Nov 11, 2021
The October Consumer Price Index data has gotten the inflation hawks into a frenzy. And, there is no doubt it is bad news. The overall index was up 0.9 percent in the month, while the core index, which excludes food and energy, rose by 0.6 percent. Over the last year, they are up 6.2 percent and 4.6 percent, respectively. This eats into purchasing power, leaving people able to buy less with their paychecks or Social Security benefits.
While the stretch of high inflation has gone on much longer than many of us anticipated, there are still good reasons for thinking that inflation will slow sharply in the months ahead.
There is no argument about what the numbers show, but the key questions are what caused this rise in inflation and what can be done to bring it down. There are four important points to recognize:
- Inflation has risen sharply in many wealthy countries, so this isn't something that can be laid entirely on the policies of the Trump and Biden administrations.
- There are good reasons for believing that many of the factors driving this inflation are temporary and will be reversed in the not too distant future.
- Conventional remedies for inflation, like raising interest rates to increase unemployment, and thereby putting downward pressure on wages, are likely to prove counterproductive; and
- Many people have seen increases in wages and benefits that far outweigh the impact of higher prices.
Inflation Has Risen Sharply in Many Countries, not Just the United States
On the first point, most wealthy countries have seen a substantial increase in their inflation rate in the last year, even if the current pace may not be as high as in the United States. The OECD puts Canada's inflation rate at 4.4 percent over the last year. In Norway and Germany, the inflation rate was 4.1 percent. Some countries do have lower inflation rates. In France, the inflation rate over the last year was 2.6 percent, in Italy 2.5 percent, and in Japan, the debt king of the world, just 0.2 percent. (These data only run through September, a period in which the inflation rate for the U.S. was 5.3 percent over the prior year.)
While there are differences in inflation rates across countries, the sharp increases in places like Canada, and especially European countries like Norway and Germany, can't be blamed in any plausible way on U.S. policies to get through and recover from the pandemic. There is also no clear relationship between the size of the rescue and recovery packages and current inflation. For example, the size of the packages in France and Japan were considerably larger than the packages put in place in Germany, yet both countries have considerably lower inflation.
The Case for This Inflation Being Temporary
In many of the areas seeing the sharpest price increases, the inflation is clearly due to factors associated with the pandemic and the reopening of the economy which are not likely to persist long into the future. The most obvious example here is new and used vehicles, the prices of which have risen over the last year by 9.8 percent and 26.4 percent, respectively.
These two sectors, which added more than 1.2 percentage points to the overall inflation rate over the last year, have seen sharp rises in prices due to production snags associated with a worldwide shortage of semiconductors. The latter shortage in turn results from a major semiconductor producer in Japan being temporarily sidelined by a fire. This supply reduction coincided with a big upturn in worldwide demand. Because of the pandemic, consumers in the United States and other countries shifted their consumption from services, like restaurants and movies, to goods like cars, television sets, and smartphones.
This surge in demand for goods created the backlog of containers and container ships that we are now seeing at major ports. However, we will likely work through this backlog, both because supply issues will eventually be resolved as companies arrange to hire more truck drivers and trucks, and because demand for goods will wane for the simple reason that people don't make these purchases every month. If someone bought a car in May of 2021, they are not likely to buy another one in May of 2022.
It is not hard to find an example of this sort of price reversal. Television prices rose by 10.2 percent in the five months from March to August, a 26.3 percent annual rate of increase. In the last two months, they have fallen by 2.8 percent.
We can see similar stories in other areas. The price of a bushel of corn rose by more than 100 percent from its low in August of 2020 to its high in May of this year. It has since fallen back by almost 20 percent, to a price that is well below what we were seeing back in 2013. Lumber is an even more striking case. The price more than quadrupled from its low point in April of 2020 to its peak in May of this year. It has now fallen back by more than 50 percent to a price that is about 10 percent higher than a peak hit in June of 2018.
It's not easy to determine how quickly supply chain issues will be resolved, but when they are, we are likely to see the price of a wide range of goods, starting with cars and trucks, reverse itself and start falling. This will be true not only for consumer goods but many intermediate goods that have been in short supply in recent months. The end of the backlogs is also likely to mean a reversal in shipping costs, which have risen by 11.2 percent in the last year, adding to the price of a wide range of products.
It is also worth noting some prices that have not risen much. The cost of medical care has risen by just 1.3 percent over the last year. The cost of college tuition is up 1.8 percent. Inflation in these former problem sectors has remained well under control through the pandemic and recovery.
Finally, it is worth mentioning the situation with rent, which accounts for almost a third of the overall CPI. We are seeing a sharp divergence in rental inflation across cities. The rent proper index was up 1.5 percent year-over-year in Boston and Los Angeles, 1.7 percent in Seattle and 0.2 percent in NYC. It was down 0.3 percent in Washington, DC and 0.4 percent in San Francisco over the last year. By contrast, it is up 6.3 percent in Detroit and 7.5 percent in Atlanta. This is consistent with people moving from high-priced cities to lower-priced ones.
