Posted by: Josh Lehner | September 14, 2021

Persistent Inflation is a Risk

This morning the Bureau of Labor Statistics released the August CPI data. As expected it showed both a slowing in inflation, but still at a rate above the Federal Reserve’s target. Inflation over the coming 3, 6, 12 months is one of the most interesting economic developments to watch. This is something an increasing number of you have reached out to our office about. In our latest few forecast documents we have had a couple pages on the inflation outlook. Today I am pulling out and updating our most recent thoughts on the subject.

In recent months inflation is running hot. Much of this can be explicitly tied to reopening sectors of the economy, or shortages in the automobile industry. However, even stripping away these likely temporary issues, the risk remains that underlying inflationary pressures will remain somewhat above the Federal Reserve’s target moving forward.

On the one hand, prices in recent months have surged in sectors and activities previously restricted by the pandemic. The costs for airfares, hotels, and admissions to events are up. However these prices also dropped earlier in the pandemic. The current surge is really bringing these prices in line with where they likely would have been absent the pandemic. As such, these prices will moderate moving forward. [This morning’s report showed an unexpected decline in these prices, likely due to the delta wave, even if these broader dynamics were anticipated.]

Additionally, demand for automobiles has recovered much quicker than production has, largely due to the shortage of semiconductors needed to complete assemblies. This mismatch between supply and demand is driving the price of both new and used cars considerably higher. As computer chip production increases, and as demand slows in the face of these higher prices, the overall dynamics in the auto industry should moderate as well.

While these examples may explain a large part of the current high readings for inflation, they are not particularly interesting or pertinent to the overall monetary policy discussion. The Federal Reserve will look through temporary bouts of inflation. What the Fed ultimately cares about is persistent inflation that is higher than its 2% target on an ongoing basis. For this reason note the gray bars in the chart above. The All Other portion of the inflation readings are currently running at about a 4% annualized pace. This is well above target. How long does this last? At what point would the Federal Reserve respond to readings continuing in this range?

The key dynamics to watch here are the interactions between actual inflation, expectations about future inflation, and underlying wage and income growth. Of course all three of these are point up today, but what does the intersection between them look like in 3, 6, 9 months from today? Without the belief that prices moving forward will be higher, it is harder for firms to raise prices. Similarly for income gains, if consumers cannot afford the higher prices without sacrificing quantities consumed, then prices will slow accordingly. Such inflationary pressures will peter out on their own.

The ultimate economic risk lies in inflation proving more persistent than believed such that the Federal Reserve steps in and raises interest rates to cool the economy. Not only would this slow economic growth, but in some historical periods, it has even caused a recession. The Fed has not yet laid down hard markers on what it will or will not tolerate when it comes to inflation, nor its beliefs on just how much is transitory versus persistent. However the answers to these questions in the quarters ahead will matter considerably. To be clear, no reasonable outlook calls for hyperinflation or even mid to high single digit inflation. However, the underlying stage is set for inflation that could be modestly, yet persistently above target. Whether the economy actually experiences that or not is unknown.

Today the Federal Reserve is nearing agreement on the timing and pace of tapering, or reducing its long-term asset purchases. Many market participants expect the announcement in the next month or so with the actual tapering to begin late this year or early next. In terms of interest rates, market participants expect the first rate hike to occur in late 2022 or early 2023. The risks on the timing are balanced. A few more hot inflation prints and rate hikes may occur sooner, a few weaker monthly jobs reports and slowing inflation, and rate hikes may be pushed to later dates.

Now, one potential saving grace for inflation could be productivity growth. Not only does increased productivity raise the overall speed limit of the economy, but it also helps firms absorb higher costs without pushing them all forward onto consumers. If a business is able to produce more output with fewer workers, it makes the cost pressures on their inputs (parts and labor) more manageable. As a result, inflation in the overall economy can better be kept in check.

To date, productivity has increased during the pandemic. Output per worker in Oregon is up around 8 percent. Much of these gains have been forced onto firms where they must try and make do with what they have. Consumer demand is strong, and the firms have limited staff and production capabilities. They are doing more with less because they really have no other choice.

However, over the medium- and long-run firms can better plan for their investments which tend to raise productivity as well. Nationally, new orders for capital goods and announcements of capital expenditures are up indicating businesses are looking to invest in new plants, equipment, and software moving forward. This should make managing price pressures easier in the years ahead.

Two final notes on productivity and inflation.

First, new business formation is strong since the start of the pandemic. New firms tend to bring new products and services to the economy, and improve efficiencies and raise overall productivity. Should this new generation of businesses do likewise, productivity should continue to improve.

Second, increased production capacity should also relieve price pressures. If products are no longer supply-constrained, increased demand should result in more production and not just higher prices. As detailed in our office’s previous forecast, a number of manufacturing subsectors – food, machinery, and wood products in particular – were already at their historical limits in terms of capacity utilization. They need to expand in order to meet demand. However a similar argument applies to services like child care. A national boost to increase the supply of these, be they semiconductors, housing, or child care, as is currently being debated in Washington D.C. as part of the infrastructure and/or reconciliation bills, could ultimately prove disinflationary as it would remove current choke points in the overall economy.


  1. Wow, kudos for being brave and the first govt agency state/fed to admit inflation will be a problem

    “market participants expect the first rate hike to occur in late 2022 or early 2023.”

    Will to give me the under on that over/under bet? 🙂

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