John Kemp

LONDON (Reuters) – U.S. consumer prices are rising at the fastest rate for decades, a sign that aggregate demand for goods and services from households and businesses is overwhelming the economy’s productive capacity.

Prices for all goods and services increased at a compound rate of 4.2% per year over the two years ending in December 2021, the fastest two-year increase since 1991 (https://tmsnrt.rs/3qnnbYl).

This rate will see the prices rise by a third and the nominal wage level fall by a quarter of a percent every 17 years. It is fast enough that households and businesses are more aware of inflation and it has been pushed higher up on the political agenda.

Contrary the views expressed by policymakers at both the White House, and the Federal Reserve earlier in the year, inflation has not been temporary or confined to volatile products like gasoline.

Core prices for all items other than food and energy increased at a compound annual rate of 3.5% in the two years to December, the fastest since 1993 (“Consumer price index”, U.S. Bureau of Labor Statistics, Jan. 12).

The core price indexes increased at an annualized rate of nearly 7% in the three most recent months ending December. This suggests that inflationary pressure was increasing, rather than decreasing.

Price rises were faster for goods (15.8%) even when food and energy are excluded (13.7%) but services prices were also rising much more rapidly (5.0%) than the Fed’s long-term average target of just over 2.0% per year.

HANDBRAKE TURN

Policymakers changed abruptly over the last three-months, in large part due to an increase in inflationary pressures.

“The economy has rapidly gained strength despite the ongoing pandemic, giving rise to persistent supply and demand imbalances and bottlenecks, and thus to elevated inflation,” Fed Chairman Jerome Powell said this week.

“We know that high inflation exacts a toll, particularly for those less able to meet the higher costs of essentials like food, housing, and transportation,” the Fed chief told senators at his confirmation on Tuesday.

“We will use our tools to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.”

As of now, both the Fed and White House tend to put blame for price rises on microeconomic problems (a micro-economic problem), instead of too much aggregate consumption (a macroeconomic one).

These experts have shown evidence of significant labour market capacity, with far less people employed than prior to the outbreak of the pandemic in 2020.

The December figure was still just 149million non-farm employment, which is a far cry from the 157 million expected to be if employment growth had continued in line with its pre-pandemic trajectory.

The December civilian labour force participation rate of those 25 and older was still just 62.8%, as compared with 64.5% for the same month in 2019.

Both the Fed and White House have pointed out the jobs gap as a reason why the economy has not reached its full potential. The Fed also believes that short-term stimulation is needed to ensure the economy reaches full employment.

The availability of capital and energy as well as the production capacities are important factors in determining potential output.

Many of these measures indicate that the economy is close to its prepandemic level, which implies there may not be much spare capacity.

Only 2.5% of real gross domestic products is below the pre-pandemic five year trend. Only 0.8% of real personal consumption expenses are below the trend.

In the three months ending September, total energy consumption was 1.1% lower than normal. However, manufacturing production had already risen 2.9% from its pre-pandemic anaemia trajectory to November.

Practically speaking, it is likely that recession and the pandemic have both disrupted productivity growth. Some capacity has been lost semi-permanently.

MICRO VERSUS MACRO

The economy has been operating near its full potential, with demand increasing quickly, so inflationary pressures seem to have increased significantly.

The rate-limiting factor in an economy that is complex or machine-like isn’t labour availability but rather tightness in energy, production, and other materials.

In the first nine months of 2021, the White House and Federal Reserve’s exclusive focus on the labour market blinded them to the increase in frictional pressures in other parts of the system.

The macroeconomic policies of policymakers (low interest rates and bond buying, government spending) were used to address a microeconomic issue (persistently underemployed in certain sections of the workforce).

In April, White House advisers gave a lengthy press briefing in which they argued the economy could be run “hot” without “overheating”, but this has proved impossible.

It is difficult to produce enough, transport sufficient freight, or oil and gas, in order for the demand to grow at an unprecedented rate, which has been fueled by fiscal and monetary expansion.

Excessive demand results in rapid price hikes for a wider range of end products (furniture), semifinished products (semiconductors), and raw materials (cotton).

The macroeconomic problem of too much demand is now a policymaker’s dilemma. They are trying to fix it with microeconomic intervention (antitrust enforcement, targeted supply chain support measures)

Prices will rise until aggregate demand matches aggregate supply. This can be achieved through either slower demand growth or faster supplies growth.

There may be some room to improve supply growth. But it will likely be short-term. The bulk of adjustment will be due to slower growth in demand.

In order to reduce inflationary pressure, the government will need to stop central bank bond purchasing, raise interest rates and grow less in government spending.

Policymakers face the challenge of achieving a slower pace in inflation and demand growth without causing a recession.

John Kemp is a Reuters Market Analyst. These views represent John Kemp’s own.