Prices have been rising too fast since mass vaccination enabled the great reopening of early 2021. Much of this unwanted inflation can be attributed to specific supply disruptions caused by the pandemic or to temporary pandemic-related changes in the mix of goods and services that consumers wanted to buy.1

But rapid wage growth has partly contributed to America’s excessive inflation—and the importance of this channel is only increasing as supply disruptions unwind and spending patterns normalize. Workers’ pay gains will need to slow if we want to squeeze inflation out of the U.S. economy. The ease of this adjustment depends in part on the flexibility of corporate profit margins, which remain unusually elevated.

The Looming Deflation in Goods vs. Underlying Inflation

As I have explained at length in previous notes, most of the unwanted price increases we have experienced since the start of the pandemic can be explained by idiosyncratic factors. Those forces made inflation worse than what might reasonably have been expected based on fundamental domestic economic conditions. Nominal national income in 2022Q2 was less than 5% higher than what might have been expected based on the 2018-2019 trend, yet the Consumer Price Index (CPI) was 8% higher.

The good news is that the impact of those disruptions should fade as businesses adjust and society normalizes. In fact, this already seems to be happening. Input prices for manufactured goods are starting to fall while the Federal Reserve Bank of New York’s index of “global supply chain pressures” has been plunging since the peak reached at the end of 2021.

With the notable exception of auto dealers, which are still struggling with the underproduction of new vehicles since February 2020, U.S. retailers’ inventories have mostly normalized relative to sales. The dollar value of retailers’ inventories in August 2022 (the latest month for which we have data) is up by 12% since January 2022, while spending at retailers excluding gasoline stations is up by less than 3%.

The situation looks similar further upstream, with American wholesalers’ inventories up by more than 14% since the start of 2022 while sales excluding crude oil and refined petroleum products have grown less than 4%. That has helped bring most I/S ratios back to where they were before the pandemic.

For the most part, these deflationary forces have yet to reach consumers. Durable goods prices have stopped rising, but before the pandemic they generally fell about 1% a year. The price index for “major appliances”, which was a harbinger in the first months of the pandemic, has dropped by 8% since the peak in March, although it’s still more than 20% above pre-pandemic levels.

It’s therefore reasonable to suspect that the unusual—but temporary—price increases in goods will eventually be followed by unusually large—but temporary—price declines. We may also benefit from normalizing inflation rates for various services that had fallen in price during the pandemic only to shoot up during the reopening. Hotel room rates, for example, fell more than 15% during the pandemic, jumped more than 25% during the reopening, and have been essentially flat since last October. Other services may soon follow suit.

These developments, should they occur, would make inflation appear slower than the underlying trend determined by domestic conditions. Just as it would have been wrong to conclude that the 11.1% yearly CPI inflation rate in the first half of 2022 was an accurate reflection of domestic conditions, it might also be wrong to view a sharp slowdown in inflation as a sign that spending and production have gotten back into balance. Discounting temporary factors can be appropriate, but this must be done in a consistent and transparent way.

The question is: what will inflation look like once the one-off price spikes and one-off price declines finish working their way through the data? This is not a simple question to answer. But we can be reasonably confident that prices can’t grow too much faster (or slower) than incomes for very long—and the largest source of consumers’ income, by far, is worker pay.

Wage Growth Has Been Too Fast. Will It Slow On Its Own?

The Overshoot

Wages, Prices, and Taming U.S. Inflation

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