Episode 41: Has the Fed fallen behind the curve on inflation?
17 Dec 2021
For much of 2021, inflation in the US was labeled as “transitory” by the Federal Reserve.
Yet the FOMC pivoted toward a much more hawkish stance at its December meeting, indicating that it believes inflation pressures will prove more persistent. With that shift in thinking, the Fed pulled forward the anticipated timing of its interest rate hikes, and the market now expects the first hike in March 2022. But is that the right move, given the economic factors at play?
In episode 41 of The Flip Side, Head of Research Jeff Meli and Senior US Economist Jonathan Millar debate whether inflation is transitory or here to stay. Our analysts discuss how forces such as consumer behavioural changes, the shortage of workers, and the exertion of market power on prices are factoring in to inflation.
Jeff Meli: Welcome to this episode of The Flip Side. I’m Jeff Meli, the Head of Research at Barclays, and I’m joined today by Jonathan Millar, our Senior U.S. Economist. Thanks for joining me, Jonathan, on what’s going to be the last episode of 2021.
Jonathan Millar: Thanks for having me, Jeff.
Jeff Meli: Now we’re going to talk today about the recent hawkish turn by the U.S. Federal Reserve. Now inflation has been stubbornly high in the U.S. for most of the year. What changed recently was that Chair Powell and some other officials at the Fed now believe that these inflationary pressures are not going away.
Even some of the dovish members of the committee have gravitated towards removing accommodation to limit the risk of even further increases in inflation. Practically what they’ve done is drop the term transitory to describe inflation, which means that the Fed will likely pull forward the timing of its interest rate hikes, and we now expect what we call liftoff, which means the first hikes to happen in March of 2022, which is over a year earlier than we had been expecting.
Jonathan Millar: Well Jeff, it was quite a shift for the Fed, but even though our Economics team has changed its FOMC call, I still think this hawkish turn was premature. I believe their former narrative on transitory inflation was the right one, and just because price pressures are taking longer to ease than expected doesn’t mean that the underlying reasoning behind the Fed’s transitory narrative was wrong.
To put it in a nutshell, I think the inflationary pressures can be traced to influences that monetary policy is not well equipped to address, that these pressures will ease on their own over time, and that we will end up regarding any hikes that happen early next year as misguided.
Jeff Meli: Well I disagree, Jonathan. I think these pressures are not going to fade. And in fact, there are some new and interesting channels through which the generalized inflation that we’re experiencing right now will become self reinforcing or at least they would become that absent the action that it seems like the Fed is gearing up to take.
Jonathan Millar: So now that we have stated our positions, let me start by laying out my thinking about the drivers of recent inflation. In my view it all comes down to changes in household behavior brought on by the pandemic and the challenges that these have created for the global economy. These behavioral changes amount to a substantial, real, structural shock rather than a more standard, monetary, or fiscal shock that shows up in the usual macroeconomic models.
Structural shocks cause changes in relative prices, but effects on inflation should recede over time as we approach a new equilibrium partly because profit motives provide incentives for markets to reallocate resources across sectors.
Jeff Meli: Well I just want to put some context on this. What you're saying is that a structural shift can cause a one-time change in price levels. So for example, some good or service experiences a really big increase in demand, so the price of that good or service goes up and maybe vice versa for some place where demand fell. But the new price level gets set, and then from there there’s no reason to believer that the price changes just continue to occur.
Jonathan Millar: That is correct with one caveat. It may take some time for the market price to reach that new equilibrium. This is particularly true now since the behavioral changes from the pandemic have both driven the shocks and are slowing the global economy’s response.
And, of course, nobody knows how long the pandemic will last. So while these are level changes in a sense, it is clearly taking time to find that new equilibrium. But regardless of timing as the strains from the pandemic fade, these price pressures will subside, and we could plausibly see some culmination of a resource allocation or unwinding behavioral changes that reverse some of these price changes.
Jeff Meli: Well I agree, of course, that COVID is behind the rise of inflation, and as economists I’m sure that we agree that the economy will adjust over time and resources get reallocated in response to opportunities. You're starting to see some evidence of that already.
One example is the surge in new business formation in retail as people start businesses to take advantage of some of the COVID-related trends, but I disagree that the behavioral changes necessarily reverse once the pandemic fades. First of all, that might not actually happen. COVID could be with us for the foreseeable future. I mean, we could suffer from a sort of economic long COVID.
Second, big shocks like this can be the source of permanent changes. We may have entered a new paradigm. And finally, we need to worry that all these price changes feed into inflationary expectations, which triggers a self reinforcing spiral.
