Why Inflation May Still Persist

Several contributing factors to inflation may not be addressed by simply raising rates.

By
Samuel Park
Director of Fundamental Research, Pacific Life Fund Advisors
By
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Key Takeaways

  • Inflation may have peaked, but high prices for services have continued.
  • Several factors may be contributing to the “sticky” inflation, including a strong labor market, deglobalization, excess savings and immigration barriers.
  • These inflationary forces may keep inflation running relatively hot for the time being, since interest-rate hikes may not have much impact on them.

Inflation (particularly for goods) may have finally peaked during the summer as supply chains have opened further. However, we have reason to believe inflation may not come down as quickly as the Federal Reserve (Fed) would like, as various factors continue to contribute to the rise in prices. Persistency of inflation has been a major theme of 2022, forcing the Fed to take aggressive measures to counter the problem. As the following chart illustrates, pressure from goods and broken supply chains has been diminishing; however, inflationary pressure from services have persisted.

The Price for Services has Continued to Rise
Source: FactSet as of 10/31/22

One of the sources that has contributed to the rise in inflation in the U.S. stems from the historic amount of government stimulus handed out during the pandemic. According to the Fed, U.S. households accumulated $2.3 trillion in savings between 2020 and 2021. The excess savings led to high levels of spending, which likely contributed to the persistently high inflation amid constrained supply.

Although the level of excess savings has started to dwindle as spending has picked up and fiscal support diminished, the stock of excess savings remained at about $1.7 trillion by mid-2022. This buffer has continued to provide some balance sheet support that will likely keep inflation elevated for some time.

Another key factor that has contributed to the recent inflationary environment stems from the extraordinary strength of the labor force, which has added to the resiliency of the U.S. consumer. Other macro factors such as immigration barriers and deglobalization have also contributed the persistency of inflation.

Flexible vs. Sticky Inflation

Prices in the U.S. have continued to stay elevated. At its recent peak, headline Consumer Price Index (CPI) ran at a 9.0% pace in June. Since then, the rate decelerated down to 7.7% as of October. Falling gasoline prices contributed to the decline. However, other items such as rent and services have continued to accelerate.

The Cost of Rent and Services Continue to Increase
Source: FactSet as of 10/31/22

While items such as energy and food can fluctuate wildly, others tend to change slowly because of the low frequency of their price adjustments. According to the Federal Reserve Bank of Atlanta, CPI can be divided into two broad sets of inflation: flexible and sticky.

Flexible prices, which include gasoline and fresh produce, are affected by cost and availability of raw materials or weather and can change quickly. On the other hand, sticky prices tend to be more stable and include many service-based categories such as shelter, insurance, and other bills. These prices may be established annually, and changing these prices can incur considerable direct and indirect costs, which may deter firms from frequently changing prices.

Because sticky prices change slowly, they tend to incorporate expectations about future inflation. In other words, when consumers and businesses start to anticipate price increases, they can make inflation self-perpetuating.

According to the Atlanta Fed’s study, “[I]nflation is a function of two forces: the inflation expectations of the public and the amount of slack in the economy.” Inflation expectations are key in determining things such as wages and price decisions, whereas slack impacts pricing power of firms and workers.

Since sticky inflation can incorporate inflation expectations, it may be useful when determining the direction of inflation.

Accelerating sticky inflation can be problematic for a Fed trying to get price increases under control. This may indicate that inflation has spread to the broader economy, making it an even bigger problem rather than being transitory. The recent pickup in sticky inflation has forced the Fed to act aggressively with its interest-rate hikes.

"Sticky" Inflation and Fed Funds Target Rate
Source" FactSet as of 10/31/22

Given the current stickiness of inflation, the Fed may feel its job is far from complete. This has the potential for the Fed to overshoot.

Excess Savings

As mentioned, trillions of dollars in stimulus money were created during the pandemic to keep the U.S. economy afloat. Initially, high-income households saved this money by not traveling, not eating at restaurants, and spending normally due to pandemic restrictions. Low- and middle-income families benefitted from abundant government support, as this cash pile provided a buffer to counter higher prices, higher borrowing costs and the threat of an imminent recession. This has allowed many businesses to report strong consumer demand, even as they have been raising prices to pass along rising costs.

This excess savings have not only kept the U.S. economy relatively resilient, but it has also allowed inflation to remain sticky. Households in the top half of the income distribution have continued to hold most of their excess savings. As this group is now able to travel and spend again, their excess savings are likely contributing to higher spending because of pent-up demand.

If the excess savings stood at around $1.7 trillion in June, a burn rate of $100 billion per month would mean consumers’ bank balances could normalize in 17 months. The $100-billion burn rate was extrapolated by assuming that $600 billion of the savings was used up over the first half of 2022. The actual monthly burn rate could vary from this estimate, and it should be taken with grain of salt. Although this is a very rough estimate, it suggests inflation could remain sticky for several more months.

While this money will eventually run out, Americans have continued to spend. Recently, consumption patterns have shifted from goods to services such as airlines and hotels, which have been reporting strong bookings. This shift also benefitted low-wage workers as those in industries such as hospitality, retail, and health care have seen their wages rise faster than inflation.

