Bloomberg — The United States is entering a new era of high inflation that is likely to linger long after last year’s red-hot prices cool off.
Deep-seated trends in trade and demographics helped keep inflation in a comfort zone for decades, but now the two are pulling in the opposite direction. Globalization was weakening even before the Covid-19 pandemic and war made things worse. The growth of the global workforce has slowed.
In addition, there is the looming cost of the transition to net-zero carbon emissions (which will likely drive all sorts of prices higher for years to come) and the prospect of sustained rent growth due to America’s affordable housing shortage. .
All this translates into a changing landscape. Yes, Inflation is likely to retrace from near four-decade highs, as supply chain issues are ironed out and economic growth slows in response to Federal Reserve interest rate hikes. But inflation may still be higher than the 1.5% to 2% range that American consumers, businesses and investors were used to before the pandemic.
“The long era of low inflation, contained volatility and easy financial conditions is ending,” said Mark Carney, who headed the Canadian and UK central banks.
In this new environment, borrowers, from homebuyers to the US Treasury, will have to pay more. There will be fewer jobs for workers as the Federal Reserve tightens labor markets, and more risks for investors to reckon with a central bank more concerned with cooling inflation than promoting economic growth. Politicians may see further pushback in their spending plans and will face voters increasingly unhappy with rising costs of living.
“Mode to the Old Testament”
Fed officials have hinted that they see lasting changes ahead.
President Jerome Powell said last month that globalization has slowed down and that if it went into reverse, “it would be a different world.” Richmond Fed chief Tom Barkin cited the potential for “more inflationary pressure in the medium term” that the central bank will need to take into account as it pushes to hit its 2% target.
Where inflation ultimately settles will largely depend on what the Fed, and the American public, are willing to put up with.
The late Paul Volcker demonstrated in the 1970s that the Federal Reserve has the tools to curb inflation, but at a high cost. To curb double-digit price increases, he pushed 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 that it depends centrally on what the Fed’s preferences are,” said the chief economist at JPMorgan Chase & Co. (JPM)Bruce Kasman. “And the preferences of the Fed have to do with the preferences of society.”
Kasman estimates that Powell and company would be comfortable with inflation landing in a “sweet spot” of around 2.5%.
Anything much higher, he said, would likely throw the Fed into “Old Testament mode.” The lenient approach to unfulfilled inflation targets would end, to be replaced by “a vindictive central bank that begins to punish us.” In that scenario, the risks of recession would increase significantly.
The following are some of the long-term inflationary forces the Fed will have to deal with:
Nearly 20 years ago, at the Jackson Hole Fed symposium, Harvard University professor Kenneth Rogoff noted that the removal of trade barriers was helping to reduce inflation around the world. Now Rogoff worries that that is being reversed, under the pressure of a war in Ukraine and a Cold War-style feud between the United States and China.
It all started with the tariffs that President Donald Trump imposed on China. They added about a quarter of a percentage point to US inflation in 2018, as estimated by analysts at the Peterson Institute for International Economics.
Since then, both the pandemic and Russia’s invasion of its neighbor have accelerated efforts by governments and multinational companies to make their supplies, whether personal protective equipment or microchips, more secure. Which probably means they are more expensive.
That’s a big problem. Before last year’s wave of the pandemic, US consumer goods prices (excluding food and energy) had been virtually unchanged since China entered the World Trade Organization some 20 years earlier. . Inflation came largely from services, whose prices increased at an annual rate of about 2.7% during that period.
If the slowdown in globalization means that goods prices will now rise by 1% to 2% a year, as Moody’s Analytics Chief Economist Mark Zandi expects, services price inflation will have to come down if the Fed wants to meet its 2% target. That could mean crushing a sector of the economy that employs the vast majority of American workers.
Where are the workers?
In the period between the collapse of the Soviet bloc and China’s entry into the World Trade Organization (WTO), more than three-quarters of a billion low-paid workers entered the labor force of the globalized economy.
That is credited with helping to suppress inflation by keeping manufacturing costs down. But the process may already be over. China’s workforce has peaked, after expanding 10% between 2000 and 2020, according to the World Bank. There is no comparable group of untapped workers.
The demographics in the US also herald greater inflationary pressure.
In part due to Covid-19, last year’s population growth was the slowest since the nation’s founding in 1776. In addition, the retirement of the baby boomer generation, along with the tightening of immigration restrictions, is limiting the number of Americans available for companies to hire, which could drive up wages for those who are. Unit labor costs recorded their largest annual increase since 1982 in the first quarter of this year.
“There are job markets that are demographically constrained,” said Jonas Prising, CEO of ManpowerGroup Inc. (MAN), a staffing firm. “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 speech delivered in March, Carney he compared the necessary changes to those that followed the two oil shocks of the 1970s, which left much of the economy uncompetitive and fueled the surge in inflation that Volcker had to control. One difference: The transition to net zero can be spread over a longer period, giving companies more time to adjust.
The BlackRock Investment Institute estimates that consumer prices could rise as much as 4% within a decade if transition costs shift entirely to households.
“They are going to have to adapt their factories. They’re going to have to change their teams. That’s going to cost,” said Dana Peterson, chief economist at the Conference Board. “And who is going to pay for it? The client”.
Isabel Schnabel, a member of the Executive Board of the European Central Bank, points to the risk that the costs of energy and key materials, such as lithium used in batteries, could remain high. “There’s a more persistent or more structural component to these energy price shocks,” she said this month on Bloomberg’s Stephanomics podcast.
Although the US housing market will be hit in the short term by a Fed-driven increase in mortgage rates, many economists still believe it will put upward pressure on inflation over the next decade. This is because high demand from aging millennials is facing limited supply.
The housing crisis a dozen years ago forced some small builders out of business, leading to a supply shortfall that Zandi says is on the order of 1.5 million to 2 million homes, and will take years to fix.
“Given the shortage in the housing market, it will be very difficult to lower rents,” Zandi said. “That is going to be a persistent problem for the Fed.”
One thing that could help the Fed out of its difficulties with inflation would be for the US economy to achieve faster productivity growth.
That would allow companies to cover higher costs for labor or materials without having to raise prices to keep their profits. It’s what happened in the late 1990s when the internet took off, after a series of Federal Reserve rate hikes kept inflation at bay.
There are some reasons for optimism. Business spending on equipment rose at an annualized rate of more than 15% last quarter, the fastest in more than a year. Manpower’s Prising said he hopes companies will push ahead with a digital transformation accelerated by the pandemic, allowing them to “do more with less,” roughly the definition of higher productivity.
That would be a welcome change, but it probably won’t be enough to make up for all the others to come.
“Large structural forces have pushed inflation down for the last 40 years,” said former Fed Governor Kevin Warsh. “Those structural forces are now being reversed.”
With the assistance of Simon Kennedy and Brendan Murray.