Jonathan Millar: OK. Well let’s discuss one behavioral change that I think is having the largest affect on inflation; the increase in the relative demand for goods which has come at the expense of services. This compositional change means that the global economy has been forced to abruptly shift the composition of production as well.
The way I see things the economy just isn’t well equipped to do that in short order, especially during a pandemic of uncertain duration. This has created all sort of bottlenecks in the goods sector as businesses struggle to move materials and goods back and forth within global and domestic supply chains that are simply overwhelmed by the enormous volumes.
Jeff Meli: All this focus on goods, Jonathan, is hard to reconcile with the fact that the U.S. is primarily a services-oriented economy.
Jonathan Millar: Well goods were 30 percent and they're now closer to 35 percent of consumer spending, which actually is a huge change.
Jeff Meli: Five percent doesn’t sound like much, but of course consumer spending in the U.S. is nearly $16 trillion, so five percent of that is an extra $800 billion being spent on goods, and that’s just the extra goods demand that’s coming out of the U.S.
Jonathan Miller: Jeff, this amounts to a staggering amount of stuff. At one point last March, real durable goods spending was up 34 percent from its pre-pandemic level, and services spending was down 5.5 percent. That’s just a huge swing. And since it has been largely sustained, the repercussions have cumulated over time. Inventories have depleted to very low levels. Domestic manufacturers are struggling to keep up, and the trade deficit has ballooned as we import many of these goods from aboard.
And when you look at what all this means in terms of logistics, we see something akin to gridlock affects on a freeway. For example, the volume of containers unloaded at the Ports of Los Angeles and Long Beach, which together handle much of the throughput from the manufacturing centers of Asia, over the past 12 months leading into September were up 17.5 percent relative to the corresponding 12-month period in 2019. That’s just an immense increase relative to the pre-pandemic experience.
And the challenges of dealing with these volumes have been exacerbated by a series of other issues: complex global supply chains with production having become increasingly fragmented by globalization, shortages of available warehouse space in Southern California, and dislocations of empty containers due to the extreme imbalance between inbound and outbound traffic.
Jeff Meli: Yes. That’s before you’ve even transported any goods to their destinations in the U.S. where you have to deal with the domestic logistical challenges like the shortage of truck drivers.
Jonathan Millar: That’s right, and there the problem is again; volume. We don't really have fewer truck drivers than we did prior to the pandemic. The demand for now is simply outstripping the supply.
Jeff Meli: OK, Jonathan. That’s a great explanation of how extreme demand for goods is driving inflation, but what I haven’t heard is any reasoning behind it reversing.
Jonathan Millar: Well the first point is that goods demand won’t continue to increase. It shifted higher and has already come down somewhat from its peak. Second, I believe that all this services spending that was disrupted by COVID – things like travel, tourism, restaurants, cultural activities – all of those will return. You only need to rehab your kitchen once. There’s a natural limit on the amount of consumer durables we can purchase, for example, and I know all my storage space is full.
But once conditions allow, services will recover. For instance, think of all the travel that households are foregoing and people still fundamentally want to travel. Not to mention all the forgone medical procedures and so on. As consumers rebalance back towards their pre-COVID mix of spending, many of these supply bottlenecks in the goods market should recede, which should at least stabilize goods prices if not reverse some of the increases.
Jeff Meli: Yes. Well I can see that supply chains will adjust and the bottlenecks will dissipate. However, you have left out a major constraint, and that’s that any resurgence in services spending will require a major increase in services employment, and the fact is there’s nobody left to hire in the U.S.
So just to put some numbers on it, job openings were at a record level of more than 11 million in October, almost 7 percent of the amount of employment. In the November employment report, the unemployment rate dropped by almost half a percentage point to just over 4 percent, which is actually not that far from what the median Fed participant views as full employment.
Jonathan Millar: Well that is true, and to underscore your point our research indicates that the measure of employment from the household survey has been lagging the payroll measure throughout the pandemic and that correcting that discrepancy could reduce the unemployment rate by as much as half a percentage point more.
Jeff Meli: I mean, that sounds like a pretty tight labor market to me. See, I think there’s a strong case to be made but the Fed is actually been caught flatfooted by its more inclusive view of full employment, chasing job losses relative to the pre-pandemic world rather than accepting what’s becoming evident, which is a lot of people have left the labor market and they're not coming back.
What this means is that if consumption patterns normalize we’re simply going to replace goods inflation with services inflation. Underlying all of this is a supply constraint, and it’s got to show up some place. It showed up in goods because that’s what we’re trying to buy. If we try to buy something else, it’s going to show up there.
Jonathan Millar: Well you have identified one of the key uncertainties in the outlook. Is the labor market only temporarily tight with much of the four million workers who have exited the labor market likely to reenter going forward, or have these workers permanently left the labor market? Which means that labor supply will be a lot tighter going forward than the Fed has been counting on.
