Getting high on inflation

The October Consumer Price Index data has gotten the inflation hawks into a frenzy. And, there is no doubt it is bad news. The overall index was up 0.9 per cent the month, while the core index, which excludes food and energy, rose by 0.6 per cent. Over the last year, they are up 6.2 per cent and 4.6 per cent, respectively. This eats into purchasing power, leaving people able to buy less with their paychecks or Social Security benefits.

There is no argument about what the numbers show, but the key questions are what caused this rise in inflation and what can be done to bring it down.

Most wealthy countries have seen a substantial increase in their inflation rate in the last year, even if the current pace may not be as high as in the United States. The OECD puts Canada’s inflation rate at 4.4 per cent over the last year. In Norway and Germany, the inflation rate was 4.1 per cent. Some countries do have lower inflation rates. In France, the inflation rate over the last year was 2.6 per cent, in Italy 2.5 per cent, and in Japan, the debt king of the world, just 0.2 per cent.

While there are differences in inflation rates across countries, the sharp increases in places like Canada, and especially European countries like Norway and Germany, can’t be blamed in any plausible way on US policies to get through and recover from the pandemic. There is also no clear relationship between the size of the rescue and recovery packages and current inflation. For example, the size of the packages in France and Japan were considerably larger than the packages put in place in Germany, yet both countries have considerably lower inflation.

In many of the areas seeing the sharpest price increases, the inflation is clearly due to factors associated with the pandemic and the reopening of the economy which are not likely to persist long into the future. The most obvious example here is new and used vehicles, the prices of which have risen over the last year by 9.8 per cent and 26.4 per cent, respectively.

These two sectors, which added more than 1.2 percentage points to the overall inflation rate over the last year, have seen sharp rises in prices due to production snags associated with a worldwide shortage of semiconductors. The latter shortage in turn results from a major semiconductor producer in Japan being temporarily sidelined by a fire. This supply reduction coincided with a big upturn in worldwide demand. Because of the pandemic, consumers in the United States and other countries shifted their consumption from services, like restaurants and movies, to goods like cars, television sets, and smartphones.

This surge in demand for goods created the backlog of containers and container ships that we are now seeing at major ports. However, we will likely work through this backlog, both because supply issues will eventually be resolved as companies arrange to hire more truck drivers and trucks, and because demand for goods will wane for the simple reason that people don’t make these purchases every month. If someone bought a car in May of 2021, they are not likely to buy another one in May of 2022.

It is not hard to find an example of this sort of price reversal. Television prices rose by 10.2 per cent in the five months from March to August, a 26.3 per cent annual rate of increase. In the last two months, they have fallen by 2.8 per cent.

We can see similar stories in other areas.  The price of a bushel of corn rose by more than 100 per cent from its low in August of 2020 to its high in May of this year. It has since fallen back by almost 20 per cent, to a price that is well below what we were seeing back in 2013. Lumber is an even more striking case. The price more than quadrupled from its low point in April of 2020 to its peak in May of this year. It has now fallen back by more than 50 per cent to a price that is about 10 per cent higher than a peak hit in June of 2018.

It’s not easy to determine how quickly supply chain issues will be resolved, but when they are, we are likely to see the price of a wide range of goods, starting with cars and trucks, reverse itself and start falling. This will be true not only for consumer goods but many intermediate goods that have been in short supply in recent months. The end of the backlogs is also likely to mean a reversal in shipping costs, which have risen by 11.2 per cent in the last year, adding to the price of a wide range of products.

It is also worth noting some prices that have not risen much. The cost of medical care has risen by just 1.3 per cent over the last year. The cost of college tuition is up 1.8 per cent. Inflation in these former problem sectors has remained well under control through the pandemic and recovery.

Finally, it is worth mentioning the situation with rent, which accounts for almost a third of the overall CPI. We are seeing a sharp divergence in rental inflation across cities. The rent proper index was up 1.5 per cent year-over-year in Boston and Los Angeles, 1.7 per cent in Seattle and 0.2 per cent in NYC. It was down 0.3 per cent in Washington, DC and 0.4 per cent in San Francisco over the last year. By contrast, it is up 6.3 per cent in Detroit and 7.5 per cent in Atlanta. This is consistent with people moving from high-priced cities to lower-priced ones.

The low rental inflation, or falling rents, in high-priced metro areas is obviously good news for renters there. However, the rising rents in previously low-priced areas are bad news for prior residents who may be looking at large rent increases. Even with 6.3 per cent rental inflation, rents will still look cheap in Detroit for someone moving from Boston or New York.

It’s also important to remember that almost two-thirds of households are homeowners (only 44 per cent for Blacks and 48 per cent for Hispanics). For people who own their home, higher implicit rents are not a problem, and if the sale price goes up, as it has been doing, this is good news.

Anyhow, we may see some further increases in rental inflation in the months ahead. We have seen a large rise in home sales prices since the pandemic, which has far exceeded the rise in rents. The vacancy rate has also fallen somewhat, although the pace of new construction did pick up sharply, which should help to lower rents over time.

The standard remedy for inflation is to deliberately slow the economy with higher interest rates from the Fed and possibly cuts in government spending and/or tax increases. The idea is that by slowing the economy and throwing people out of work, we can put downward pressure on wages, which will then mean lower prices.

There is no doubt that if we force workers to take large enough pay cuts, it will alleviate inflationary pressures, but this is a rather perverse way to accomplish the goal. With low interest rates and high demand, companies have large incentives to innovate to get around bottlenecks. It’s much better to allow the economy to work its way through a stretch of high inflation in ways that could lead to lasting productivity gains than to squeeze workers so as to alleviate cost pressures.

It’s also worth noting that many of the proposals being put forward by the Biden administration will help to alleviate inflationary pressures in both the long term and the short term. In the latter category, universal pre-K and increased access to childcare will make it easier for many parents, primarily women, to enter the labor force or to work more hours.

In the longer-term category, increased access to broadband and improving our transportation infrastructure will increase our capacity in many areas. Also, money spent to protect against the effects of climate change will reduce the disruptions caused by extreme weather events in the future. This is a much more promising path for dealing with inflation than forcing workers to take pay cuts.