When will this inflation episode abate?  We don’t have a specific view on pace and timing, but we do have some observations as to why inflation may have reached its peak and may decelerate going forward.  In particular, we want to tap into the wisdom of my Uncle Bill, who was quite fond of quoting Will Rogers: “If you want to get out of a hole, the first thing you need to do is stop digging.” 

So, in this research report, we examine five of the often-cited possible causes for high inflation in the U.S., and we ask the basic question of whether we have stopped digging yet – a key prerequisite for inflation to begin declining.  And to anticipate our conclusion – yes, we have stopped digging, and the forces that created the inflation are either no longer in play or are in the process of being resolved.  This gives us optimism that inflation may have peaked, even if some of the high prices stick around longer than we might like, and the deceleration path could a bumpy ride on the way down.

The pandemic dramatically shifted consumption patterns with the partial shutdown of the U.S. economy back in 2020/2021.  The relative share of goods consumption increased at the expense of services, with the limits on travel, tourism, dining, etc.  For example, in the 12 months from July 2020 through June 2021, durable goods spending was 25% higher than in calendar year 2019, and non-durable good spending was up 9%, compared to modest declines in services spending.  Not surprisingly, the initial upticks in inflation were most severely felt in the durable goods category, followed by non-durable goods.  More recently, the annualized spending growth of durable, non-durable, and service spending comparing January 2022 through June 2022 to the previous six months, July 2021 through December 2021, has been 9%, 10%, and 8%, respectively.  That is, spending growth has evened out among these three critical categories.

Our conclusion is that the pandemic-induced boom in spending on goods has run its course, and that in the post-pandemic world the U.S. is returning to a more typical balance between goods and services consumption. What we have not seen yet is a shift back in the relative share of consumption toward services, although durable goods spending is starting to revert to a lower relative share. In short, the pandemic shift in consumption patterns is no longer a driver of future inflation.

The global goods producing engine was not remotely ready for the surge in the pandemic-induced demand for goods, especially durable goods, such as automobiles. At the same time, in the early phases of the pandemic, COVID-19 was disrupting both production and transportation of goods. That is, the goods markets was hit simultaneously both by demand and supply shocks.

For example, computer chip shortages hit new car production especially hard, leading to a major surge in the prices of used cars. On the transport side, many of the goods in high demand were produced in China, and shipping costs from Shanghai to Los Angeles soared. While it takes billions of dollars and years of planning and construction to build new computer chip factories, suggesting a lengthy multi-year period to resolve many supply chain challenges, there is clear evidence in prices that the worst is over. Shipping costs from Shanghai to Los Angeles are well off their peaks, even if they remain well above pre-pandemic norms. Similarly, used automobile prices are no longer climbing to the stratosphere. That is, prices have stabilized near their highest levels, yet are no longer rising.

While we are probably a few years away from resolving the vast majority of supply chain challenges, there is no question that progress has been made and that supply chain disruptions are no longer pushing prices higher and higher, even if in many cases prices remain elevated just no longer adding to more inflation.

Both the Trump and Biden Administrations provided trillions of dollars of emergency fiscal spending during 2020 and early 2021 to offset the worst of the pandemic’s impact on job losses. Much of the emergency government spending was made in the form of direct transfer payments to individuals, of which a considerable amount was spent within months of being received. Indeed, one of the main differences in the fiscal response to the Great Recession in 2008-2009 and the Pandemic in 2020 was the massive fiscal response to assist individuals to keep spending, even among those who had lost their jobs. The result was that personal consumption expenditures rapidly regained the pre-pandemic peak, while after the Great Recession, there was no quick recovery at all in personal consumption, which makes up roughly two-thirds of the U.S. economy.

The point we want to make here, though, is that the emergency fiscal spending has run its course and is not being renewed. Indeed, the U.S. government federal budget deficit, which hit $2.4 trillion in fiscal year 2021, is on track to come in at $637 billion in fiscal year 2022, and decline further in 2023, according to the projections from the Congressional Budget Office (CBO). The inflation impetus from fiscal spending during the pandemic was undoubtedly massive, but fiscal policy as a source of future inflation is no longer in play.

The role of central bank asset purchases in feeding consumer price inflation is going to be debated for a long time to come. What happened during the pandemic, however, can be interpreted as an experiment in Modern Monetary Theory or MMT. When the government embarks on a major new spending program, it has the choice of financing the new spending by raising taxes, selling debt to the public, or selling debt to the central bank. The last is what goes by the name of Modern Monetary Theory, and this is what happened in 2020 and 2021 in the U.S. The trillions of dollars of new spending by the federal government were largely bought by the Federal Reserve, limiting the amount of new borrowing required from the public sector.

A key point to appreciate when government spending is massively increased and associated with equally massive debt purchases by the central bank is the price discovery process is prevented from working. The presumption is that without central bank debt purchases, and without any tax increases, the additional supply of government debt sold to the public would have pushed bond yields higher, perhaps significantly higher. Higher bond yields would have meant higher mortgage rates, and the boom in housing prices that occurred in 2021 might never have happened, impacting durable goods demand associated with house purchases.

Importantly, there is a distinction here between central bank asset purchases that support increased government spending and central bank asset purchases that occur independently of fiscal policy. The latter version of quantitative easing (QE), as it has come to be called, appears to have contributed to significant asset price inflation in the 2010-2016 period, but QE without accompanying fiscal spending does not appear to encourage either faster growth in the real economy or inflation in consumer prices.

That is, what made the Federal Reserve’s asset purchases so important as an inflation driver in 2020-2021 and not in the 2010-2016 period was the linking of the asset purchases to massive new government spending. In any case, regardless of one’s view of the role of central bank asset purchases as a cause of future inflation, the Federal Reserve is now shrinking its balance sheet, and this source of future inflation no longer is occurring.

Our last observation is that the era of near-zero short-term interest rates has been ended by the Federal Reserve. To the extent that an accommodative interest rate policy was a driver of future inflation, that driver is being withdrawn.

Importantly, the short-term interest rate increases taken by the Federal Reserve in 2022 are often described as an “aggressive tightening” of interest rate policy. Our interpretation is decidedly different. In our interpretation, any level of short-term rates that is below a reasonable view of inflation expectations remains accommodative, just not as accommodative as zero rates. That is, the Federal Reserve in moving the effective federal funds rate, from around 0.10% to 2.33% from January through July 2022, has merely taken its foot off the accelerator, but it has not hit the brakes. This is better described as a withdrawal of accommodation and not a tightening of monetary policy.

Regardless of the preferred interpretation, interest rate policy as a source of future inflation is being withdrawn. And very importantly, a change in interest rate policy is typically thought to impact the real economy with long and variable lags. While mortgage rates have already doubled, the longer-term implications for the housing market have not yet been observed. Put another way, whatever the long-run impact higher rates are going to have on the real economy, it has not been felt yet. 

There is only one key observation from going through these five potential sources of past and future inflation – from pandemic-induced consumption shifts, supply chain challenges, fiscal policy expansion, central bank asset purchases, to interest rate policy at the Federal Reserve. Every one of these five factors has changed course in the past six to 12 months and is no longer likely to be a source of future inflation regardless of its role in creating the inflation currently being observed. That is, if Will Rogers and my Uncle Bill were right that the first step in getting out of a hole is to stop digging; well, the digging has stopped. Inflation may well be a bit sticky and take its time coming down, yet the likely suspects of the root causes of the current inflation episode have all been addressed in full or in part.