High Inflation Could Be Stickier Than Anticipated

Companies raise prices in response to higher labor costs, fanning inflation further

People walk through Times Square in New York City on July 13, 2021. Angela Weiss/AFP via Getty Images

U.S. inflation showed some cooling off in July after posting large gains in prior months. Consumer prices rose at their slowest monthly pace since February, providing some relief to those in the “transitory” camp, who hold that this bout of inflation isn’t a long-term phenomenon.

But, inflation fears still linger. The year-on-year increase in consumer prices remained stubbornly high at 5.4 percent, the same as in June.

While it’s unclear when inflation could return to a level closer to its 2 percent long-term trend, economists are increasingly talking about a gradual slowdown in inflation in the months and quarters ahead.

In a recent note, Goldman Sachs economists state that current levels of inflation will prove transitory, although a rapidly tightening labor market poses a risk as it could “translate into more persistent inflation pressures down the road.”

A swift rebound in the economy and a tight labor supply have returned the upper hand to American workers. Employers are competing to attract qualified candidates by raising wages and offering bonuses and other perks.

Companies are passing along these higher labor costs to consumers via price increases, hence adding to the inflationary pressures. And a record level of open job positions in the country suggests that businesses may continue to raise wages to attract people, which could in turn boost consumer prices further.

U.S. job openings reached an all-time high of 10.1 million in June. Layoffs also hit a record low as companies want to hold onto their employees to weather the labor crisis in the country.

Meanwhile, optimism among U.S. small businesses is dipping as labor shortage and supply chain constraints continue to cripple their business operations. The NFIB Small Business Optimism survey in July showed that a record-high 49 percent of small firms struggled to find workers to fill open positions.

The survey also found that 52 percent of small business owners raised the prices of their goods and services to mitigate higher costs.

Companies, both small and large, currently face no difficulty in passing along labor cost increases to consumers, according to Scott Anderson, chief economist of Bank of the West. And this suggests that “inflationary pressures will dissipate more gradually than expected six months ago,” he wrote in a recent report.

Supply Chain Constraints

In addition, the COVID-19 Delta variant is deepening already substantial supply chain disruptions, putting pressure on prices. For example, setbacks in the Asia-Pacific region, according to Goldman Sachs, are delaying the normalization of car prices.

The semiconductor shortage amid the pandemic continues to hammer auto production worldwide. Nissan announced on Aug. 10 that it would close its large factory in Tennessee for two weeks because of computer chip shortages. More than a dozen factories in North America and Europe have halted or reduced operations in recent weeks.

The global scarcity of chips has tightened new and used vehicle inventories and pushed up prices this year. Prices of new and used vehicles have been on the rise for months, making them a major driver of inflation.

While used car prices stabilized in July, rising only 0.2 percent over the month, they are still over 40 percent above their pre-COVID trend. And the yearly inflation for new vehicles stood at 6.4 percent in July, the largest gain in nearly four decades.

As noted by Elon Musk, founder and CEO of Tesla, during an earnings call in late July, the chip shortage is “out of control,” and it’s hard for carmakers to predict how long this will last.

Persistent supply shortages have gone beyond the auto sector and affected prices of consumer electronics and shipping, as well. Many areas of the economy are now facing supply shortages, including raw materials, housing, freight, and labor, which could take more than a year to normalize, according to analysts.

How Sticky Is Inflation?

Inflation has turned into a major source of disagreement among economists, as they are divided over the key question of how long high inflation could stick around.

The Federal Reserve’s latest forecast shows that the inflation will be 3.4 percent this year, before settling back down to just over 2 percent in 2022 and 2023.

“The risk is that higher inflation may have a longer-than-expected ‘tail’ before normalizing, or perhaps a more enduring structural component,” Nanette Abuhoff Jacobson, global investment strategist at Hartford Funds, said in a report.

One area to watch closely, she said, is rents and shelter, the largest component in the consumer price index.

Rents dropped significantly during the pandemic across the country, but now they’re surging at a rapid pace, as more workers return to metro areas, boosting demand for rental apartments. A sustained increase in rents could lead to more persistent inflation, as price increases are hard to reverse.

“We’re going to head into a very high rent period in the next 10 years,” Ken McElroy, CEO of MC Companies, a real estate investment firm, said in an interview.

Soaring home prices are also pushing people to the rental market. Home prices nationwide rose by 16.6 percent in May, setting a record, according to the S&P CoreLogic Case–Shiller index.

If rents track home prices as in the past, then this could be “a big deal” for inflation, according to Jacobson, as shelter costs have historically lagged home prices by around 18 months.

In addition, surging gas prices have had a significant effect on inflation. In the past year, gasoline prices have risen 41.8 percent, becoming a concern for the Biden administration. The White House on Aug. 11 issued a statement urging the Organization of the Petroleum Exporting Countries and Russia (OPEC+) to address rising gasoline costs by boosting oil production. Analysts believe strong demand and slow growth in supplies will likely push energy prices higher in the coming months.

Excessive government stimulus and ever-growing national debt are also fueling inflation fears. The International Monetary Fund warned in July that more fiscal spending could increase inflationary pressures in the United States, pushing the Federal Reserve to take preemptive action.

“I’m surprised that people in Washington don’t get this,” conservative economist Stephen Moore said in an interview, criticizing fiscal spending and the Fed’s ultra-accommodative monetary policy.

Sen. Joe Manchin, a West Virginia Democrat, recently joined conservatives in sounding alarm bells on rising inflation. In a statement on Aug. 11, Manchin raised “serious concerns” about President Joe Biden’s $3.5 trillion social policy package and called rising inflation “an unavoidable tax on the wages and income of every American.”

The White House, however, is pushing back against these concerns, saying that Biden’s Build Back Better policies would address “long-standing cost pressures” facing families.