The Case for "Higher for Longer": Prices are Disinflating, But Not Wages (Yet)

The continuing unwind of pandemic-related and war-related disruptions to consumption, production, and distribution is helping inflation. But that may be temporary. Markets are not discounting this.

The latest data on incomes, spending, and prices still imply that the recent slowdown in inflation is temporary, with price growth poised to re-accelerate to around 4% a year. Incomes are still rising too fast relative to real output, so unless consumers collectively start spending a much lower share of their incremental earnings on goods and services, productivity rises sharply, or both, then the inflation rate should eventually revert to the pace of wage growth minus 1-2 percentage points.

Federal Reserve officials recognize this, which is why they continue to argue that wage growth needs to slow down. As Fed boss Jerome Powell put it at his July 26 press conference following the most recent Open Market Committee meeting:

We want wages to be going up at a level that’s consistent with 2 percent inflation over time…We don’t really think that wages were an important cause of inflation in the first year or so of the outbreak. But I would say that wages are probably an important issue going forward. Labor market conditions broadly are going to be an important part of getting inflation back down and that’s why we think we need some further softening in labor market conditions.

But Powell and his colleagues are understandably reluctant to push the economy into a downturn severe enough to generate the mass layoffs that would be necessary to scare the workers who remain employed into accepting meaningfully slower pay increases. Better to sit tight and enjoy the benign combination of low unemployment, healthy growth, and moderate inflation. Without a downturn, however, it is unclear whether (or why) wage growth would decelerate enough from here to bring inflation all the way back to the Fed’s 2% yearly goal over any reasonable time frame.

Market prices are not discounting this possibility, instead implying that inflation will normalize while growth remains robust. Futures imply that short-term interest rates will be at least 1 percentage point lower than today by the end of next year, while stock prices are buoyant and credit spreads are tight. That combination makes sense only if inflation is set to return quickly to 2% without any slowdown in the real economy. While that would be a welcome development, it does not seem as likely at this point as the “no landing” scenario: inflation remains persistently ~2pp faster than before the pandemic, growth holds up, and the Fed responds by keeping short-term interest rates at (or slightly above) current levels for a sustained period of time.

The “Transitory” Disinflation?

I have spent years arguing that (most of) the excessive inflation observed in 2021H2-2022H1 reflected temporary disruptions to consumption, production, and distribution—and that those price pressures would dissipate on their own as society normalized.

While this process took longer than I and many others had initially expected, the past 12 months have (mostly) vindicated those of us who called for patience. In the first half of 2022, the Personal Consumption Expenditures (PCE) price index that the Fed focuses on was rising by 8% a year. As of this June, it was rising just 3% a year. Throughout this disinflation, the jobless rate hovered near its all-time low while real consumer spending grew in line with the pre-pandemic trend.

In these unusual circumstances, the job for policymakers is twofold: address specific disruptions where possible—most obviously by deploying strategic energy reserves—while making sure that the “underlying” inflation rate stays under control. There is no single way to measure this “underlying” rate, but wages and the prices of services that are sensitive to domestic economic conditions seem like reasonable proxies. The goal is to “look through” the impact of temporary shocks that will eventually fade. Gasoline prices soared by nearly 70% between April 2021 and June 2022, only to fall by 30% from then until this June, for example.

Powell agrees with this framing. From his most recent press conference:

The inflation surge that we saw in the pandemic resulted from a collision of elevated demand and constrained supply, both of which followed from the unprecedented features of the pandemic and the response from fiscal and monetary policy. And we’ve always expected that the disinflationary process would stem from both from the normalization of those broad pandemic-related supply and demand conditions, and from restrictive monetary policy…We’re sort of reaping now the benefits of the reversal of some of the very specific pandemic things…Going forward, monetary policy will be important, particularly in that, in the sector, in the non-housing services sector.

Powell’s preferred measure of underlying inflation is the PCE price index for services excluding energy and housing. This measure rose by 0.21% in May relative to April and by 0.21% in June relative to May, consistent with a 2.6% yearly rate. Before the pandemic, this measure rose by 2.3% a year, on average. That sounds great, but the month-to-month data are too noisy to have confidence that this is anything other than a fluke. Temporary slowdowns in the monthly data have happened before, but the trend has proved remarkably durable.