wrong. I am happy to acknowledge my mistake, but I also want to know the reason why. This is not a question of finding excuses, I want to know why the economy is acting differently than I thought it would.
The most obvious reason is the supply chain disruptions that led to the original jump in prices have lasted longer and been more far-reaching than I expected. Part of this is due to the persistence of the pandemic, with the delta and omicron strains disrupting economies around the world.
The other major source of disruption is Russia’s invasion of Ukraine. This has blocked the supply of many items manufactured in Ukraine, but more importantly, the war reduces its ability to grow and sell wheat and other crops on world markets. There is also the risk of losing Russia’s oil and gas, which propelled oil prices to levels not seen in more than a decade.[1]
The idea that inflation would spike under such circumstances should not be surprising. As has been widely noted, the jump in inflation was worldwide, not just in the United States. The increase in the inflation rate was comparable in the European Union and the United Kingdom, so it obviously was not just a story of excessive stimulus in the United States. The break-even inflation rate on German 10-year government bonds are now essentially the same as in the United States, indicating that investors expect inflation in the two countries to be roughly the same over this period.
The logic here should not be hard to understand. The normal delivery of goods and services was disrupted by the pandemic. Since overall demand did not drop to anywhere near the same extent (due to various stimulus measures), we had shortages of many items, leading to sharp increases in prices.
While there were jumps in demand at various points during the pandemic, associated with the timing of stimulus payments, overall growth has not been extraordinary. Real consumption expenditures for February of 2022 (the most recent month for which we have data) were 4.6 percent higher than they were two years ago, a 2.3 percent annual rate of growth.
The problem has been, and still is, a huge shift from consumption of services to consumption of goods, due to the pandemic. While service consumption was still slightly below its pre-pandemic level in February of 2022, consumption of nondurable goods was up 11.8 percent, a 5.9 percent annual rate of growth. Consumption of durable goods grew even more rapidly, rising 22.6 percent, a 10.7 percent rate of growth.
This jump in demand would have been difficult for the economy to meet even without pandemic-related, and now war-related, supply issues, but definitely overstretched capacity given where the economy is at present. If the pandemic continues to wane, it should mean that consumption will continue to switch back towards services. It should also mean a reduction in pandemic-related supply disruptions, although disruptions associated with the war may continue and could grow worse.
The Optimistic Route to Lower Inflation
It is important to recount the route to the surge in inflation, since it matters for our prospects for reducing inflation. Recounting our historical track record in bringing inflation down after surges that came from fundamentally different sources is not necessarily useful in describing our prospects for bringing down the current inflation spike.
The optimistic path for lowering inflation would be for an end to the supply chain issues that pushed inflation higher. This means an end to the backlogs at ports, an end to the shortage of truckers, and an end to COVID-19-related shutdowns in China and other manufacturing locations. Also, the shift back to services will reduce the extent to which demand for goods is exceeding the economy’s ability to supply them.[2]
The story would be that when these disruptions are ended, or at least ameliorated, the prices of many items would stop rising and even come back down. This should not sound far-fetched. Televisions provide a great example. The price of televisions had been falling gradually for decades. It suddenly surged 8.7 percent in the five months from March of 2021 until August. The index then turned around and fell sharply, so that it’s now lower than it had been in March of last year.
We may also be seeing this story now with used cars and trucks. Used vehicles prices rose 41.2 percent from February 2021 to February 2022, adding 1.1 percentage points to the overall inflation rate. (New vehicle prices rose 12.4 percent over this period, adding 0.5 percentage points to the inflation rate over the year.) Used vehicle prices fell 3.8 percent in March, after dropping 0.2 percent in February. A private index shows an even sharper drop in used vehicle prices, dropping 6.3 percent since its peak in January.
If we don’t see another resurgence of the pandemic, and the war in Ukraine doesn’t escalate further, these sorts of price reversals may be the norm. A wide range of goods that saw sharp increases in price during the pandemic may experience rapid price declines as the economy normalizes further and supply chain problems are overcome.
Apart from the small number of cases where prices are now falling, there is a more general reason why we might expect these price reversals to be common. Prices have hugely outpaced costs during the pandemic. This has led to a large shift from wages to profits, with the profit share of corporate income rising by more than two percentage points since the pandemic began.
If we think that the conditions of competition have not changed in most sectors since the start of the pandemic, it is reasonable to think that the labor and capital shares will return to their pre-pandemic level. Of course, this is not a given. Inertia is a powerful economic force, so it may be the case that even if we return to roughly pre-pandemic conditions, the profit share will remain elevated. But it is still plausible that we would return to pre-pandemic shares. That would increase the likelihood of price reversals like what we have already seen with televisions and may be now seeing with used vehicles.
