by Chris Black
Inflation declined rapidly largely due to onetime supply side improvements and will likely resurface as easing financial conditions rekindle demand.
Improving supply chains and increases in labor force participation played a major role in moderating inflation by increasing the overall supply of goods and services.
The Fed’s restrictive policy also played a role by having some impact in dampening overall demand, but that policy is in the process of being unwound.
Household purchasing power remains very strong due to elevated wage growth, record high net worth, and increasingly attractive interest rates.
With supply side improvements behind us, increases in demand from easing financial conditions will likely lead to a resurgence in inflation later this year or perhaps next year.
The immaculate disinflation of the past year is largely due to improvements in supply chains and increases in labor force participation that are unlikely to continue.
While the Fed sought to ease inflation by reducing demand (https://www.cnbc.com/2022/08/26/powell-warns-of-some-pain-ahead-as-fed-fights-to-lower-inflation.html), the strong economic growth (https://www.bea.gov/news/2023/gross-domestic-product-third-estimate-corporate-profits-revised-estimate-and-gdp) and declining inflation (https://www.bls.gov/news.release/cpi.nr0.htm) over the past year suggest that disinflation largely occurred due to increases in supply. Pandemic era lockdowns scrambled global supply chains and led to a period of widespread shortages that is now largely over.
The New York Fed’s Global Supply Chain Pressure Index (https://www.newyorkfed.org/research/policy/gscpi#/overview) (first image) illustrates the supply chain stress in prior years and also suggests that the problems have largely been resolved. This indicates that further increases of supply from improving supply chains is unlikely.
The sudden shortage in labor that led to a surge in wages (https://www.atlantafed.org/chcs/wage-growth-tracker) was met with an increase in labor force participation that may be approaching its limit. Recall, the pandemic led to a wave of early retirements that left the labor force around 2 million workers short (https://www.federalreserve.gov/econres/feds/files/2022081pap.pdf) from pre-pandemic projections.
The sudden shortfall in labor led to rapid wage increases that attracted more people into the work force to ease the shortage.
While the labor force participation rate of those 55+ has remained subdued, the participation rate of those between 25-55 rose to multi-decade highs.
This suggests that marginal increases in labor from increasing participation will be more difficult going forward. Note that unprecedented immigration (https://t.me/CIG_telegram/40905) has of course also boosted labor supply. and that may continue.
While improvements in supply are waning, demand is set to pick-up as household purchasing power has increased through the rise in asset prices and declining interest rates.
A household’s purchasing power is in part due to the value of its assets, which can be monetized through outright sales or as collateral for a loan.
While the increases in household wealth have disproportionately accrued to higher income households, even households in lower income brackets have seen marked wealth increases.
This is largely due to the appreciation of real estate, which is widely held across the income spectrum.
The prior rise in mortgages rate had moderated the rate of home price appreciation, but the recent slide in mortgage rates (https://finance.yahoo.com/news/mortgage-rates-slide-again-to-lowest-level-since-may-171054445.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAD83056VpceJyZf-Zh9ev8NTxaOGqTcd2gDqpS9F236mEdHphLk6u0gbmEMMJrQxo9T802hGMsw_NUxZjD-3XVP8i2B-2Ci88_0IK_UgcH6IbivvFuWNLT0oIWuk35kaHW1BOfaUloRKVA_TmvRNRVlrllUQwNSG01HSH9Z_szLr) suggests that appreciation is set to reaccelerate.
The sharp decline in interest rates amidst strongly rising wages suggest households could take on more debt to finance and leverage their consumption.
Household debt servicing ratios remain historically low due to a large stock of sub-4% (https://investors.redfin.com/news-events/press-releases/detail/930/nearly-everyone-with-a-mortgage-has-an-interest-rate-below) home mortgages and continued wage growth at a historically high rate of 5% (https://www.atlantafed.org/chcs/wage-growth-tracker).
A decline in interest rates could reignite interest rate sensitive purchases such as cars and homes.
The recent decline in mortgage rates has already led to a surge in housing starts , which would lead to increased demand for labor , materials, and a host of other related goods.
The recent bout of disinflation likely occurred from both improvements in supply and decreases in demand, but both effects are fading away.
Supply improvements are largely over, and the Fed’s anticipated pivot may rekindle demand both domestically and abroad.
In addition to raising asset prices and lowering interest rates, the anticipated Fed pivot has also eased global financial conditions by weakening the dollar.
A weaker dollar is globally stimulative because it improves the balance sheets of foreign corporations borrowing in dollars (https://www.bis.org/publ/work819.pdf) and foreign banks that lend dollars.
More directly, a weaker dollar is also usually directly associated with a rise in global commodity prices. Both of these effects place upward pressure on inflation.
Market pricing is suggesting a steady return to 2% inflation (https://fred.stlouisfed.org/series/T5YIE), but that is likely too optimistic.
Recall, the prior inflationary period was one with many peaks and troughs.
This time around we are starting a cutting cycle with above trend growth, significant household purchasing power, and record peacetime deficit spending (https://www.wsj.com/articles/washington-stages-a-peacetime-fiscal-blowout-3ba548d).
Inflation data may look very benign in the near term, but a return to a steady 2% inflation regime seems unlikely.