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Is U.S. inflation here to stay?

Ron Leven
Ron Leven
Professor of Economics at Duke University

U.S. inflation is currently running at 4 percent. What are the factors behind this increase and how long will the world’s largest economy need to tackle threats arising from rising prices?

  1. Following fiscal stimulus and money easing in the U.S., inflation has surged to 4 percent.
  2. The Federal Reserve has not yet taken action to stem the flow by either tapering bond purchases or raising interest rates. And hikes in interest rates are believed to be some way off being made.
  3. Refinitiv Eikon data explores the catalysts for the inflation rise and analyses the prospects for inflation to stay at high levels or subside as the temporary factors recede.

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Last January’s Market Voice considered whether the prospect of massive fiscal stimulus coupled with aggressive monetary ease would result in a significant increase in U.S. inflation.

We zeroed-in on two conditions that were traditional backdrops to high and rising inflation. The first is tight labour markets, as characterised by a combination of an unemployment rate below 6 percent and 12-month average payroll gains above 175,000. The second is constraints on production indicated by capacity utilisation above 75 percent.

At the time of the January article, payroll gains were averaging well above the key level but both unemployment and capacity utilisation were still not at critical levels. And so while we saw potential for higher inflation, we did not think it would materialise quite so quickly – it was expected to be next year’s problem. Indeed, as shown in Figure 1, 12-month average capacity utilisation is just now hitting the key 75 percent level.

Historical tracking with capacity does support some firming in core inflation but the recent surge to a multi-decade 4 percent year-over-year rate is literally off the chart.

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Figure 1: Capacity utilisation and core CPI inflation

Capacity utilisation and core CPI inflation
Source: Eikon

Fed ponders impact of inflation surge

Perhaps reflecting the misalignment of inflation with ample production capacity and unemployment still above pre-pandemic levels, the Fed has yet to react to the inflationary surge. While reducing bond market purchases is under consideration, the Fed has yet to take any action on tapering and rate hikes are seemingly still well off in the future.

The other major central banks are also apparently in no hurry to raise rates. Figure 2 shows what the repo rate yield curve implies for the path of 3-month borrowing rates over the next four years.

While the BoE is priced to raise rates before year end, the market is heeding the signals from the Fed and is not pricing hikes by it or the other central banks until the second half of next year.

Expectations for overall hikes are also quite modest. 3-month rates are not priced to move significantly above 2 percent in any of these markets – e.g. well below the current rate of inflation – and, except in the United States, easier conditions are expected to return by early 2023.

U.S. rates are a modest outlier as they are priced to remain close to 2 percent into the middle of the decade suggesting still modest but more persistent inflation.

Figure 2: Yield-curve implied future 3-month repo borrowing rates

Yield-curve implied future 3-month repo borrowing rates
Source: Eikon

How “temporary” factors are the inflation drivers

The relatively benign outlook priced in for interest rates suggests the market believes the Fed’s view that the recent inflation surge reflects temporary structural impediments that will fade with time.

The consensus is the structural problems stem from the following unusual conditions in the economy:

  • Workers are showing reluctance to re-enter the job market, creating a shortage of labour and this is putting upward pressure on wages, which is feeding through to higher prices.
  • The COVID-19 pandemic caused a shift in consumer patterns, resulting in severe shortages in some goods markets.
  • Logistic constraints are preventing producers from reversing production cuts instituted early in the pandemic. This causing bottlenecks in global supply chains – especially transportation and warehousing.

We think it is worthwhile to present data demonstrating the validity of each of these potential sources of inflation and, more importantly, find early indicators that the pressures for higher prices are abating.

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Labour finally getting its due?

Figure 3 shows the 1-year moving average unemployment rate (note the scale is inverted so a rising line is a falling rate) and the y-o-y rise in labour costs.

While unemployment is declining, it is lagging the economic recovery: real GDP is back at pre-pandemic levels, but unemployment is still well above pre-pandemic levels.

There are several potential explanations for the lag in employment gains, in particular, concerns about COVID-19, a` lack of child care, and shifts in in the type of workers in demand.

One of the key inflation conundrums is the acceleration of wage gains despite unemployment of 4.8 percent, roughly one percent point above pre-pandemic levels.

Figure 3 highlights an earlier version of this conundrum. Prior to the pandemic, wage gains remained marginal even as unemployment dropped to record lows. Based on longer-term tracking, the recent wage gains are roughly in line with employment conditions.

