US inflation continues to accelerate

In the past week, there was much anticipation about Friday’s US government report on inflation for November. After annual inflation hit a 30-year high of 6.1% in October, there was a widespread expectation that the November number would be close to or above 7.0%, especially given the recent surge in energy prices. On Friday, expectations were roughly met—but not exceeded—and that seemed to please investors who pushed up equity prices and pushed down bond yields. Many investors were evidently pleased that inflation was not worse than expected, which suggests that they expected the unexpected. Recall that Federal Reserve Chairman Powell had previously said that inflation will likely get worse before it gets better. That turned out to be true.

The bullwhip effect and its impact on inflation

There are many sources of the higher inflation we are currently seeing in the United States, Europe, and emerging markets. These include fiscal-stimulus-fueled increases in consumer demand, the decision by consumers to shift spending from services to goods during the pandemic, and pandemic-induced disruption of production and transportation capacity. Yet, according to economists from the Bank for International Settlements (BIS), which is the central bank to central bankers, another important factor has been the so-called “bullwhip” effect.

A paper by economists at the BIS describes the bullwhip effect as happening when “supply chain participants react to perceived shortages by ordering more, ordering earlier and by hoarding inputs. This kind of reaction is prudent and rational when considered in isolation but can lead to aggregate outcomes that are ultimately self-defeating.” That is, such behavior exacerbates shortages and contributes to higher prices. However, a deeper analysis of specific ruptures in supply chains reveals that “bottlenecks are not simply a uniform squeeze everywhere along the supply chain. Instead, we have seen commodities demand whipsaw as pressures emerged at different points in the supply chain, resulting in large price fluctuations.” In other words, prices of some commodities and inputs have soared due to the bullwhip effect, only to collapse afterwards. The BIS points to what happened with the prices of iron ore, lumber, and coal as well as the cost of shipping containers. In each case, prices soared and then fell sharply as capacity increased faster than demand.

What are the implications of the BIS analysis? Lately, the conventional wisdom has been that the bullwhip effect will exacerbate supply-chain disruption, thereby prolonging inflationary pressures and boosting expectations of future inflation. Indeed, the OECD has called attention to this problem. However, the BIS asks, “To what extent will the behavioral responses that gave rise to bottlenecks work in reverse to clear up backlogs once supply chain problems begin to ease? Depending on the answer, we may find that supply bottlenecks may be resolved faster than currently feared, just as they have persisted longer than initially expected.” Thus, the reversal of the bullwhip effect could be the path to lower inflation.

In any event, most of the increased inflation in major economies has been in goods rather than services, evidently due to supply-chain issues. This follows a decades-long period in which prices of services increased while prices of goods declined. This relative decline in the prices of goods was due, in part, to sharp increases in the productivity of goods-producing industries relative to service-producing industries. The sudden reversal of this long-term pricing phenomenon was due to the temporary disruptive impact of the pandemic. It led many consumers to shift to more goods spending while capacity remained restricted. The bullwhip effect simply exacerbated supply-chain difficulties. The question going forward is whether the end of supply-chain disruption will be accompanied by a consumer shift back toward spending on services and toward reduced spending on goods. The degree to which that happens will influence inflation, labor markets, and the structure of the economy. 

More evidence on US inflation

Recent evidence suggests the possibility that the blistering rise in consumer demand could be abating, thereby reducing inflationary pressures.

The evidence comes from the recent purchasing managers’ index (PMI) reports for US manufacturing. It says that manufacturing inventories are starting to rise sharply after a sustained period of declining. Order backlogs for manufacturers are declining. This implies either a weakening of consumer demand and/or an easing of supply-chain disruption. If sustained, these trends suggest weaker pressure on prices and the possibility that, in the months to come, inflation will decelerate.

A weakening of consumer demand would not be surprising. After all, surveys on consumer sentiment have worsened, in large part because consumers are unhappy about inflation and about the sharp rise in the price of gasoline. Moreover, employment growth slowed last month. Real (inflation-adjusted) wages are declining even as nominal wages are accelerating. Plus, consumer spending on goods, which rose precipitously when people were largely staying at home, has probably run its course. After all, there are only so many refrigerators or treadmills one can purchase for one home. Thus, one can imagine a scenario in which the consumer sector of the US economy weakens in the first quarter of 2022 accompanied by a decline in inflation.