Jeff Meli: I think that’s an essential question. If those workers don’t return I do not see how we can avoid higher inflation.
Jonathan Millar: So one way to consider this is to take a look at the profile of the workers who have left the labor market. We’ve looked at this pretty closely and we find that they have many characteristics which suggest that they are likely to return. Generally they lack college degrees, they (had been) employed in service or entered occupation where infection risks tend to be high like retail. And they live in married household where they likely benefit from having another bread winner.
Between being in a two income household and the various COVID related stimulus supports these are people who can afford to remain out of the work force for a time but not forever. This certainly helps tip the balance in terms of letting things like infection risk and children and childcare dictate whether they return to work.
But I think there are several forces that will eventually pull them back into the labor force. First they will eventually spend whatever excess savings they accumulated in the pandemic. Second, with higher prices raising the cost of living, incentives to go back to work will improve. Finally wages will rise and higher pay will get them back to work.
Indeed that’s kind of happening already. Private sector early compensation, in other words wages, accelerated to 4 percent year-over-year in September according to the Employment Cost Index compared with pre-pandemic rates of around 2.5 to 3 percent.
Jeff Meli: Yes you know the final critique I have of what I would call your somewhat hopeful outlook is that you’re discounting the risk of a wage price spiral. So you mentioned that wages will have to go up as sort of part of the trifecta of forces that will bring people back to the labor market.
But wage price spiral happens when the higher wages that are required to attract workers forces the companies that are employing them to raise their prices. That in turn forces workers to go back and demand even higher pay. And that’s – you get that become sort of self reinforcing spiral that pushes inflation higher.
We’ve got all of these ingredients in place and in fact you laid out a lot of them in the comments you just made. So I think that the hawkish turn that the Fed made recently is precisely can nip this is in the bud, they’ll stop this dynamic from taking shape. You keep expectations of future inflation grounded and that way the current experience never becomes self reinforcing.
Jonathan Millar: Well a wage price spiral would certainly be worrisome but I don’t think we’re anywhere close to that point. Indeed wage pressures are much more uneven than many recognize with many of the most intense pressure for less skilled occupations that have seen the biggest exodus during the pandemic.
Moreover, measures of longer term inflation expectations really aren’t that high by historical standards. And rising inflation expectation would certainly be a very key ingredient in this spiral dynamic you just sketched out. And Jeff, I kind of take issue with the idea that raising wages for left skilled workers must inevitably trigger an inflationary spiral and that the Fed should tighten monetary conditions to (restore) this kind of a dynamic.
This would be bad news for anyone who is concerned about income inequality in the U.S. We finally have some economic forces that are pushing up relative wages of less skilled workers and the Fed needs to step in and lean against it. If the problem is lower labor market participation, particularly for those in married couples, then it’s probably better to implement targeted policies that incentivize work such as subsidized childcare.
Jeff Meli: Well the first thing I would say is that of course we don’t want to argue against higher wages for lower income people. But I would also point out that if inflation were to take off it’s exactly those lower income people the bear the brunt of higher inflation. So it’s a delicate dance from the Fed and maybe not quite as easy as saying just let their wages increase regardless of the source of the increase or the impetuous economically that’s causing it.
But I do admit that it will take more than just the normal economic forces that we have spoken about so far to get this type of wage price spiral that I was talking about going.
Jonathan Millar: So it kind of sounds like I’ve persuaded you a bit?
Jeff Meli: Well not so fast. There are other changes that are happening in the economy that could help perpetuate elevated inflation. And one that we’ve done some work on is the decline in competition in the U.S. That the largest companies in each industry accumulate what’s known as market power which is basically the ability to set prices and earn abnormally high profits due to a lack of serious competitors.
Jonathan Millar: Yes and that is getting attention from the Biden administration which has taken a more skeptical view of mergers than its predecessors. And has asked various federal agencies to look into potential remedies for declining competition.
But, Jeff, this skepticism about the structure of the economy predates COVID and is really related to excessive profitability. I found the way certain pundits have linked it to the current inflationary which is really about input prices and supply chain constraints to be disingenuous.
Jeff Meli: Well I agree that this concerns has little to do with the current inflation that we’re experiencing. But I do think that it can contribute over time if inflation lasts. And stopping that process now is one reason why the Fed’s recent shift makes sense to me. So the reason goes back to how antitrust authorities identify companies that are abusing market power. They look at prices. A company that looks like it’s boosting its profits by raising prices attracts scrutiny.
