Is Stagflation Returning?

This past year we’ve seen an unmistakable uptick in inflation measures. We’ve all experienced it firsthand at grocery stores and gas pumps, now the official numbers have confirmed our observations. Canada’s December Consumer Price Index rose 4.7% on a year-over-year basis while in the United States, CPI rose 7.0%.

Under these circumstances, a rise in inflation was to be expected.  On the supply side, the last two years unleashed an unprecedented wave of factory closures, production delays, materials shortages, and global shipping disruptions. Empty shelves and back ordered items have become commonplace. In simple terms, there’s less inventory for sale and things are harder to come by.  In economic terms, a widespread decrease in the availability of product is called a “negative supply shock” and is typically accompanied by job losses and inflation.  

The combination of high unemployment and rising prices is known as “stagflation”, and the experience of the 1970s showed us that economists have no ideal policy response to deal with the effects of negative supply shocks.  Instead, they face a dilemma: If they raise interest rates to dampen inflation, this causes greater unemployment.  If they pursue an expansionary policy to stimulate demand and reduce unemployment, the result will be more inflation.

We already know how policy makers responded to the pandemic-induced supply shock, they went all-in on inflation.  The economic impact was met head-on with unprecedented stimulus, both fiscal and monetary.  Governments ran up record deficits, borrowing to create new benefit entitlements, mailing out stimulus checks, and spending on nearly anything, while central banks cut policy rates to effectively zero while buying up the trillions of growing government debt.

Mortgage rates fell and home prices soared. Investment markets rebounded from the sharp losses experienced at the onset of the pandemic and embarked on a string of record highs. Many households, watching both their home equity and investment account balances rocket higher, suddenly found themselves wealthier than they’d ever been.  This wealth effect drove consumption, especially on goods since many services were altogether unavailable.

When supply is constrained and demand grows, prices inevitably rise.  For example, US new vehicle prices rose 11.1% as dealer inventories were replaced by waiting lists.  Used vehicle prices (unhindered by MSRPs and immediately available) jumped 31.4% year over year.

Under these supply circumstances, and with an expansionary policy response, there was no question that there would be price inflation; the only questions were how much, and for how long.  Central banks initially ran with the talking point that any inflation would be merely “transitory”, but what turned out to be especially short-lived was the talking point itself.

“We tend to use [transitory] to mean that it won’t leave a permanent mark in the form of higher inflation,” Fed Chair Jerome Powell said during a congressional hearing in November. “I think it’s probably a good time to retire that.”  Former Fed Chair Janet Yellen echoed Powell’s opinion: “I am ready to retire the word ‘transitory’.  I can agree that that hasn’t been an apt description of what we are dealing with.”

Central banks have acknowledged that higher inflation will probably be with us for a while, and they have signaled that they’ll perhaps take action to do something about it. They’re quite at ease with letting inflation run hot while the economy returns to full employment.  What they might not have noticed are the “help wanted” and “now hiring” signs plastered virtually everywhere.  The United States “unemployed to job openings” ratio, which peaked at 5.0x at the start of the pandemic has fallen to an all-time low of 0.7x.

Fig 1: Number of Unemployed Persons per Job Opening, seasonally adjusted

Shaded area represents recession, as determined by the National Bureau of Economic Research Source: U.S. Bureau of Labor Statistics There are presently about 50% more available jobs than there are job-seekers. By this measure, the US labor market has never been tighter, and the US unemployment rate has marched steadily lower since the start of the pandemic, falling to 3.9% in December.

Fig 2: US Civilian Unemployment Rate, Seasonally Adjusted

Shaded area represents recession, as determined by the National Bureau of Economic Research Source: U.S. Bureau of Labor Statistics By historical standards, a 3.9% unemployment rate is low. In fact, it’s not very far above the all-time low of 3.5% set immediately pre-pandemic. Without high unemployment, we’re not currently seeing stagflation.

What we’re seeing is straight-up inflation, and there are a few signs that it may persist and perhaps intensify.

• First, interest rate hikes are still likely months away. Central banks prefer to gradually ease off the accelerator rather than slam on the brakes. But policy rate changes can take several quarters to affect price levels, and the Fed is already late getting started.
• Second, energy prices have risen sharply (gasoline prices were up 58.1% year-on-year, and well above pre-pandemic levels). We should expect these higher transport costs to work their way through to higher tangible goods prices.
• Third, a tight labor market drives wages higher… and higher wages mean higher production costs, but also more household purchasing power… both inflationary.
• Fourth, the disruption of global supply chains is driving a move toward “reshoring” … a reversal of decades of “offshoring” production to cheaper labor markets. Domestic manufacturing will inevitably cost more.
• And fifth, central banks have been explicitly telling us they’re going to allow higher inflation in the short term to target “average inflation” over the long term. In 2020 the Fed announced a policy shift toward achieving “inflation that averages 2 percent over time”. And because inflation had been below 2% for several years, the Fed has given itself permission to stand by and watch as inflation runs above 2% for a few years.

So, based on all of the above, for the next few years we should probably prepare for prices to rise faster than over the last few years. This isn’t likely a rerun of the stagflationary 1970s, but it is a sign that the disinflationary trend we’ve enjoyed for so long may be ending.