Posted by: Josh Lehner | December 29, 2021

Inflation is not costless

An economy where demand is very strong and supply is constrained is a classic recipe for rising prices. Inflation is running hot, and showing no real signs of letting up in the near term. Initially, much of the inflation could be directly tied to reopening sectors of the economy, and shortages in the automobile industry. More recently gas prices pushed headline inflation higher. However, inflationary pressures have widened beyond these specific, temporary issues. Inflation is currently running at about a 4 percent annualized pace in recent months, even after excluding these well-known issues. As discussed previously, persistent inflation is a moderate risk to the overall outlook.

Given the faster and broader inflationary pressures the Federal Reserve has pivoted in recent months. They are accelerating their tapering so that it ends in March instead of June of next year, and raised their forecast of interest rate hikes as well. Current expectations are for 3 rate hikes next year, in part to head off inflation so that it does not become more entrenched in the economy, but also in part due to the strong labor market. An underappreciated view has been that in the quarters ahead the Fed will meet both aspects of its dual mandate.

It’s important to keep in mind that inflation impacts the real economy in a few ways. Inflation is not costless.

First, higher prices eat into household budgets, ultimately resulting in what economists call demand destruction. When prices get too high, people stop buying. This feeds back into the production side of the economy. If sales slow, then firms do not need to produce as much, or employ as many workers. Now, this process typically results in slower real growth rather than outright declines. To date the U.S. economy has not reached this point given the strong income growth. However if hot inflation persists, we eventually will.

Second, higher prices also eat into the strong wage gains workers are experiencing. While the average wage in Oregon is up about 15 percent since the start of the pandemic, the real, or inflation-adjusted average wage is up 8 percent. Clearly those are still solid gains over the entire period, however as seen below, inflation is beginning to impact real wages much more in recent quarters. Inflation-adjusted wages are declining for most workers in the past 6-12 months.

Should inflation considerations become a more regular part of wage negotiations, it can lead to more cost-push inflationary pressures in the broader economy. What matters most for workers and households are real wage gains, which are not expected to pick up again in the current outlook until late next year as inflationary pressures subside.

Even so, wages are continuing to rise fastest among low-wage workers throughout the pandemic. After adjusting for inflation, Oregon workers earning less than $20 per hour are seeing real wage gains and an overall increase in their standard of living. On the other hand, middle- and high-wage workers are, on average, still earning wage gains, but those raises have not fully kept pace with inflation. (See here for the latest on real wages nationally.) One result of this wage compression is a reduction in overall wage inequality, which may have some social or economic benefits even in a high inflation environment.

Third, as costs rise, firms face the decision to pass these costs forward onto consumers, contributing to overall inflation, or to reduce margins or other costs to help keep final prices lower. These adjustments take time, and are based in part on businesses’ beliefs about the ability of consumers to absorb higher prices. Today, given incomes and demand, firms are passing along cost increases and profit margins have actually increased to be at or near record highs. Moving forward, at some point it is likely that rising labor costs will begin to reduce profit margins back down to their historical range. This will be disinflationary as final consumer prices increase at a lower rate than underlying costs.

Bottom Line: Inflation continues to run hot. Inflation is not costless for households or the economy more broadly. The Federal Reserve is pivoting to tightening policy more quickly than they had been anticipating to ensure that higher inflation does not become more entrenched in the economy. The ultimate economic risk is that tightening policy too quickly cools the economy too much leading to a boom/bust cycle. But for now the baseline outlook remains that the Fed is able to engineer a soft landing. The current inflationary boom turns into an ongoing economic expansion with moderate inflation at or near the Fed’s 2 percent target. Inflation continues to be one of the most interesting economic developments to watch in the year ahead.


  1. How about an update on PERS assets and how much of the under-funding has been reduced with robust market performance this year!

  2. Highly recommended reading on the dangerous underlying situation with respect to inflation and wealth disparity:

  3. OK, they’ve dropped the “transitory” tag, how much longer before this cools down? Election in Nov 22, is kinda forcing the Fed (and Biden) to do something isn’t it?

    On the inflation adjust you show wages still beating inflation, but I thought at 7% +/- that wages are up like 5%, what’s going to change that? Any higher wages get passed on in product costs, right?

    Any tool besides higher interest rates? a 50-point jump will really mess with the RE market which is a lot of people’s piggie bank.

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