How Transitory? Structural forces and the inflation outlook

Summary

The recent bout of price increases that have driven the PCE deflator to a 13-year high is believed to be transitory by the Federal Reserve. Not only are the current bottlenecks expected to ease as the reopening of the economy moves further along, but FOMC members have been cautious to presume that the structural forces holding down inflation before COVID have fallen to the wayside. Despite the record-long cycle and tight labor market, inflation struggled to meet 2% on a sustained basis over the past business cycle due in large part to forces beyond the Fed's influence.

In this report, we unpack the major structural dynamics that thwarted inflation from consistently reaching 2% prior to the pandemic. The degree to which these forces reassert themselves will influence if inflation easily falls back to the Fed's target or causes the current 2%+ environment to be more persistent. As summarized below, we see the inflationary effects of these secular forces easing in the years ahead.

• Healthcare: Inflationary
  The policy-induced disinflation of the past cycle from the Affordable Care Act is behind us, and further policy changes will likely be less revolutionary. Meanwhile, pent-up demand for medical care points to higher usage, while compensation costs in this labor-intensive sector are running above the early 2010s' pace.

• Globalization & Supply Chain Management: Inflationary
  Globalization showed signs of topping out before the pandemic. More nationalistic trade policy on top of current logistical challenges will likely lead to a reassessment of far-using global supply chains and just-in-time inventory models. Such de-risking will come at a cost.

• Aging Demographics: Inflationary, but limited
  A larger share of the U.S. population is now dis-saving, supporting demand but not contributing to production. Slower growth in the domestic working population will not be as easily offset by the global labor supply as it was in prior years, leading to a tighter labor market and higher wage inflation. Rising longevity and the need for greater savings, however, should limit the inflationary effect.

• Technology & Productivity: Coin-Toss
  Well-known digital-based platforms are raising prices to finally become profitable, while e-commerce penetration is poised to slow. However, an increase in business dynamism and high-tech investment suggests productivity growth could take off.

The upshot: It is not just the FOMC's more tolerant stance on inflation under its new framework or a rebound in inflation expectations that is likely to lead to a higher inflation environment after the pandemic. The current degree of inflation is unlikely to persist beyond the next 12 months or so, consistent with the FOMC's “transitory” characterization. However, we believe inflation will not fall as easily back to 2% as Fed officials and the consensus seem to expect, given that many of the forces that stymied inflation from reaching its target last cycle were beginning to shift before the pandemic. A combination of higher inflation and higher interest rates is therefore likely over the next few years. 

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