US inflation risks highest in last 25 years

US inflation has risen to 5%, but this is mainly driven by temporary factors. A spectacular tightening of the labor market is visible, increasing the risks of high wage increases. That can trigger a self-perpetuating inflation process. The Fed is too laconic and should at least explicitly state the risks.

Inflation will have a major impact on developments in the financial markets in the coming months. This applies in particular to US inflation. Firstly, it has risen further than in Europe. Second, US inflation affects financial markets more than ours and third, US economic growth is clearly higher than ours. This is because the US government has taken the risk of blowing the economy with various stimulus packages, possibly resulting in higher inflation. In the following, it is therefore about the US.

When the pandemic broke out last year, consumer prices were quite erratic. The collapse in activity and demand mainly led to lower prices. In March, April and May, prices fell month-on-month.

The economic recovery started in the third quarter of last year. In China, that recovery has continued well since then. Deteriorating corona figures and new lockdown measures caused many European countries to contract again in the last quarter of last year. The recovery only started towards the end of the first quarter. In the US, the economy continued to grow after the third quarter of last year, helped in part by extensive government support packages in December and March.

The faster vaccination process than in Europe also leads to a faster reopening of the economy. Consumers are ready to go, helped by the stimulus packages mentioned, but also by the fact that last year no money could be spent on certain things. There will be catch-up demand, which consumers can finance from the increased savings rate.

It seems very likely that aggregate demand in the US economy will exceed supply for some time. In that case, it could lead to either higher inflation, a larger foreign trade deficit, or a combination of both.

A rather unexpected feature of the global recovery is that of several logistical disruptions. Demand for raw materials and goods rose so abruptly that there was a shortage of transport capacity, causing freight prices to rise sharply. The prices of raw materials and goods that could still be delivered have also risen. Producers have also limited their production capacity in response to the drop in demand last year. Now that demand is coming back faster and more vigorously than anticipated, supply problems arise.

Three driving forces tut so far
Meanwhile, year-on-year inflation on the CPI measure has risen to 5,0% in May, the highest level since August 2008 due to a month-on-month increase of 0,6%. Excluding food and energy, inflation was 0,7% mom and 3,8% yoy. The latter is the highest level since 1992.

You can say that there are 3 driving forces behind the increased inflation. First, there are base effects, as prices fell in March, April and May last year. Even if prices in those months remain unchanged month-on-month this year, year-on-year inflation will rise. Incidentally, prices rose quite strongly in June, July and August last year, so that the base effect may work the other way in the coming months.

So, secondly, there are the effects of the logistical disruptions that have led to higher freight rates and higher commodity prices, and so on. The following picture shows what is happening so far at the producer price level. I have always taken the development over 4 months and converted the increase to an annual figure (annualized). It shows how much inflation is accelerating at the producer level and also shows that we have not seen such a rate of increase in the last 10 years.

Thirdly, entrepreneurs in sectors that are 'opening' again are trying to make up for the loss suffered by sharply raising prices. In April, for example, prices for airline tickets and hotel stays rose by about 10% month-on-month. Second-hand car prices also rose by 10% in April and by another 7% in May. The next picture shows that nothing like this had happened in the last 65 years.

What's next with inflation?
Central banks argue that the rise in inflation is temporary. Many economists agree. The reasoning is that the factors that have pushed up inflation are temporary. In the end, logistical disruptions are overcome and used car prices do not continue to rise 10% every month. It is further argued that the factors that have kept inflation low in recent decades are still valid. Finally, the overcapacity created by the pandemic is often referred to.

It would lead too far to go into all these arguments here. In the rest of this commentary, I will focus mainly on inflation expectations, in particular labor market developments.

Expectations can play an important role in the inflation process. There are several ways to measure inflation expectations. So-called market-related measures of inflation expectations now reflect increased inflation. However, these measures also suggest that market participants subscribe to central bankers' view that higher inflation is temporary.

Above is the so-called 5yr/5yr Forward Rate. Which shows the priced in average inflation for a period of 5 years starting in 5 years. Yes, inflation expectations have risen from very low levels in the last 12 months, but inflation expectations for that period are close to the Fed's target. He can therefore rightly argue that expectations are still quite firmly anchored.

The situation is slightly different for measures based on consumer surveys. According to figures from the University of Michigan, inflation expectations among consumers have risen markedly in recent times. It should also be noted that the inflation expectations in the 1-year period (4,6% in May) have risen much more than those for the 5-year period (3,0% in May).

However, we should not downplay the rise in inflation expectations over the 5-year term. The last time consumers expected inflation above 3,0% for a 5-year period was in 2011, and the last time they expected higher inflation for several consecutive months for a 5-year period was in 2008.

Little to no signs of acceleration in wage growth
Wage developments also play an important role in an inflation process. The higher inflation caused by logistical disruptions and because entrepreneurs are using the opening of the economy to make up for losses will be temporary if wage growth does not accelerate significantly. Whether and by how much the wage increase accelerates partly depends on the situation on the labor market. Average hourly earnings, the average hourly wages, are a widely used yardstick for assessing wage trends.

As the following picture shows, those hourly average wages have been pretty upset since the outbreak of the pandemic. This is due to a so-called composition effect. When unemployment soared last year, low-paid jobs were especially lost in the service sector. If low-paid jobs in particular disappear, the average hourly wage of the remaining jobs will of course also rise if the wages of other jobs themselves do not increase at all. The opposite effect is visible from the moment the economy 'opens up' again and many low-paid jobs are created. Be that as it may, it requires a more detailed analysis of these figures to gain insight into the real wage pressures.

