Three Reasons Inflation May Be With Us Longer Than We Think

Predictions for where the U.S. economy is heading in 2023 have been conflicting, to say the least. We closed out 2022 with the expectation that we were moving into an economic recession during the first two quarters of the new year, but more recent indicators cast serious doubt on that possibility. For example, recent data shows high inflation has not stopped consumer spending.

Moreover, both the January and February jobs reports surpassed estimates, and the unemployment rate is at its lowest point in more than 50 years. Interestingly, March jobs data came in below expert estimates.

We don’t anticipate the Federal Reserve to lower interest rates any time soon (making it cheaper for businesses and consumers to borrow) as the Fed continues its ongoing war against inflation. Thus, it would be a mistake to believe a mild recession is not on the short-term horizon. Usually, the Fed gets what it wants — eventually.

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However, we should consider thinking beyond the short term. It’s becoming clear that the post-pandemic world has unleashed massive, lasting changes on the global economy, ending a decade of low inflation, low interest rates and easy monetary policy. Let’s be clear: It is not likely we will soon be going back to the economy we once knew.

Here are three reasons to expect inflation to present a long-term challenge for the U.S.

1. Trajectory for the Labor Market

We can anticipate continued issues for employers in filling jobs. We have seen a clear structural shift in the relationship between life and work for Americans as many individuals are prioritizing lifestyle, geography and family over simply finding a job. Some factors that will likely continue to impact the labor market include:

• The labor participation rate will continue to be depressed due to more people permanently retiring.
• Lower productivity will remain sticky because many people will continue to participate in “quiet quitting,” i.e., employees working just enough to keep their jobs.
• Low population growth, particularly due to a drop in immigration to the U.S.

Conventional wisdom tells us employers must increase wages to attract workers when the labor market is tight. Thus, wages have grown significantly since the middle of 2020.

However, we can anticipate wage growth to slow significantly in 2023. According to a recent report by Payscale (opens in new tab), the number of employers who plan to provide base-pay increases will drop 13% this year over 2022. The report also revealed that fewer firms say they will allot pay increases of more than 5% — decreasing the overall amount of average raises.

So, yes, the Fed’s strategic plan to raise interest rates to depress business and consumer spending and dampen inflation could work to some extent in 2023. But there are further reasons to believe inflation will continue to stick with us.

2. Tenuous Transition to Green Energy

U.S. policymakers are adamant in their efforts to transition the economy away from fossil fuels and toward renewable energy. For example, the recently enacted Inflation Reduction Act includes billions of dollars to spur financing and deployment of new clean energy strategies designed to cut greenhouse gas emissions and other pollutants. Additionally, many leading companies have committed to net-zero emissions, including Coca-Cola (opens in new tab), General Motors (opens in new tab), BlackRock (opens in new tab) and more.

However, we will likely feel short-term economic pain in exchange for long-term sustainability gains. The overall production of fossil fuels is likely to slow before investment in renewables catches up, leading to limited supply and higher prices for both businesses and consumers.

Like the handoff of a baton in a relay race, this is a delicate transition and must be well-timed. There will likely be three drivers of inflation due to the energy transition:

• A reduction in capital expenditures and output by the petroleum industry. This decline in supply will drive commodities prices in the energy sector higher. This scenario has historically been shown to have an enduring, multiyear impact on overall inflation.
• Customarily, non-energy commodity price increases have been passed through to intermediate producers, as well as to end consumers. If this pattern holds true during the green transition, the green supply chain will see price spikes. Public policy may push prices for certain items higher through “green premiums.” As businesses rush to meet mandates for net-zero goals, they will be forced to buy materials such as low-carbon steel and plastic. Demand will likely outstrip supply until producers catch up. Econ 101 tells us high demand and low supply results in price increases — and businesses may pass on these green premiums to end users.
• Finally, public policy currently provides billions of tax incentives for green solutions. If these tax strategies result in higher deficits, this, too, poses a long-term inflation risk.

3. China’s Demographic Changes

China’s 14th Five-Year Plan (opens in new tab) articulates a strategic shift by Chinese policymakers to reshape their economy with a focus on elevating the middle class (and living standards more broadly) by transitioning from a manufacturing economy to a services-led economy. Their hope is that this evolution will result in higher productivity, a more robust consumer economy, improved living standards and a more stable growth trajectory.

At the same time, in one of the largest supply chain hubs in the world, China’s policies are expected to have wide-ranging implications for global inflation and are likely to increase costs for corporations operating in China. Additionally, with its population aging at one of the fastest rates of any major country (opens in new tab) (the number of people over 60 in China is projected to reach 28% by 2040 due to longer life expectancy and declining fertility rates), this will further tighten the global labor market as the number of retirees grows. In other words, fewer working-age adults in the market will likely push up wages, which could mean higher prices for everyone.

While reports of U.S. companies looking to operate outside of China (opens in new tab) increase — even if some corporations can extricate themselves from China’s grip of cheap labor and easy supply chain access and move to other parts of the world — this will likely create redundancies within manufacturing and R&D.

For example, companies may find themselves with multiple R&D labs in different countries developing similar solutions because they are prohibited from sharing intellectual property across borders. This may add to higher costs and overall inflation.

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