Jonathan Millar: But that price lens is really a short-hand for consumer welfare. Theoretically when one considers mergers one should consider wider effects on consumer welfare; efficiency, product quality, price markups and other things like that. But those are hard to measure while prices are easy to measure. So that’s why authorities focus on it.
Jeff Meli: Yes, that’s right but now think about the pre-COVID economy. Inflation was completely absent, it was below the Fed’s target for nearly an entire decade. Any company that raised prices would have stood out like a sore thumb. Even if companies could raise prices, meaning they wouldn’t have lost their customers, they would be reluctant because of the potential attention it would have attracted.
Instead they pressured their suppliers, they kept wages low which I think can help explain why wage growth was anemic pre-crisis even though the unemployment rate was at or near historic lows. Now look around, inflation’s everywhere.
Who could tell why the price of some good or service is going up? It could be a labor shortage, energy prices, supply chain issues or maybe because the company has market power. Those companies now have the air cover they need to raise prices. And the longer inflation last the more this is an issue. And it tilts the risks that the price increases we’re seeing now will become self reinforcing.
Jonathan Millar: I get your argument but my sense is that the role of market power for inflation has been somewhat limited in practice. You and I both know that almost every industry in the U.S. has experienced consolidation. The market share of the largest companies has grown significantly over the past two decades. And this only accelerated with COVID.
The current administration along with some others points at this rise as evidence of the problems with competition that you’re talking about. But it’s not the case that this necessarily implies that there is a competition problem. Many economists think the reverse. That rising concentration might be a side effect of intensified price competition with only the best and most efficient firms surviving.
According to the so-called winner take all theory such companies can’t raise prices without losing out to their competitors. Which means they probably don’t contribute much to worsening inflation.
Jeff Meli: I agree there is an important distinction. But we make a real effort to distinguish between the two theories by looking for the symptoms of low competition. Things like lower labor share of income, reduced investment and signs of business dynamism being diminished like having less job turn.
You would expect these in such industries, for example, companies that aren’t worried about competitors don’t have to invest that much. As it turns out there are a lot of industries that are simultaneously exhibiting all of these symptoms. It is true that it’s not the case in every industry where concentration is high. So probably that winner take all theory does have some merit to it.
But enough industries are showing a simultaneous set of symptoms of low competition that we think it’s an issue for the economy in aggregate.
Jonathan Millar: Well this is an interesting argument but if the underlying concern is market power, targeted interventions to limit this power might be a better remedy than jacking up interest rates. High rates affect every corner of the economy even the parts not suffering from reduced competition. And have long term consequences for growth and employment.
But again why would one advocate for monetary policy as a solution rather than enhanced antitrust policies to address competition directly?
Jeff Meli: Well if we thought that such a policy intervention was possible in the timeline required than I agree and certainly pre-COVID when there was no generalized inflation out there I don’t think anybody was seriously suggesting that concerns about competition would be pushing monetary policy authorities to raise rates.
We’re in a different environment right now. I don’t think policy works quickly enough to address the possibility that this contributes to the sort of self reinforcing spiral we’ve been talking about.
Jonathan Millar: Well I’d also stress that if I’m right that inflation is temporary then won’t the air cover, as you call it, go away? Isn’t this also a temporary worry?
Jeff Meli: If you’re right of course I don’t think you are and if I’m right it will only add fuel to the fire. Well interested listeners can find out more about these topics in “Inflation: Everything is Relative” available on Barclays Live, and in our latest Global Outlook, which includes the chapters; “The Great Hesitation” and “The Rise of Market Power 2.0: Has COVID Crushed Competition”.
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About the analysts
Jeff Meli is Global Head of Research at Barclays, based in New York. Jeff joined Barclays in 2005 as the Head of US Structured Credit Strategy and has held a number of other senior positions in the research department, including Head of Credit Research and co-Head of FICC Research. Jeff spearheaded the firm’s response to regulatory changes in Research, including MiFID II, and has revamped the department’s approach to content monetisation. Jeff leads the development of the Research Data Science Platform, tasked with integrating new data sets and modern data techniques into investment research. He writes regularly about special topics in credit markets, liquidity, and financial market regulation, and hosts The Flip Side, a podcast covering current events in finance and macroeconomics. Previously, he worked at Deutsche Bank and J.P. Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.
Jonathan Millar is Senior US Economist at Barclays in New York. He has expertise in monetary policy, productivity, business investment and the industrial sector. Prior to joining Barclays, Jonathan was a Principal Economist at the Board of Governors of the Federal Reserve in Washington, DC. He also spent two years in Paris as an economist with the Organisation for Economic Development. Prior to these roles, Jonathan taught economics at the University of Michigan and had positions at the Bank of Canada, at the IMF, and as a specialist in energy derivatives at DTE Energy Trading.