Tue. May 24th, 2022


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Last week, US inflation figures for December were released. They showed year-on-year inflation at 7 percent, the highest rate in four decades. This caused a lot of alarm. Much of it is based on an ill-considered reading of the data, for three reasons.

Graph showing annual change in CPI

First, please ignore year-on-year measures. Whatever drives the price dynamics, these forces tend to change quickly and unpredictably.

We know this because they have changed rapidly and unpredictably. Take this example: last February, consumer prices were a subdued 1.7 percent higher than a year earlier. It was no good guide to the big jumps in prices in the months that followed immediately, which pushed the year-on-year rate above 5 percent (and will keep it there for some time, even if it drops monthly inflation right back this month.).

It would have been wiser to look at the monthly rate of change (mea culpa: I have not). It was the fourth consecutive monthly price acceleration, showing a rapid change in inflationary pressures, and it hit a rate of change that, if sustained, would eventually push annual inflation above 4 percent on its own.

As a result, the revolving inflation data should not have been that of December, but that of September and October, when monthly inflation rose again, high above sustainable levels, after delayed from early summer peak (see graph below). After that, high year-on-year numbers were arithmetically baked into the December release, and anyone pretending to be shocked by the December numbers without pointing them out relieves you (maybe not even themselves).

Line chart of seasonally adjusted consumer price index (all urban consumers, all items in U.S. city average), month-on-month percentage change showing that Monthly inflation is falling again

Second, what do we learn from the December release that is new?

Most importantly, overall inflation declined rapidly. The (seasonally adjusted) monthly rate has halved over the past two months. The same pattern applies to all the main sub-categories – including food prices, and energy inflation has even become negative – but one. The exception is commodities excluding energy and food, for which prices are growing at a stable but high rate.

In particular, there has been no increase in broad services inflation, which has also halved in the past two months. Non-energy services’ price inflation is stable; energy services price inflation is negative.

Those who, like me, expect inflation to fall by itself do so because we do not think it is caused by excessive total spending, but by the enormous and unprecedented shift of spending away from services to goods. Nothing in the December figures gives a reason to give up that belief. Those worried about inflation are on the lookout for price pressures spreading from goods to services. There is also not much to support that fear.

If we think that people will eventually split their spending between goods and services more or less as they did before the pandemic (or that global capitalism will soon enough adapt to any modest, permanent shift in their shares), then we should expect commodity price inflation – which is all that is there at the moment – to go away too.

The important data exemption to wait for is therefore not for inflation, but for the gross domestic product: on January 27 we will get a sense of whether growth in the fourth quarter continued the preliminary trend away from spending on goods and back to services, which could be obtained in the third quarter. As I have previously said, reasonable disagreement about inflation should logically amount to different views on whether this will happen.

A colleague pointed out that 0.3 percent month-on-month services inflation could still make 3.7 percent price growth over a year if sustained. That’s true – but it’s right on the level of services inflation. For decades, overall inflation near 2 percent has meant that service prices have risen by 3 percent or more, and commodity prices have fallen enough to bring the average down.

Chart showing US consumer price index by sector from 2015 to 2021

My colleague Rana Foroohar has an important point in her column this week: if durable goods prices stop falling as before, this average will no longer work. But why should they? The factors that Rana mentions – relocation, 3D printing and decarburization – can increase the cost of goods. But apart from a one-time shift, why should it reduce productivity? growth in how we make goods? 3D printing in particular should boost productivity. In any case, once consumption patterns are established, normal sectoral inflation rates should be as well.

Third, the fear of rising inflation is usually expressed as a fear of a wage price spiral. So another series of US data releases – from wage data, show average hourly earnings year-on-year rise by about 6 percent – worried people. Here, too, things look different with the monthly changes – overall wage growth has declined sharply. But it is true that wages for ordinary workers (“production and non-supervisory employees”) continue to rise sharply.

The fear is that as businesses face rising costs, they will drive up prices. But wage pressure is not the same as cost pressure. The best measure of how much labor compensation costs businesses is rather the Employment cost index, which includes non-wage compensation costs (such as benefits and health insurance). It did rise sharply in the third quarter, the latest available (look out for Q4 on January 28) – up 1.3 per cent in three months. Year on year, the figure was 3.7 percent.

But we must note that this comes after a decline in compensation growth early in the pandemic: employees cost employers on average just 6.2 percent more than two years earlier. It also comes after decades of employee compensation not matching productivity growth. To judge whether growth in employment costs is “pressure”, we need to compare it with labor productivity. And if we only match the (weak) growth in real output per hour worked over the past decade, which was average 1.1 percent per year, employers can, without real cost pressures, absorb annual wage growth of 3.1 in a world of 2 percent inflation. This is a conservative estimate; it both ignores that compensation has lagged behind productivity growth – so there is room to catch up – and that a high-pressure economy can help increases productivity growth.

All this reasoning is based on the state of the US economy. Other economies have seen rising inflation, but for different reasons. Europe in particular has not experienced the same extraordinary swing from services to goods spending, as Laurence Boone, OECD chief economist, said recently in a recent blog posting (see her chart below).

Very strong demand for goods, especially durable, in the US

There are other sources of inflation – notably Europe’s energy squeeze – but there are clear signs that policymakers around the world are now grappling with a commodity price inflation that is widely made in America.

Other readable

News numbers

  • My FT colleagues compiled a great zip code tool where you can see how your own main street fared in the UK’s pandemic.

  • British inflation is also on a record high.

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