The low rental inflation, or falling rents, in high-priced metro areas is obviously good news for renters there. However, the rising rents in previously low-priced areas are bad news for prior residents who may be looking at large rent increases. Even with 6.3 percent rental inflation, rents will still look cheap in Detroit for someone moving from Boston or New York.
It's also important to remember that almost two-thirds of households are homeowners (only 44 percent for Blacks and 48 percent for Hispanics). For people who own their home, higher implicit rents are not a problem, and if the sale price goes up, as it has been doing, this is good news.
Anyhow, we may see some further increases in rental inflation in the months ahead. We have seen a large rise in home sales prices since the pandemic, which has far exceeded the rise in rents. The vacancy rate has also fallen somewhat, although the pace of new construction did pick up sharply, which should help to lower rents over time.
Will Slamming on the Brakes Cure Inflation?
The standard remedy for inflation is to deliberately slow the economy with higher interest rates from the Fed and possibly cuts in government spending and/or tax increases. The idea is that by slowing the economy and throwing people out of work, we can put downward pressure on wages, which will then mean lower prices.
There is no doubt that if we force workers to take large enough pay cuts, it will alleviate inflationary pressures, but this is a rather perverse way to accomplish the goal. With low interest rates and high demand, companies have large incentives to innovate to get around bottlenecks. It's much better to allow the economy to work its way through a stretch of high inflation in ways that could lead to lasting productivity gains than to squeeze workers so as to alleviate cost pressures.
It's also worth noting that many of the proposals being put forward by the Biden administration will help to alleviate inflationary pressures in both the long term and the short term. In the latter category, universal pre-K and increased access to childcare will make it easier for many parents, primarily women, to enter the labor force or to work more hours.
In the longer-term category, increased access to broadband and improving our transportation infrastructure will increase our capacity in many areas. Also, money spent to protect against the effects of climate change will reduce the disruptions caused by extreme weather events in the future.
This is a much more promising path for dealing with inflation than forcing workers to take pay cuts.
Keeping Score on Inflation
There have been several pieces in major news outlets in the last week telling people how inflation has been devastating for low- and moderate-income families. While it is undoubtedly hard for many families to pay more for food and other necessities, it is important to keep an eye on the income side of the equation.
In the case of families who have children, the vast majority are receiving the expanded child tax credit. Before the American Recovery Act (ARA), the credit was $2,000, but only partially refundable. This meant that many low- and moderate-income families only received $1,400 per child. Under the ARA, these families are receiving $3,000 per child and $3,600 for every child under the age of six. This is a big gain in income for a family with an income of $20,000 or $30,000. (There are families that don't get the credit. This includes undocumented workers who are not eligible and others who are excluded because of bureaucratic obstacles. These are important issues, but unrelated to the problem of inflation.)
There also have been sharp increases in wages for workers at the bottom end of the pay ladder. Restaurant workers have seen their pay rise by $1.84 an hour over the last year. This would come to an increase of $3,680 for a full-year, full-time worker.
These increases in income would dwarf the rise in food costs that have featured prominently in news accounts on inflation. The Bureau of Labor Statistics puts the weight of food in a household's budget at 7.4 percent. Suppose we double this for moderate-income families and make it 15 percent. For a family that spends $30,000 a year, that comes to $4,500 a year. If we apply the estimated 4.5 percent rate of food inflation over the last year, the higher prices will take a bit more than $200 out of this family's pockets.
That is less than 10 percent of the pay increases that we expect low-paid workers to be receiving or the gains from the child tax credit for families with kids. If we're going to talk about the well-being of these families it is incredibly irresponsible to only talk about the spending side of the ledger and ignore the income side.
Conclusion: Team Transitory Is Not Throwing in the Towel
While the stretch of high inflation has gone on much longer than many of us anticipated, there are still good reasons for thinking that inflation will slow sharply in the months ahead. We have seen the prices of many items, like television sets and lumber, reverse and fall sharply after prior run-ups. It is likely that many other items, like cars and meat, will be in this category in the near future.
For what it's worth, it seems that financial markets also agree with this assessment. The interest rate on 10-year Treasury bonds is only 1.56 percent, well below the pre-pandemic level. That is not consistent with a story where markets expect 4 or 5 percent inflation in coming years.
Also, contrary to gloom and doom predictions, the dollar has been rising in value against the euro and other currencies. That is also not consistent with a belief that the U.S. is facing a wage-price spiral.
Financial markets can be wrong, as those of us who predicted the collapse of the stock and housing bubbles know well. But for now at least, they seem to be in agreement with the analysis from Team Transitory.
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