That said, a new omicron outbreak of the virus could be disruptive to supply chains, thereby exacerbating inflationary pressures. Moreover, a survey conducted by the Conference Board found that companies are setting aside 3.9% of payroll for wage increases in 2022, the largest amount since 2008. This suggests that wages will accelerate further in 2022, possibly adding to inflationary pressure. Still, if the average wage increase next year is 3.9%, that will likely not offset the average inflation for 2021. Thus, real wages will have fallen. Meanwhile, the US government reported recently that average hourly wages were up 4.8% in November versus a year earlier, the same as in October. While high, this too is lower than the rise in prices. Thus, so far it appears that labor market tightness is not driving inflation. 

Chinese trade remains strong

In November, China’s year-over-year export growth decelerated while imports accelerated. When measured in US dollars, exports were up 22.0% from a year earlier, slower than the 27.1% clocked in October. Still, 22.0% is a strong number. Moreover, exports were up 8.4% from the previous month, having fallen from September to October. The strength of exports comes at a time when the domestic Chinese economy is facing significant headwinds, especially as the property sector falters, electricity rationing remains, and the zero-tolerance policy toward the virus disrupts factories and ports. From a year earlier, exports were up 22.3% to ASEAN, 33.5% to the European Union, but only 5.3% to the United States. The weakness of exports to the United States could reflect the impact of the rising value of the renminbi. Or it could reflect a weakening of US demand.

Meanwhile, imports into China accelerated, growing 31.7% in November versus a year earlier. This was up from growth of 20.6% in the previous month. Imports were especially fueled by a 200.3% year-on-year increase in imports of coal and lignite. Coal and lignite imports were up 769.9% from the previous month. This was due to the need to boost electricity production at a time when rising demand has led to shortages, thereby causing rationing and factory shutdowns. In addition, the rise in imports reflected the sharp increases in the prices of oil, other commodities, and some manufactured inputs. For example, the value of imports of integrated circuits was up 25.3% in November versus a year earlier while the volume was up only 2.8%. The difference in these two numbers was due to the sharp rise in prices. Still, an increase in the volume of integrated circuits suggests a slight easing of supply-chain restrictions. 

RCEP goes into effect, liberalizing Asian trade

On January 1, 2022, the Regional Comprehensive Economic Partnership (RCEP) will go into effect for China, Japan, Australia, New Zealand, Singapore, Thailand, Vietnam, Brunei, Cambodia, and Laos. These countries have ratified the agreement. The Philippines, Myanmar, and Malaysia have yet to ratify it. South Korea has just ratified the agreement and will join soon. The RCEP is a free-trade agreement among Pacific Rim nations that was initiated by ASEAN and has been fueled and dominated by China. It will eliminate many tariffs starting in 2022 and will eventually lead to free trade for 90% of goods traded in the region. The members account for about 30% of global GDP. Notably, this agreement will eventually lead to free trade between Japan and South Korea, two of the three largest economies in East Asia. Currently, only 19% of bilateral trade between these countries is tariff-free. Eventually, that number will hit 92%.

The RCEP competes with the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), which is the successor to the TPP from which the United States withdrew in 2017—and has said that it will not rejoin the CPTPP, but will seek a new framework for regional trade that will focus on digital trade. The CPTPP involves not only East Asian countries but also Canada and Mexico. China and the United Kingdom have expressed an interest in joining the CPTPP, which is a more comprehensive agreement than the RCEP. That is, while the RCEP cuts tariffs, the CPTPP also implements trading rules governing data privacy, protection of intellectual property, subsidies to state-owned enterprises, labor standards, and environmental standards.

Both the RCEP and the CPTPP have the potential to boost intra-regional trade and lead to further rationalization of regional supply chains. The RCEP is the vehicle by which China hopes to dominate trading rules in the region. The CPTPP is the vehicle by which Japan and Australia hope to offset China’s footprint in the region. The absence of the United States from either agreement means that the world’s largest economy is expected to play a lesser role in the Asia Pacific economy. 

Federal Reserve more concerned about inflation, investors less so

• Amid all the public discussion about rising inflation, it is a bit surprising that investor expectations of future inflation have been falling. Specifically, the breakeven rates for the five-year and 10-year bonds have fallen steadily since mid-November. The breakeven rate is the difference between the yield on regular Treasury bonds and bonds protected from inflation. The difference denotes investor expectations of average inflation in the future. The five-year breakeven has fallen almost 40 basis points since mid-November. In other words, the decline cannot simply be explained by the Federal Reserve’s latest signal that it will adjust policy or by last Friday’s news about the omicron variant. Rather, it likely reflects an increasing belief that the Fed will not allow inflation to become sustained; that the oil price surge will be temporary (indeed oil prices have fallen); and that a slower Chinese economy will drive down some commodity prices.

