The US is heading into a new era of elevated inflation that’s likely to persist long after the red-hot prices of the past year or so come off the boil.
Deep-seated trends in trade and demographics helped keep inflation in a comfort zone for decades, but both are now pushing in the opposite direction. Globalization was fraying even before pandemic and war made things worse. Growth in the world’s labor force has slowed.
Then there’s the looming cost of transition to net-zero carbon emissions -- likely to push all kinds of prices higher in the years ahead -– and the prospect of a sustained run-up in rents due to America’s dearth of affordable housing.
It all adds up to a changed landscape. Yes, inflation probably will retreat from near four-decade highs, as supply-chain snafus unwind and economic growth slows in response to interest-rate increases by the Federal Reserve. But it may prove stubbornly higher than the 1.5%-to-2% range that American consumers, businesses and investors grew accustomed to before the pandemic spike.
“The long era of low inflation, suppressed volatility, and easy financial conditions is ending,” said Mark Carney, who ran the central banks of Canada and the U.K. The economics of the coming period will be “more challenging,” he said.
In this new environment, borrowers from homebuyers to the US Treasury will have to pay more. There’ll be fewer jobs for workers, as the Fed puts a squeeze on labor markets -- and more risks for investors, who’ll have to factor in a central bank more preoccupied with cooling inflation than promoting economic growth. Politicians may see more pushback against their spending plans, and they’ll face voters increasingly unhappy about rising costs of living.
‘Old Testament Mode’
Fed officials have hinted that they see lasting shifts ahead.
Chair Jerome Powell said last month that globalization has slowed down -- and that if goes into reverse, “it would be a different world.” Richmond Fed chief Tom Barkin cited the potential for “more medium-term inflationary pressure” that the central bank will have to take into account as it strives to hit its 2% target.
Where inflation ultimately settles will largely depend on what the Fed -– and the American public –- are willing to tolerate.
The late Paul Volcker showed in the 1970s that the Fed has the tools to rein in inflation, but at a high cost. To break the back of double-digit price gains, he drove the economy into a deep recession and pushed unemployment above 10%.
“If you ask me where inflation is going to be in the next 10 years, I’m going to tell you it depends centrally on what the Fed’s preferences are,” said JPMorgan Chase & Co. chief economist Bruce Kasman. “And the Fed’s preferences have to do with societal preferences.”
Kasman reckons that Powell & Co. would be comfortable with inflation landing in a “sweet spot” around 2.5%.
Anything much higher, he said, would likely tip the Fed into “Old Testament mode.” Out would go the forgiving approach to missed inflation targets -- to be replaced by “a vengeful central bank that starts to smite us.” In that scenario, recession risks would rise significantly.
Following are some of the long-run inflationary forces that the Fed will have to contend with:
Almost 20 years ago, at the Fed’s Jackson Hole symposium, Harvard University professor Kenneth Rogoff pointed out that the removal of trade barriers was helping to deliver lower inflation worldwide. Now Rogoff worries that’s going into reverse, under pressure from a hot war in Ukraine and a Cold War-style contest between the US and China.
It started with the tariffs President Donald Trump imposed on China. They added about a quarter of a percentage point to US inflation in 2018, analysts at the Peterson Institute for International Economics estimate.
Since then, both the pandemic and Russia’s invasion of its neighbor have accelerated efforts by governments and multinational firms to make their supplies –- whether personal protective equipment or microchips -- more secure. Which likely means more costly.
That’s a big deal. Before last year’s pandemic-driven surge, US consumer prices for goods (not counting food and energy) were basically unchanged since China entered the World Trade Organization some 20 years earlier. What inflation there was largely came from services, where prices were rising at an annual rate of about 2.7% over the period.
If waning globalization means that goods prices are now set to rise by 1% to 2% a year, as Moody’s Analytics chief economist Mark Zandi expects, then service-price inflation will have to come down if the Fed wants to meet its 2% target. That might mean crunching a sector of the economy that employs the vast majority of American workers.
Where Are the Workers?
In the period encompassing the collapse of the Soviet bloc and China’s arrival in the WTO, more than three-quarters of a billion low-paid workers joined the labor force of the globalized economy.
That’s credited with helping to suppress inflation by keeping manufacturing costs down. But the process may have already played out. China’s labor force has peaked, after expanding by 10% from 2000 to 2020, according to the World Bank. There’s no comparable pool of untapped workers out there.
Demographics in the US, too, herald more inflationary pressure.
In part due to Covid-19, population growth last year was the slowest since the nation was founded in 1776. And the ongoing retirement of the baby boom generation, coupled with tighter curbs on immigration, is limiting the number of Americans available for companies to hire -– which could push up wages for those who are. Unit labor costs posted their largest annual increase since 1982 in the first quarter of this year.
“You have labor markets that are demographically constrained,” said Jonas Prising, chief executive officer of ManpowerGroup Inc., a staffing company. “Workers have a much better bargaining position.”
Even ardent supporters of a “greener” world -- like Carney -– acknowledge that getting there will be costly.
In a March speech, Carney likened the necessary changes to those that followed the twin oil shocks of the 1970s -- which rendered swathes of the economy uncompetitive, and fueled the inflationary surge that Volcker had to tame. One difference: The transition to net zero can be spread over a longer period, giving companies more time to adapt.
The BlackRock Investment Institute estimates consumer prices could rise by as much as 4% a decade from now if the transition costs are fully passed on to households.
“You’re going to have to retrofit your factories. You’re going to have to swap out your equipment. That’s going to cost you,” said Dana Peterson, chief economist for the Conference Board. “And who’s going to pay for that? The customer.”
European Central Bank Executive Board member Isabel Schnabel points to the risk that costs of energy, and key materials such as the lithium used in batteries, could remain elevated. “There’s a more persistent or more structural component to these energy-price shocks,” she said this month in Bloomberg’s Stephanomics podcast.
While the US housing market will get hit in the short-run by a Fed-driven rise in mortgage rates, many economists still think it will put upward pressure on inflation over the next decade. That’s because elevated demand from aging millennials is running up against constrained supply.
The housing bust a dozen years ago drove some smaller home-builders out of business, leading to a shortfall of supply that Zandi estimates is on the order of 1.5 million to 2 million homes –- and which will take years to clear.
“Given the shortages in the housing market, it’s going to be very difficult to get rents down,” Zandi said. “That’s going to be a persistent problem for the Fed.”
One thing that could help the Fed out of its inflation difficulties would be if the US economy can achieve faster productivity growth.
That would allow companies to meet higher costs for labor or materials without having to raise prices to maintain their profits. It’s what happened in the late 1990s as the internet took off, after a series of Fed rate increases kept inflation at bay.
There are some grounds for optimism. Business spending on equipment surged at an annualized pace above 15% last quarter, the fastest in over a year. Manpower’s Prising said he expects companies to forge ahead with a digital transformation turbocharged by the pandemic, which is enabling them to “do more with less” -- pretty much the definition of higher productivity.
That would be a welcome change –- but likely not enough to offset all the others in store.
“Large structural forces pushed inflation down for the last 40 years,” former Fed Governor Kevin Warsh said. “Those structural forces are now reversing.”