Labor Shortage Continues

There have been various forces at play in pushing up hourly rates for some positions that traditionally paid minimum wage. In fact, wage growth for the youngest group (ages 16-24) has accelerated much faster than those of other age groups.

Wages Have Risen Faster for the Economy's Youngest Workers
Source: FactSet as of 9/30/22

The relationship between minimum wage and inflation has been widely debated and remains complex. However, there is reason to believe that forces that have lifted lower wages recently may have been impacting prices for consumers.

Labor shortage and the “Great Resignation” have been a new reality that has affected the labor market. According to a Pew Research Center survey, people have left jobs last year mainly due to low wages. Evidence suggests that wage growth has recently been the strongest for low-wage workers.

According to the Economic Policy Institute, more than 25 U.S. states will raise their minimum wages next year. The benefits of raising the minimum wage have been debated for the past decade. Minimum wages may boost low-wage hourly earnings, but it also burdens businesses with additional financial strain. Despite the absence of federal action, many states and cities have been raising their own minimum wages.

In fact, businesses have been so desperate for workers that many have been already paying low-wage staff above the federal minimum wage. In recent years, employers have had to compete to attract staff, which has been particularly true in industries such as leisure and hospitality.

Rising minimum wages will at some point likely lead to layoffs as labor costs rise, but no one is certain when or to what degree that will happen. In the meantime, many employers have been covering the cost of higher wages by raising prices on consumers.

Wage increases have a circular effect. As higher cost of goods and services eventually cause market prices to increase, higher wages will be necessary to compensate the increased prices on consumer goods.

Another reason to believe wage inflation may remain sticky stems from the excess demand for labor relative to the number of unemployed people. Currently, there are nearly two job openings per one unemployed person.

Job Openings Have Soared Since 2020
Source: FactSet as of 10/31/22

Even as pandemic protocols were lifted, many businesses haven’t been able to operate at pre-pandemic capacity. Restaurant service has remained an issue, and employers have been struggling with productivity as they train new workers. Studies have shown that lower productivity leads to higher inflation.

Worker Productivity has Continued to be an Issue
Source: FactSet as of 9/30/22

Immigration Barriers

Since 2020, employers have been short workers, which partly stems from lower immigration and excess retirements. While opening barriers to immigration may be an answer to surging inflation, it hasn’t been a politically palatable option for many years. In short, we have too few workers, which has led employers to raise wages.

Worker shortages have particularly affected industries such as transportation and warehousing as well as accommodation and food services. For instance, a severe shortage of workers in the transportation and warehousing have directly impacted supply chains, which, in turn, has contributed to inflation.

In recent years, the U.S. government has issued fewer visas to adult immigrants than prior years. This has burdened businesses as they have been having a tough time filling vacant jobs. Allowing immigrants to fill some of the vacant jobs would help ease labor shortages and slow down inflation, especially given that services is one of the major contributors to the current inflation rate. However, the immigration situation is unlikely to get resolved anytime soon.

Deglobalization

Friend-shoring (or the transferring of supply chains to ally countries) is another trend that may push prices higher. Whereas globalization reduced production and labor costs, the recent trend toward deglobalization has been burdened by high tariffs and geopolitical tensions. The supply-chain congestion during the pandemic has forced companies and national leaders to reconsider a global supply chain that is dependent on a few nations to produce manufactured goods.

China’s zero-COVID policy and geopolitical tensions such as the one caused by Russia’s invasion of Ukraine has led businesses to scramble to find alternative sources to fill in the gap. Tensions between the U.S. and China further exacerbates the supply-chain issue, as deglobalization will undo the cost savings that benefitted consumers around the globe. This deglobalization trend will put upward pressure on prices even as supply shortages are addressed.

Conclusion

According to the International Monetary Fund, central banks must keep raising interest rates aggressively to prevent prices and wages from spiraling out of control. This has been the Fed’s playbook, but it also slows business expansion. Many of these contributors to the recent inflation problem is unlikely to get fully addressed by interest-rate hikes. However, raising interest rates has been the primary strategy for central banks in a high-inflation environment. While the Fed may be able to influence demand to control costs, there is little the central bank can do to address some of the other forces keeping inflation sticky.

Unlike the Fed’s initial thinking, the recent runup in inflation has not been transitory. Instead, inflation turned out to be much stickier than central bankers had anticipated.

Whereas the traditional measure of headline CPI has started to decelerate, sticky CPI has continued to accelerate. As the high month-over-month numbers start to roll off, year-over-year numbers may come down, particularly next year. However, it is still a long way to get to a 3% or much less 2% inflation level, the Fed’s goal. Certain factors such as excess savings, tight labor force, immigration barriers, and deglobalization represent relatively new forces that may be keeping inflation running relatively hot for the time being. The Fed has clearly articulated its intentions of taming inflation. Perhaps the Fed simply needs time and the Congress and the Administration’s help such as improving trade relations and relaxing immigration barriers to allow inflation to naturally come down again.

The views in this commentary are as of the publication date and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. All third-party trademarks referenced belong to their respective owners.

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