May seems to have seen a turnaround in wage formation. In the previous period, average hourly wages fell in months with strong growth in the number of service jobs, while average hourly wages grew more sharply in months with few new jobs in the service sector. That's exactly the pattern you expect. In May, however, average hourly wages rose quite strongly (0,5% month-on-month), while the number of jobs in the service sector grew quite strongly.

The figure for one month is not yet a trend, but this development is in line with the possible narrative that a tighter labor market leads to a considerable acceleration in wage growth. On balance, however, we have to conclude for the time being that the average hourly wages are too distorted by composition effects to paint a clear picture of what exactly happens to the wages.

An alternate measure of wage growth is compiled by the Atlanta Fed. The following picture shows that according to this measure (which runs until April 2021), no upward wage pressures have yet manifested themselves that give rise to inflation fears.

Shortage in the labor market is increasing rapidly
So far, so good, so. It must be said, however, that wage developments are influenced by the shortage on the labor market and that it is not standing still. The Job Openings and Labor Turnover Survey (JOLTS) provides a good overview of the dynamics on a monthly basis. The following picture shows that the number of unfilled vacancies (as a percentage of total employment) has increased sharply since the beginning of this year and has now reached its highest level since the start of this series in December 2000. In absolute numbers, At the end of 2020 there will be almost 6,8 million vacancies, now there are about 9,3 million. It is striking that the increase has accelerated strongly in recent months. In January 2021, 347.000 vacancies were added, in February 427.000, in March 762.000 and in April 998.000. It doesn't matter. It indicates a rapid tightening of the labor market.

Of course, the degree to which the labor market is tightening is not the same in all sectors. The next picture shows the figures for 2 different sectors. Last year, accommodation and food services and recreation were the worst hit. About half of all jobs in leisure and hospitality were lost. Now that the economy is reopening, employers are struggling to find people.

Those who lost their jobs last year have naturally looked for other employment. People who have found that are no longer available for their old job. It is also important that schools have not yet reopened completely, so that single parents, especially women, have not yet been able to register their full potential in the labor market. According to the JOLTS report, there were 2019 open vacancies in accommodation and food services at the end of 785.000. In April 2021 there were 1.338.000.

The labor shortage is spreading to other sectors. For example, there were about 2019 vacancies in the processing industry at the end of 385.000, but this increased to 851.000 in April this year. Total employment in this sector was 'only' 519.000 lower in May than before the pandemic.

Will a tighter labor market translate into an acceleration in wage growth?
Earlier this week, I listened to an American Enterprise Institute webinar, "Is Inflation Back?" †Is inflation back? † American Enterprise Institute - AEI† During the Q&A, I asked whether the panelists can detect any acceleration in the wage increase in the figures. Former Fed driver Kevin Warsh replied that he sees an acceleration in wage growth everywhere except official statistics. I think he meant to say that it is only a matter of time before wage growth accelerates markedly, under the pressure of the growing tightness in the labor market.

We need to thoroughly analyze new figures in order to form an opinion as to whether and to what extent there is an acceleration in wage growth. Julie Hotchkiss of the Atlanta Fed recently published a short study on the latest wage developments in various segments of the labor market. In this report, Hotchkiss develops a model with which it can predict wage growth in various segments of the labor market.

She then compares the actual wage development over the period January to March 2021 with the forecast. The following picture shows that for people who already had a job ("Continuing Employed") the actual wage increase turned out fractionally higher than predicted. This is especially true for low-paid jobs in the service sector. This may point to an otherwise very limited effect of the tighter labor market on wage growth.

Hotchkiss finds a much stronger effect in people who are newly recruited ('Newly Employed'). Within that category, the actual wage increase exceeds the model predicted by as much as 7,7%, as can be seen in the following picture. This seems to indicate that labor shortages are forcing employers to pay markedly higher wages when they want to fill low-paid vacancies.

In all this, it should be borne in mind that Hotchkiss' research is limited to the wage increase up to and including March. From the JOLTS report (up to date until April) we know that the tightening of the labor market is accelerating. The May labor market figures also show a relatively strong increase in average hourly wages, which is remarkable given the robust increase in many low-paid jobs in that month. All of this could confirm Kevin Warsh's statement that you're seeing an acceleration in wage growth everywhere except the official statistics. But I would add: this may change soon.

Response from the Fed
It is still not possible to say with much certainty how this will work out. If you've had any doubts over the past 20 years about whether inflation is going up or not, you'd better bet it wasn't. In my view, that is a lot less certain under the current circumstances. The chance that inflation will remain higher than the central banks would like is now higher than at any time in the last 20 years.

There is certainly a chance that wage growth will accelerate sharply. Then the rise in inflation will be less temporary than the Fed is now claiming. I think the Fed is much too laconic, it is good if the central bank at least explicitly names the risks. However, the risk is that the Fed will wait too long to tighten monetary policy, ultimately requiring a stronger rate hike to get the inflationary spirit back in the bottle. That interest rate hike could cause unnecessary damage to the economy. It will no doubt not be as bad as it was in the 80s under then-Fed boss Paul Volcker. But a 'Volcker-lite' cannot be ruled out.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

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