After a lengthy absence, inflation has finally returned to the US, but for how long depends on who you ask. Many observers, including the US Federal Reserve (Fed), continue to expect today’s inflationary pressures to be more or less “transitory” in nature. Recent market pricing would seem to suggest that they may be right.
But the more I think about it, the more I think they may be wrong. Here are five reasons why I believe US inflation could prove to be far more enduring than widely expected.
- A still-early economic cycle: The US economic cycle is still in its very early stages, as shown by the recent high level of new business orders relative to the supply of available inventory (Figure 1). This metric, tracked by the National Association of Purchasing Managers (NAPM), typically rises at the beginning of an economic cycle (the expansion phase) and then falls steadily throughout the remainder of the cycle. This tells me that, like the current cycle itself, inflation too may have legs for the foreseeable future.
- A persistently tighter labor force: The US labor pool looks more constrained than many people realize and, thanks to demographics, may stay that way for some time. Roughly 5 million US workers have left the labor force since the onset of COVID-19, including around 3 million from the 65+ age bracket that are unlikely to ever rejoin. And the ratio of prime workers to the total US population is declining. This could translate to ongoing labor shortages and thus upward pressure on wages, which trends to be inflationary.
- Commodities sector behavior: Whereas many commodity producers ramped up their production output sharply during past cycles of rising commodity prices, we are not seeing the same type of response from the commodities sector this time around. Take the oil industry, for instance: As of this writing, Brent crude oil was trading at nearly $70 per barrel – comparable to its 2018 price range – yet the number of oil rigs was down about 55%. If this trend continues, it may help support higher US inflation more broadly.
- Banks and the velocity of money: So far, US banks as a group have not been deleveraging like they did during the last credit cycle. This could be another inflationary dynamic. In addition, there has historically been a loose correlation between the velocity of money in the US and the relative performance of bank stocks. The velocity of money has been subdued in recent years, but if it were to increase or even just stabilize going forward, this could also contribute to higher US inflation.
- US policy coordination: The US inflation picture appears much more aggressive than the rest of the world. For example, the difference between US inflation and average emerging markets inflation is only about 0.5%, but the gap in their nominal bond yields is more than 4%. In other words, US inflation expectations are running high. One reason why: Unlike the US policy response to the 2008 global financial crisis, US fiscal and monetary policy actions have been very well coordinated in the era of COVID-19. The combined effect has been economically stimulative (and inflationary).