Today’s inflation puzzle

Global inflation is trending upward. The war in Ukraine has amplified existing supply and demand imbalances originally brought about by the Covid-19 pandemic. The shock from volatile commodities markets comes at a time of already elevated inflation.

What’s curious about this particular bout of inflation is that it’s running at much higher levels relative to current growth and employment measures. The last time US core inflation ran above 6% with the unemployment rate below 4%, as it’s now, was in the 1970s, ahead of a decade lost to stagflation. Chart 1 illustrates this using the Phillips curve.

Source: aRI, Haver Analytics, April 2022.

There are several reasons behind this puzzle of higher inflation relative to current slack. These include:

• The labour market might be much tighter than it seems based on a simple measure of unemployment rates
• Supply bottlenecks may have temporarily steepened the Phillips curve or pushed the economy to a steeper part of the curve
• Inflation expectations may have started shifting higher

The third point is the most challenging. If the Phillips curve starts shifting up, as it did during the inflationary period of the 1970s.

Lessons from the swinging ‘60s and stagflationary ‘70s

The Phillips curve, which we plotted for the US in Chart 1, is meant to illustrate an inverse relationship between unemployment and nominal wage or price growth.

When unemployment is high, supply outstrips demand for labour, goods and services. Wage and prices start to fall in response to the excess supply. This results in a negatively sloped curve, which characterizes the relationship between inflation and unemployment.

In the late 1960s, US Federal Reserve (Fed) policy remained loose despite the backdrop of rising inflation, as the central bank prioritised growth and employment over inflation risks. In doing so, it overlooked the economy’s supply constraints. By assuming a long-run trade-off between growth and inflation, the Fed underestimated the impact excessively loose policy could have on inflation in the form of higher inflation expectations. This oversight came back to haunt it in the next decade.

By the 1970s, a combination of these policy errors and oil shocks caused inflation expectations to become unanchored. These rising inflation expectations triggered behavior changes and a wage-price spiral. This is what the Fed is trying to avoid in the current environment.

How can central banks respond?

Analysing the nature of the recent change in the relationship between inflation, wages and employment is central to engineering a soft landing, which the Fed failed to do in the 1970s. There are two key questions that will determine the outlook for the economy and investors:

1. How much policy tightening will be required to tame inflation?
2. How much growth will need to be sacrificed in order to achieve price stability?

From here on out, central bank credibility is going to be critical to both the policy and macroeconomic outlook. Inflation expectations have been well anchored for most of the past two decades following central bank independence and the introduction of inflation targeting frameworks across developed and emerging economies.

Once medium-term expectations shift higher, and a wage-price inflationary spiral takes hold, it will be much harder for policymakers to control inflation. The cost in terms of growth and jobs lost will be much greater under these conditions.

The evidence so far suggests that medium-term inflation expectations remain stable. Currently, five-year inflation expectations are 3%¹ — lower than the current spike in inflation and much lower than in the 1970s. However, the window of opportunity to engineer a soft landing may be quite narrow.

The longer inflation remains elevated, the greater the chance of expectations becoming unanchored. Central banks may be wise to prioritise inflation over growth and risk a shorter recession, rather than losing another decade to stagflation. 

If policymakers don’t act swiftly or aggressively enough, there’s a risk that inflation expectations could come unanchored.

Labour market mismeasurement?

It’s also possible that consensus estimations of labour market tightness are too modest. In the wake of the pandemic, labour market supply and demand signals have diverged in some countries. In the US, demand-side employment measures, such as vacancies and quit rates, have also shifted relative to the unemployment rate. This implies a tighter labour market in the US than the unemployment rate suggests.

Source: Domash and Summers (2022) “How tight are US labour markets?”

While elevated vacancy and quit rates imply a tighter labour market, employment levels remain well below pre-pandemic trends. Decomposing this shortfall shows a significant shift in labour market dynamics during the pandemic, some temporary, some more permanent and structural.

Structural demographic changes account for an estimated 1.3 million workers dropping out of the labour market altogether. Health fears continue to deter immunocompromised workers, while long-term Covid-19 symptoms limit return to work for some individuals. Vaccine mandates are estimated to limit just 0.4 million workers. These Covid-19-related health fears will likely persist for many months to come, but as societies move from pandemic to endemic, some of these workers are likely to return.

Immigration growth effectively dropped to zero during the pandemic. Now, backlogs in the US legal immigration system will most likely continue to suppress migration flows, limiting the boost from foreign workers for the rest of the year.

The “reservation wage,” or minimum wage required to entice workers back into the labour force, may have risen for several reasons:

• Greater personal savings – during the pandemic, trends toward higher savings took off as people stayed in amid Covid-19 lockdowns. Net wealth across developed economies has increased and provided a buffer for would-be workers, who now have more choices for their employment options.
• Shifts in work-life preferences – after working from home during the pandemic, many people are rethinking jobs, remote-work options and early retirement, which impacts labour force participation.

It’s worth noting that the increased cost of living thanks to this bout of inflation and greater uncertainty over the economic outlook may lower the reservation wage in the coming months. These factors could also entice more workers back into the labour market.

Pulling all of the different employment signals together suggests that labour market tightness could persist well into 2023 for some economies. So the risk of increases in long-term inflation expectations will remain elevated unless central banks act swiftly to dampen them.

What to watch in the coming months

The impact of the pandemic and the latest commodity shock will work through multiple channels, both temporary/cyclical and structural/longer term. Assessing these will be central to the outlook for growth, inflation and path of policy response. We believe that there are a few key economic factors to watch in the coming months:

• Inflation expectations and central bank credibility – right now, medium-term inflation expectations are 3%, which bodes well for the future. But if those inflation expectations rise, central banks will have to act more aggressively to bring inflation under control. And if central bank credibility comes into question, we risk seeing history repeat itself with an inflationary episode more like what we saw in the 1970s.
• Globalisation and supply chains – supply-chain disruptions have been a hallmark of the pandemic years. And today, supply-chain issues are entwined with globalisation. For example, semiconductor manufacturers in Taiwan have struggled during the pandemic, which, in turn, disrupts the American auto industry that relies on these semiconductors. These global supply-chain issues, which are new relative to historical inflationary episodes, like the 1970s, make short-term inflation look worse than it is. But we expect these problems to shake out over time.
• The state of the labour market – measures of labour force participation, vacancy and quit rates, employment levels alongside the standard unemployment rate can help us assess more comprehensively the degree of labour market tightness.
• Consumer spending indicators – these can help us identify the path of demand-driven inflation pressures. These indicators include changes in high frequency credit and debit card spending data, monthly consumer confidence, changes in the monthly stock of household savings as well as standard monthly retail and consumer spending data.

Thinking about these economic indicators can help inform our outlook and expectations when it comes to inflation. However, while there are longer-term risks to be mindful of, we ultimately believe that if the Fed can keep longer-term inflation expectations at the current level and implement effective policies, this bout of inflation could be contained at the cost of fewer jobs.

¹ Michigan consumer survey, March 2022