Moreover, nominal wage gains have lagged the inflation surge, which justifies sustained upward pressure on nominal wages.

While some of the wage gains may reflect the structural factors slowing labour re-entering the job market, we think the long-term dynamics in Figure 3 suggest upward pressure on wages (and hence inflation) has the potential to persist even if the impediments to labour re-entering the work force fades.

This is particularly true if Congress passes an aggressive fiscal spending package which would undoubtedly help maintain tightness in labour markets.

Figure 3: Employment cost trend and unemployment rate

Employment cost trend and unemployment rate
Source: Eikon

The wrong goods in the wrong place and not enough of them

Figure 4 indicates several of the structural problems facing the U.S. real goods economy that are sources of inflationary pressure.

The ratio of consumer durable purchases to overall inventories is at record levels and is a clear indicator of the shortages that are plaguing the economy.

Consumers forced to isolate at home during the pandemic shifted spending away from services – especially restaurants, entertainment and travel – and increased purchases of manufactures – especially related to home improvement.

The result was the surge in demand for consumer durables.

Unfortunately, the uncertainty of economic prospects in the early stages of the pandemic incentivised producers to cut back on inventory. Consequently, there was little supply of goods on hand as demand soared.

A decline in the durable goods spending versus inventories back towards normal levels would be a useful indicator that the imbalances contributing to price pressures are moderating. But these data are only available with roughly a six-month lag.

Figure 4: Structural mismatches in the U.S. economy

Structural mis-matches in the U.S. economy
Source: Eikon

One would expect that firms scrambling to rebuild inventories would lead to a surge in U.S. imports, however, as is also shown in Figure 4 the level of imports relative to GDP remains near the lows of the past decade.

Global supply chain disruptions are one of the clearest structural problems generated by pandemic.

Early in the pandemic, producers across the globe faced the same bleak outlook as U.S. firms, so massive inventory drawdown occurred in every market. Foreign producers are not positioned to quickly respond to the U.S. surging demand for manufactures. And COVID-19 is still raging in many countries, inhibiting efforts to increase hiring and ramp-up production.

Even when goods make it into the supply chain, limitations at port facilities and warehousing is creating bottlenecks, preventing timely delivery. Indeed, just last week President Biden committed to getting the Long Beach, California port operating on a 24-hour basis to get goods delivered to the U.S. market more quickly.

However, the shortage of labour noted above has created limitations on trucking and warehousing capacity, so it is unclear that increasing port operating times will have much impact on the throughput of goods.

Despite the focus on Long Beach, the Eikon Shipping App indicates the Houston/Galveston port in Texas, is the most congested U.S. port (and number five globally). Figure 5 is a snapshot taken from the Eikon Interactive Map App that provides updates of the global locations of ships (Note, this app also provides detailed information on mining activity and energy production).

The more macro view on the right indicates there are a total of 2,321 ships in the vicinity of this port. The more detailed map on the left shows the specific locations of container, tanker and bulk cargo ships (the other ships are too numerous to be included). The ships shown as squares are at anchor so implicitly are waiting for an open berth.

This app is updated roughly every 10 minutes, so signs that the backup of ships at anchor is moderating could serve as an early indicator that the supply chain is normalising.

Figure 5: Shipping traffic at the Houston Galveston Port

Shipping traffic at the Houston Galveston Port
Blue = Container; Orange & Yellow = Tankers; Green = Bulk (mostly mineral ore); Pink = other. Source: Eikon

Inflation will be an enduring theme

The shortage of inventories and port backups are evidence that pricing pressures do reflect structural problems that will fade over time. But the shortage of inventories is so extreme relative to demand that it is likely months – and maybe years – before supply conditions normalise.

The first stage in normalisation will probably be a reduction in the backup at port facilities, so it is important to keep tabs on this via the Interactive Map. But even as port operations normalise it will still take many months for inventories to get back to historical norms.

We are also concerned the market is suffering from myopia on the relationship between wages and economic activity.

The stability of wages as the economy recovered from the financial crisis over the past decade was an anomaly from a longer-term historical perspective. Indeed, the gains in wages over the past year are closer to the historical norm of the relationship to levels of employment.

There is clear risk that the rise in wages is more than just a “structural” problem and, again, this is particularly true if Congress passes an aggressive fiscal package.

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