The inflation question

Inflation price changes are reverberating throughout the economy as pent-up demand runs up against tight supply chains and bottlenecks. Companies are experiencing a rise in materials prices, many workers have begun to ask for higher wages, and services prices have started to climb—all of this amid government spending levels not seen since World War II as we have fought the silent enemy, COVID-19.

The data is clear: Headline inflation is at the highest levels since the 2008–2009 global financial crisis, when that recession similarly induced supply bottlenecks that pushed up prices. Are today’s higher prices here to stay? Or are they transitory?

The consensus view from economists and policy makers—that the present rise in prices is transitory—is encouraging, yet frustrating for many business operators: How long is a transitory price rise expected to last? And even if it is only expected to last a year or less, how disruptive will it be?

Disequilibrium

The classic economic argument for why the price increases are transitory is because we still have an output gap—i.e., when growth and employment are below trend, creating excess capacity that tends to exert downward pressure on prices. But the disequilibrium caused by the pandemic-induced recession has caused supply disruptions that are much greater than a normal recession. This, coupled with increased demand, is causing significant price spikes for many goods.

As business leaders—and boardroom conversations—weigh the impact of these transitory price pressures and make plans to mitigate them, it is helpful to consider the four main factors driving inflation today: demand shock, supply shock, labor frictions, and the company’s reaction function.

Demand and supply shocks

The COVID-19 pandemic represented a demand shock that saw markedly higher demand for goods (and a significant decline in the demand for services). Normally, this increase in demand would be met with an increase in supply, which would mean that prices would rise only slightly, or perhaps not at all. Many companies are geared to produce at volume, and so greater demand improves profit margins. This means that price increases for inputs that are accompanied by greater demand can often be substantially offset. However, the pandemic has resulted in rolling supply shocks that are causing significant price spikes while the demand for goods remains elevated. These supply shocks are caused by pandemic-induced shutdowns of economies, metro areas, or individual factories, hampering the supply of many input goods and leading to price increases. The pandemic is also creating challenges for shipping, which further exacerbates the supply shortages.

Many of the goods that are experiencing price increases will see a combination of factors conspiring to ensure these price increases are either a step-level change (not to be repeated year after year) or a fall in prices such that in 2022 we will see declining prices on a year-over-year basis. In managing transitory pricing shocks, companies must decide how they will respond and what risks price increases, even temporary ones, pose to their business.

The good news is that higher demand and healthy household balance sheets (helped by significant fiscal assistance) mean that companies can pass on some of the price increases to their customers. Additionally, the persistence of low interest rates means companies can finance investment in productivity-enhancing capex with a greater likelihood of positive return on investment.

Labor market frictions

For many companies, current labor market frictions are proving more challenging than the temporary price spikes of input goods. When looking at the overall labor market, we can see that we are not back to pre-pandemic employment levels. We learned from the previous cycle that there was significantly more slack in the labor market than many economists anticipated: Labor force participation grew from 62.7% in 2015 (well into the expansion) to 63.3% by February 2020. With present labor force participation sitting at 61.6%, received wisdom would suggest there is significant slack not just from those actively looking for work but from those who dropped out of the labor force and who would likely return if there is a sustained expansion. Nevertheless, evidence of wage pressure abounds. What explains this disconnect? 

Research shows that past pandemics resulted in a larger share of output going to labor—i.e., higher real wages than what would have otherwise been observed in the years directly proceeding pandemics.¹

It seems highly likely that many workers’ preferences around work change when faced with life-altering events such as a pandemic. This research matches data from the New York Federal Reserve about the wage workers are willing to accept and helps square a puzzling circle: It is puzzling that wage pressure is coming mostly from the portion of the labor market that has the elevated slack—i.e., workers who must work from their job site and where the unemployment rate is 6.5%.² According to the New York Fed survey, these workers, who tend to be those without bachelor’s degrees, are demanding, on average, a 24% increase from prepandemic wage levels. Meanwhile, the approximately 40% of U.S. workers who can work from home and who tend to have at least a bachelor’s degree are demanding a more modest 4.8% increase despite having an unemployment rate of 2.7%, which suggests very little slack. Combined with the fact that there are still over 8% fewer daycare workers than before the pandemic, and nearly 30% of U.S. schools were not 100% in person when the 2021 school year ended, the challenges for parents who must work at their job site are significant.³ Finally, many of the unemployed who need to work from their job site were eligible for supplemental unemployment benefits, which may also be contributing to a higher “reservation wage.” This data goes against the data from the so-called Philips Curve, which suggests there is less wage pressure when there is greater unemployment.⁴

Indeed, we believe the higher reservation wage among workers who must work at their job site is being driven by the disproportionate impact on those workers in terms of child care issues, health outcomes, and ongoing risks due largely to the fact that nearly 45% of the working-age population has yet to receive even one dose of the vaccine. We also view this as a step-change in the wage level demanded:⁵ If progress continues on vaccinations and new variants can be kept at bay, we expect that by this time next year workers with less than a bachelor’s degree, most of whom must work at their job site, will be expecting wage increases more in line with inflation. Conversely, as the expansion continues, companies should anticipate the possibility that a tight labor market for those with bachelor’s degrees or greater could lead to greater wage pressure among certain highly sought-after skill mixes. 

Boosting productivity, easing costs

How companies react to these transitory shocks and shortages will greatly influence the overall economic outcome of price pressures. Investing in technology that increases productivity will ease the cost burden and expand capacity. Services firms where productivity has lagged the gains seen in manufacturing are especially ripe for digital transformation. Technological enhancements to productivity will create a positive feedback loop for potential GDP and have significant positive externalities that extend beyond the next year or two. 

Near term, companies should expect choppiness and speed bumps as demand and supply find their way back to equilibrium and price pressures ease, potentially positioning the economy for 3–5 years (or more) of sustained growth.