Also, although the five-year breakeven is now at 2.8%, the so-called “five-year five-year” breakeven, which measures expected average inflation during the period between five and 10 years from now, has been steady and remains at about 2.2%. In other words, investors are confident that future inflation will be quite low. Thus, from an investor perspective, inflation is still seen as transitory—even though Fed Chairman Powell said that the word transitory ought to be retired because it has been misinterpreted. Meanwhile, the yield on the 10-year bond is down sharply, in line with declining expectations of inflation, hitting the lowest level since mid-September. This indicates that many investors expect lower inflation in the long-run and are not concerned that Fed purchases of bonds will soon cease. After all, US Treasury borrowing is expected to decline as fiscal stimulus ends. Thus, there will actually be a decline in the supply of bonds available to investors.

An important factor that could suppress inflation in the coming weeks and months is the fact that oil prices have fallen sharply in recent days, hitting the lowest level since August. This was driven by an expectation that the omicron variant of the virus will significantly suppress travel. Petrol (gasoline) prices are likely to follow. This will help to dampen inflation and will be politically favorable for President Biden. Only a drastic effort by OPEC could quickly reverse this trend. Fears about omicron also caused a sharp drop in coal prices.

• Meanwhile, in Congressional testimony, Federal Reserve Chair Powell indicated that the inflation environment could lead the Fed to accelerate the pace of tapering of asset purchases. Specifically, Powell said, “The economy is very strong and inflationary pressures are high, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, which we actually announced at the November meeting, perhaps a few months sooner. I expect that we will discuss that in our upcoming meeting in a couple of weeks.” The Fed had previously chosen to reduce asset purchases by US$15 billion per month until no new asset purchases take place. Evidently, they might choose to increase the monthly taper.
  

Powell has been a strong proponent of the view that the current high inflation will be transitory. That is, he has argued that the inflation is largely due to supply chain disruption, which will abate over time. Therefore, he has suggested that inflation could revert to a normal level by 2023. That said, in last week’s testimony, he acknowledged that inflation, which initially was concentrated in a relatively small number of merchandise and service categories, is becoming more broad-based. Consequently, there is an increased risk of “persistently higher inflation.” As for the transitory argument, Powell said, “The word transitory has different meanings to different people. To many it carries a sense of short-lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”

Powell committed to fighting inflation, which has become the biggest concern of consumers as well as politicians. He said, “We understand that high inflation imposes significant burdens, especially on those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.” Meanwhile, Powell acknowledged the risk from the new omicron variant of the virus and suggested that another outbreak could exacerbate inflation by further disrupting supply chains. He said, “The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people's willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.” In response to Powell’s comments, equity prices fell and bond yields increased.

A confusing US job market

When the US government released the employment report for November last week, some headline writers focused on the bad news. Yet the news from the report was mixed and, to some extent, confusing. On the one hand, the survey of establishments indicated slow growth in employment (which was the focus for headline writers). On the other hand, the survey of households indicated very rapid growth of employment, increasing labor force participation, and a sharp decline in the unemployment rate. Thus, one could either argue that the job market is decelerating or that it is accelerating. It is hard to say. Let’s look at the data.

There are two employment reports issued by the US government: One based on a survey of establishments; the other based on a survey of households. The establishment survey was disappointing in November, indicating the creation of only 210,000 new jobs—much less than forecasters expected, much less than predicted by a survey conducted by ADP, and much less than the 546,000 jobs created in October. What went wrong? The vast majority of the sharp deceleration of employment growth can be explained by just three industries: automotive manufacturing, retailing, and leisure and hospitality.

First, while overall manufacturing job growth was strong, there was a decline in employment at automotive producers, likely due to continued supply chain disruption stemming from a semiconductor shortage. Second, retail employment fell, largely due to a sharp decline in jobs at general merchandise stores and at apparel stores. These numbers are seasonally adjusted. Thus, it could be the case expansion of retail employment was slower than usual for the holiday season. Perhaps that reflects more online shopping or earlier holiday shopping. Third, employment in leisure and hospitality, having grown rapidly in October, barely grew in November. Job growth at both restaurants and hotels was feeble. It is not yet clear if this was due to reduced consumer demand or a persistent shortage of labor—or both. In any event, it should be noted that monthly movements in employment can be volatile, and that one month’s deceleration is not necessarily indicative of a trend.

Meanwhile, the separate survey of households tells a very different story. It says that the number of people choosing to participate in the labor force increased far faster than the working age population, thereby boosting the rate of participation. In addition, employment grew even faster, thereby causing the unemployment rate to fall from 4.6% in October to 4.2% in November. The survey estimates the creation of 1.1 million new jobs in November. The household survey includes self-employment, which may partly explain the relatively high number.