There is one other point that has been largely neglected in the comparisons with the 1970s inflation. In the 1970s, there was a sharp slowdown in productivity growth. Productivity had been growing at close to 2.5 percent annually in the quarter century from 1947 to 1972. This allowed for rapid wage growth, with wages rising roughly in step with productivity for most workers. This changed in the seventies, with productivity growth falling to just over 1.0 percent annually from 1972 to 1980.
By contrast, we have seen a rise in productivity growth in the last three years, with the rate of growth increasing from just over 0.7 percent annually, between the fourth quarter of 2010 and the fourth quarter of 2018, to a 2.3 percent pace in the years from the fourth quarter of 2018 to the fourth quarter of 2021. This acceleration in productivity growth should allow for healthy real wage growth without inflation.
Trends in productivity growth are notoriously unpredictable, with few economists having expected the major breaks in trend in the post-war era. But it is encouraging that we have seen strong productivity growth through the pandemic, with businesses finding ways to innovate around unpredictable disruptions to supply chains, as well as their workforce. In this respect, it is worth noting that real output is now higher in restaurants than before the pandemic, even though aggregate hours worked in the sector is 7.2 percent lower than before the pandemic.
Rent and House Prices
While we may be getting some good news on price trends with a wide range of goods, in recent months we have been seeing an acceleration in the rate of rent increases. This could be a big factor increasing inflation since the rental components accounts for more than 31 percent of the overall CPI and almost 40 percent of the core CPI.
The underlying issue in higher rents and house sales prices (house prices have been rising at more than double-digit rates since the start of the pandemic), is a dozen years of extraordinarily weak construction following the collapse of the housing bubble in 2006 to 2009. The economy recovered very slowly from the collapse of the bubble, but when the labor market began to look more normal in the five years prior to the pandemic, rent began to outpace the overall rate of inflation. The rise in rents and sales prices did lead to an increase in housing construction, but the pace of construction was likely still below the growth of demand.
The pandemic aggravated the imbalance in the housing market through several different channels. First, and most obviously, the plunge in mortgage interest rates made it far cheaper for people to buy homes. With the mortgage rate bottoming out at under 3.0 percent, prospective home buyers could afford to pay far more for a house.
Another factor pushing house prices higher was the increase of remote work. Tens of millions of people began to work from home during the pandemic. This meant that they needed more space in their house to accommodate a home office. They also had additional money to pay for rent or a mortgage, since they were saving a large amount of money on commuting costs. It’s not clear how enduring the increase in remote work will be, but it is virtually certain that millions of additional workers will be working remotely, at least part-time, even after the pandemic.
A third factor that boosted housing demand was the eviction moratorium that went in place in April of 2020 and lasted until September, 2021. In an ordinary year, there are close to 1 million evictions. This number fell by more than half during the moratorium. While there were warnings of an explosion in evictions when the moratorium ended, there was no huge surge, even as the rate of evictions moved closer to normal.
It is not good to see people evicted from their home, but keeping tenants in their home does reduce the number of units that are coming on the market. The moratorium helped increase the demand for housing over the last two years.
In the four years from the fourth quarter of 2017 to the fourth quarter of 2021, the number of occupied units increased by more than 7.2 million. By contrast, in the prior four years the number of occupied units increased by only 5.2 million units. This is likely a big part of the story of the run-up in both sales prices and rents, as vacancy rates fell to near record low levels.
However, we may be reaching a turning point in the housing market as well. The Fed’s moves on interest rates have the most direct impact on the housing market. Even though the federal funds rate has risen by just 0.25 percent, the interest rate on 30-year mortgages has already gone up by more than 2.0 percentage points from its pandemic low.
It is still early to get good data on the impact of this rise mortgage rates, but there is evidence that it has already substantially slowed the housing market. Applications for purchase mortgages are down by double-digit amounts from their year ago level. There is also considerable anecdotal evidence of realtors reporting a qualitative shift in the market, with many sellers now making cutting prices from their original listing price.
Another factor that can put downward pressure on sales prices and rents would be an increase in the rate of housing completions. The rate of housing construction rose sharply in the pandemic, rising from less than 1.3 million in 2019, to close to 1.8 million in recent months. However, there has been no comparable increase in the rate of housing completions, which is still running at just over 1.3 million annual rate.
