Recent data on price and wage growth shows increasingly clearly that the underlying inflation rate in the US economy is at least 4% and that it is more likely to rise than to fall. to lower. Although the Federal Reserve has acted forcefully in recent months to contain inflation, it will unfortunately have to stick to its plan of rapid interest rate hikes until there is clear evidence that the Underlying inflation is slowing dramatically. This is particularly difficult when the economy is already slowing, but the alternative of postponing action while inflation takes hold would be much worse.
So far, the personal consumption expenditure price index has risen at an annual rate of 7.7%, well above the Fed’s 2% target. Some of this is fueled by external events, including Russia’s invasion of Ukraine, which has driven up gasoline and food prices. And now that gasoline prices have started to fall from their peak, headline inflation should fall sharply. Yet, even excluding these volatile prices, “underlying inflation” is still running at an annualized rate of 4.8% and has been rising recently.
Additionally, other measures that remove volatile components of the price index such as the trimmed mean, median, services, and cycle-sensitive inflation all rose, and some even more so than under- inflation. underlying. It’s hard to find excuses for this inflation, let alone excuses that would justify the belief that it will go away on its own anytime soon. While Russia’s war against Ukraine has raised the price of oil and food, this has only a small direct effect on core inflation, which is itself partly offset by Behavioral changes as consumers reduce spending to account for rising gasoline and food prices.
Additionally, Covid-19 is having a smaller effect on the economy than at any time since February 2020, and to the extent that it affected inflation when it rose, it was more likely to drive it down than it did. increase it. Many commentators have blamed supply chain grunts for driving goods price inflation, but that metric has actually fallen and been replaced by much more inertial services inflation. Weaning from pandemic-era fiscal support policies was supposed to bring inflation down, but that process mostly ended more than a year ago.
At this point, inflation is increasingly integrated with price growth, which fuels wage growth which, in turn, fuels price growth. This worrying process – some call it a “price-wage spiral”, but I prefer “price-wage persistence” – is guaranteed by short-term inflation expectations, which have risen sharply. The latest data shows that private sector wages and salaries grew at an annual rate of 5.7% in the first half of this year, about 2.5 percentage points faster than the pace of growth before the pandemic.
In total, adding 2.5 percentage points to the pre-Covid inflation rate implies an underlying inflation rate of 4.5%. Moreover, a series of alternative measures of wage growth are consistent with the same or even higher inflation, according to estimates by Alex Domash of the Harvard Kennedy School. The rapid growth in nominal wages is not surprising, given that labor markets remain at near record tightness, as evidenced by the fact that there are nearly two job openings for every unemployed person. I wish companies would simply use a portion of their profits to cover additional payroll costs, but I also know not to confuse wishes with predictions. Since productivity appears to be relatively low, firms will most likely continue to pass on higher wage costs to consumers in the form of higher prices. Higher prices lead to higher wages.
This dynamic does not require unions or contracts with cost of living adjustments. Firms that can sell their products at higher prices will want to hire more workers; but they will have to pay higher wages to attract new employees, otherwise workers facing higher prices will look elsewhere.
Aside from increases in food and energy prices, most of the inflation was originally demand driven. But even if supply issues were more to blame – as others have argued – we would still be in the same place, with wage and price increases feeding into each other. Unfortunately, the only solution to the persistence of wage-prices is to restrict demand. A small reduction in demand may go a long way to containing inflation and keeping unemployment relatively low.
But it’s also possible that the sacrifice ratio – the number of percentage points by which the annual unemployment rate must rise to bring inflation down by one percentage point – could be closer to five, as in recent recessions. . If so, lowering the inflation rate from 4% to 3% (which I would consider a victory) would require at least five point-years more unemployment. And if underlying inflation is above 4% – which it likely is – or if the Fed intends to hit its 2% target, the adjustment required could easily be twice as large. Painful as it is to act now, a delay would likely make disinflation much more costly. The longer inflation persists and takes root, the higher the sacrifice ratio will be. I hope to be too pessimistic.
But the Fed tried hope as a macroeconomic strategy last year, and it contributed to rapid inflation and the weakest real wage growth in 40 years. Fortunately, monetary policy makers seem to have become more realistic and focused almost exclusively on reducing inflation. If inflation falls faster than expected, the Fed may ease its tightening. But for now, it must follow the same principle that made it so effective in helping to prevent the economic collapse of 2020.
By Jason Furman
Former Chairman of President Barack Obama’s Council of Economic Advisers, Professor of Economic Policy Practice at Harvard University’s John F. Kennedy School of Government, and Senior Fellow at the Peterson Institute for International Economics.