In response to the employment report, investors pushed down bond yields to the lowest level since mid-September. It is likely that they viewed the weak employment growth numbers as suggesting the possibility of slower growth. This, combined with continued uncertainty about the omicron variant, is likely causing a shift in market sentiment.

Meanwhile, the president of the Federal Reserve Bank of Cleveland, Loretta Mester, said that a significant outbreak of the omicron variant could fuel much higher and persistent inflation. She said, “If it turns out to be a bad variant it could exacerbate the upward price pressures we’ve seen from the supply-chain problems.” She also suggested that a new outbreak might prolong suppressed participation in the labor market. Thus, although omicron could derail the economic recovery by boosting social distancing, it could also cause an acceleration in inflation by disrupting supply chains and labor markets. It is not clear that investors have absorbed this argument into their expectations of inflation.

Eurozone inflation surges, but ECB not worried

Inflation in the 19-member Eurozone continues to accelerate. The European Union reports that, in November, consumer prices were up 4.9% from a year earlier, the highest reading since July 1991. Prices were up 0.5% from the previous month. The November annual figure is also far above the 2.2% rate seen as recently as July 2021. In large part, the surge in inflation is due to the stunning 27.4% increase in energy prices. When volatile food and energy prices are excluded, core prices were up a more modest 2.6% in November versus a year earlier, and up only 0.1% from the previous month.

Inflation varied by country. From a year earlier, consumer prices were up 6.0% in Germany, 3.4% in France, 4.0% in Italy, 5.6% in Spain, 5.6% in the Netherlands, 7.1% in Belgium, 5.4% in Ireland, 2.7% in Portugal, and 4.3% in Greece. In addition, prices were up especially sharply in the Baltics with inflation of 8.4% in Estonia, 7.4% in Latvia, and 9.3% in Lithuania.

The new inflation data will surely put pressure on the European Central Bank (ECB) to remove monetary stimulus sooner than planned. Incoming German Finance Minister Christian Lindner said that “inflation gives rise to legitimate concerns.” However, the ECB leadership continues to say that the high inflation is likely due to one-off factors, including supply chain disruption, the rise in the German VAT, and the spike in energy prices. Still, ECB Vice President Guindos said that “bottlenecks may last longer than expected” in 2022. The pattern of inflation in the Eurozone is similar to that in the United States, although at a somewhat lower level. In both locations, goods inflation exceeds service inflation, reflecting a shift in demand that businesses are struggling to accommodate. This suggests that supply chain problems are the principal cause of higher inflation.

ECB President Christine Lagarde said, “I see an inflation profile that looks like a hump. And a hump eventually declines.” Consequently, she said that it is very unlikely that the ECB will raise interest rates anytime soon.

Also, with respect to the omicron variant, Lagarde said that there is uncertainty that will only be resolved once the scientists have more information. Until that happens, she said, “We need to very clearly indicate that we stand ready [to act] in both directions.” That is, if omicron causes the economy to slow substantially, the ECB might need to extend monetary stimulus. Or, if omicron serious disrupts supply chains, the ECB might have to tighten monetary policy. Unlike in the United States, current Eurozone inflation is mostly about energy prices. Core inflation in the Eurozone remains quite low. Lagarde says that, by the end of 2022, she expects energy prices to decline “significantly.” 

Possible solutions to Japan’s onerous demographics

Last year, Japan’s working age population was 13.9% smaller than at the peak in 1995. It is no wonder that the economy has grown slowly. In fact, the working age population is now smaller than in 1975. Thanks, in part, to government efforts to encourage female labor force participation, the labor force has been increasing in the last decade as more women are working. In addition, more people are retiring later and remaining in the labor force at an older age. These trends, along with an increase in immigration, have helped to offset the impact of a declining working age population.

The other way to offset the impact is to boost productivity. In the past decade, productivity did grow at a healthy pace. This reflected more investment in labor-saving and labor-augmenting technologies, offshoring of lower productivity tasks, and more efficient usage of existing workers. Still, despite the increase, the level of productivity (output per hour worked) remains lower in Japan than in most developed economies. In other words, there is considerable room for improvement. Industries that are exposed to global competition, such as automobiles and electronics, tend to be very productive. But many domestic industries are not, often restrained by anti-competitive regulations. Former Prime Minister Abe sought to lighten regulations as part of his “Abenomics” program, but progress was slow. Abe had likely hoped that Japan’s entry into the Trans-Pacific Partnership—by exposing more of Japan’s economy to global competition—would spur political support for deregulation and improvements in efficiency. But this hope faded when, in 2017, the United States withdrew from the agreement.

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