The gap is another aspect of the supply chain crisis. Builders are finding it difficult to get the materials they need to complete a home. There are shortages of everything from lumber to garage doors. If we can resolve supply chain issues, the gap between starts and completions should close quickly. It will take several years to make up the shortfall in supply resulting from more than a decade of severe under building, but increasing completions by 500,000 to 600,000 a year should help to alleviate the severe shortages being seen in many areas.
In short, there are important factors on both the demand and the supply side that should alleviate the upward pressure on rents and house sale prices. There is always a considerably amount of inertia in the housing market, but we may not see as a high rate of rental inflation as many analysts are now expecting.
In sum, there is a plausible story whereby inflation begins to come down in the not distant future. In this scenario, instead of seeing a wage-price spiral, we see inflation gradually fall back to levels that most of us would feel comfortable with.
The Bad Inflation Story
We can hope for the good inflation story, but there is also the bad one that needs to be taken seriously. In this view, we are already seeing a wage-price spiral. High inflation is changing people’s expectations, with workers now looking to get higher wage increases to compensate for the high inflation of the prior year. A round of wage increases that compensate for last year’s inflation will put more upward pressure on prices. This sequence continues, with inflation rates getting to ever more unacceptable levels.
The seventies inflation was eventually broken by the Fed pushing its overnight interest rate to more than 20.0 percent. This led to a steep recession in 1981-1982, with the unemployment rate peaking at just under 11.0 percent.
The recession brought down inflation by forcing workers to take pay cuts. With double-digit unemployment, few workers had the bargaining power to secure wage gains that kept pace with inflation. This reduced cost pressure and led to a rapid drop in the inflation rate to a more moderate pace.
It is important to recognize that this is a process involving enormous pain for tens of millions of people. The media have been full of reports of people who have trouble paying for gas and food with the recent rise in prices. In fact, most workers have had pay increases that have roughly kept pace with inflation since the pandemic, with pay for most workers at the bottom end of the wage distribution actually outpacing inflation.
However, if the Fed brings on a serious recession to combat inflation, many of the people in these news stories, who are now struggling to pay for food and gas, will be unemployed, or at least will have endured a stretch of unemployment. (Most spells of unemployment are relatively short.) Those who have jobs will likely not be getting pay increases that keep pace with whatever rate of inflation the economy is seeing at the time. Their ability to demand higher pay from their employer, or to seek a new job, will be severely limited by high unemployment. In other words, the process whereby inflation is brought down, will not be good news for them.
This point is important to keep in mind. There is not a simple and painless way to bring down the inflation rate through interest rate hikes by the Fed. It is not just a matter of turning down the thermostat a few notches. The rate hike put in place in March, coupled with a commitment to further hikes over the course of the year, has cooled down the housing market in a way that was necessary. It will also have a modest impact in slowing inflation in other sectors.
But the sort of rate hikes put in place by the Volcker Fed at the start of the 1980s would, at least in the short-term, make life far worse for the bulk of the population, even if there may be longer term benefits in the form of a lower and stable inflation rate. Everyone should be very clear on this point.
The Pandemic and the War Created Inflation and There Is No Simple Way to Bring it Down
The main points here are that the rise in the inflation rate as the economy reopened from the pandemic was overwhelmingly the result of inherent problems with reopening, and now disruptions created by the war in Ukraine. We can see this by virtue of the fact that most of Europe is now seeing comparable inflation rates. The stimulus provided by the Biden administration undoubtedly increased the inflation rate somewhat, but we would still be seeing uncomfortably high rates of inflation, along with higher unemployment, even without this stimulus.
There are reasons for thinking that the inflation rate will slow sharply as supply chain problems get resolved. We have already seen this sort of price reversal with some items, most notably televisions, where a sharp price last summer has been completely reversed in the last seven months. While the Biden administration can try to help in working through supply chain bottlenecks, there is no simple way to resolve this problem.
There is also no happy alternative path to lowering inflation. The route pursued by the Fed under Volcker subjected tens of millions of workers to unemployment. The mechanism was to undermine workers’ bargaining power, so that they would be forced to take real wage cuts. If people are struggling now to pay for gas and milk, their situation will not be improved if they lose their jobs and/or get lower real wages when they are working.
[1] FWIW, it seems unlikely that much Russian oil would be removed from world markets. Even if European countries join the United States in boycotting Russian oil, it would most likely be sold to other countries, most importantly India and China. The net effect on world supplies is likely to be limited.
[2] It is worth noting that demand for cars and other big-ticket items is to some extent self-limiting. People who bought a car or refrigerator in 2020 or 2021 are unlikely to buy another one in 2022.
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