Economic transitions aren’t transitory
This year’s spikes in U.S. inflation seem to have a clear cause: shortages and supply interruptions. From empty container ships backing up in harbors to missing semiconductors for car production, there are real factors driving prices up. Wages and real estate prices also are being pushed upwards by local shortages of desirable workers and houses. Federal Reserve Chair Jerome Powell and the vast majority of the Federal Open Market Committee (FOMC) members have described these factors as “transitory” and predict that Core PCE inflation will average 2.1 percent in 2022 and 2023 — a steep decline from the inflation that we are experiencing now which will likely average around 4.7 percent (5.0 percent on Core CPI) for 2021.
That forecast and similar ones from private-sector forecasters is far too low for near-future inflation. Their error is not that real factors of shortages and labor-market mismatch do not matter, for they do. Their error is that they assume these issues will be resolved quickly, within just the next few months for their 2022 inflation forecasts to come true. There is a genuine uncertainty here which belies this confidence. Instead, if anything, the economic transition we are undergoing is likely to take longer to adjust to, and it will be another year or two before inflation subsides back to that long-run 2 percent level.
Both employers and workers are reevaluating their commitments to their present jobs. The pandemic lockdowns and dislocations have made the costs of change seem smaller. For businesses, this means rethinking their investment plans in light of changing demand from customers and from workers. This includes potential automation replacing some labor, but also investing in flextime and recruitment to retain high-productivity workers. For many workers, their reservation wage has gone up — meaning the minimum set of work conditions, benefits and pay they will accept versus not working or seeking a different position.
The delta variant has reinforced this rethinking, by emphasizing that there will not be a rapid return to pre-COVID-19 normal. Pandemics will persist and recur, and planning by households and businesses is now taking that into account. This is particularly true for sectors like in-person retail, hospitality and tourism, with direct knock-on effects for commercial real estate and transport. False hopes that these sectors would fully recover rather than restructure are now being set aside. While some of this adjustment is disinflationary, as workers must change industries and affected businesses lose value, this process also increases labor market mismatch and relative values of other sectors. Such large-scale reallocation of labor and capital can take years, with uncertainty persisting amid intermittent government bailouts.
More importantly, forces encouraging diversification of supply chains and increasing resilience have been building for a long time pre-COVID but take even longer to play out. Toyota found itself with a shortage of semiconductors as a result of the Fukushima disaster in 2011, and began stockpiling and diversifying production then; Boeing ran into difficulties in production of the 787 Dreamliner due to supply chain overstretch that were obvious by 2008. Despite these well-reported examples from globally prominent companies in important sectors, the bulk of multinational companies had not yet adapted, as the events of this year’s shortages revealed. There is a long road ahead to alleviating shortages across the economy, even if we get U.S.-located semiconductor fabs within a couple of years.
The economic nationalism of successive American presidential administrations, the growing conflicts with China and frictions with other major trading partners, and populist demands for trade protection and self-sufficiency have added an ongoing pressure to “bring production home” and to stockpile redundancies instead of diversifying. With long lags, this political direction has made the American economy ever less resilient, increasing the costs and uncertainties of access to needed resources and inputs. Whatever the relative importance of this geopolitical prioritization over economic efficiency, it does raise costs for U.S. producers and consumers. The anti-immigration aspect of this push causes labor shortages in fields (literal and figurative) where native-born workers will not toil at the sustainable wage, further pushing up costs. Scapegoating trade with nostalgia for old industries and jobs will fail to deliver economically but fuel these political pressures.
So, there is little reason to be confident that the current supply shock — and its inflationary impact — will only last another few months as the Fed and other forecasters apparently assume. Even if companies build up inventories and make geographically spread redundant capacity investments, that will take time to have an effect. That process will also temporarily increase GDP growth, which is always welcome but will further support inflation and wages in an unsustainable manner in the coming year.
Similarly, there is little question that climate change will continue to increase the volatility of relative prices, international tensions and barriers, interruptions in production and commerce, and basic costs of doing business, let alone of living our lives. It should — carbon should cost more, natural resource extraction should be rarer and dearer, societies must insure, and households self-insure against more frequent disasters and longer-term change. Buildings, utilities and transportation must shift technologies, as the Biden administration is rightly encouraging. At the start of the process, where we are now, though, this will likely be inflationary as well.
Bottom line, adjusting to supply shocks takes more than a few months’ time. This is partly because the supply shocks themselves can last longer, and partly because businesses and workers take time to adjust. So, though the Fed’s inflation forecast for 2022 is way too low, Chair Powell is completely right to say that central banks should not react to supply shocks by prematurely tightening. This means that the Fed will have to hold its nerve from raising interest rates for much longer than currently tipped, even when inflation overshoots both their target and forecast next year. Monetary policy can best facilitate adjustment to long-term economic transitions by keeping policy loose as relative prices work themselves out and workers shift. The FOMC should not mistake the coming inflation higher than they expect as a reason to tighten. Transitory just is longer than they seem to think.
Adam S. Posen is the president of the Peterson Institute for International Economics.
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