The Ghost Of “Inflation Yet To Come”

For most investors, the “Ghost of Inflation Past” would bring visions of long lines at gas stations, eye-popping mortgage rates, and steady wage-price spirals that entrenched expectations through the 1970s. The “Ghost of Inflation Present” would only need to roll out some recent data prints, including the headline, core, “trimmed mean” and “sticky” measures of current price dynamics.

But what does the world look like when the economic spirits send warnings of darker times ahead—and Fed Chair Jerome Powell starts to echo them?

After four decades of falling inflation and interest rates, most of the world’s central bankers and economists still believe that current price pressures will abate next year. They struggle to see what has changed fundamentally from a pre-COVID era, when the combined forces of technology, globalization, and demographics kept wage and price pressures firmly in check. Investors disagree about just how high or how long the current spike might last, but there is little ambiguity that inflation and rates will be falling soon enough.
 

U.S. Consumer Price Inflation
Y/Y % Change

Source: Bureau of Labor Statistics. As of December 17, 2021.
 

It’s still an uncertain world, and changing just a few assumptions could keep U.S. consumer price inflation above 3% late next year and edging higher. These are only “shadows of the things that May be only,” as Charles Dickens wrote in his classic tale, but it’s well worth a hard look as fresh data comes into view next year.
 

1. Smaller labor supply: There are fewer Americans to put to work since the pandemic struck. Some have chosen early retirement with savings that enjoyed nice market gains; some have stayed home while COVID risks persist; some have sought less-stressful jobs than truck driver or flight attendant. Many young parents have yet to return to work because childcare has become too expensive. Government stimulus programs have expired, but savings are historically high and we may never get back to pre-pandemic labor force participation rates near 64%. 
2. Rising labor demand: Firms that have posted record profits and plan fresh capital expenditures expect strong demand to continue. Not only can they afford to pay higher salaries, they can’t afford to lose talent. Rising wage pressures in some industries may only dissipate in the next recession, which could be years away.
3. More tangled supply chains: Coronavirus disruptions linger on, with supply shortages and rising prices on everything from garden gnomes to scented candles. If Omicron and future variants prove more dangerous and vaccines look less effective, watch for further jumps in goods prices even as restaurants, airlines, and hotels absorb another blow.
4. Tighter oil markets: It’s hard to imagine another 50% oil price spike like we got this year, but strong demand could deliver a nasty surprise if OPEC drags its feet on production growth. Climate policy has led to underinvestment here, which could provoke more volatility. (Meanwhile, a Ukraine crisis that triggers sanctions could also deliver a shock to Russian exports.)
5. Soaring house prices: They can’t really “soar” much from the current U.S. average price of $453,300, but they can keep rising amid strong demand and structurally short supply. A hot (for economists) debate rages around the methodology that incorporates home prices into the Consumer Price Index, but the market is unquestionably tight. With rising building costs, neither homebuilders nor landlords are likely to ask for less anytime soon.
6. Generosity in Washington: With two weeks to the end of the year, it’s still anyone’s guess just how America will spend taxpayer money in 2022. Deficits will be smaller than the 15% of GDP this year and last, and more stimulus checks look unlikely, short of a severe economic downturn. But President Biden’s Build Back Better program has a lot of soft benefits that will support consumer demand, and the bipartisan infrastructure package will surely give demand a boost.
7. Random events: A weaker dollar, as other central banks pivot to tightening, would make matters worse as import costs rise. More hurricanes, forest fires, and power outages could disrupt key supplies. Trade war escalation with China (or Europe) would likely add more tariff costs to final prices. Any or all of these could fuel expectations of inflation, which fuels inflation itself. 

For the most part, these events would drive U.S. inflation rather than global price dynamics, which look much less worrying for now. Yet U.S. prices will drive Fed policy, which will largely determine the direction of global markets next year. 

The root cause of the current price data still lies mainly with the unexpected surge in post-lockdown demand that will not be repeated in 2022. But we are watching these risks closely, because we’re pretty sure Ebenezer Scrooge would awaken from his visits with the inflation ghosts and put all his money into “TIPS.”