The U.S. economic recovery has picked up in mid-2021. Consumer spending is soaring thanks to vaccination efforts, stimulus, and better weather. The housing market is also very strong as low mortgage rates and strong demand for homeownership, in part because of the pandemic, have boosted residential construction and sales of existing homes. And business investment spending is rebounding as firms expand to meet surging demand.
The rebound in the economy has led to higher inflation. Prices for the goods and services consumers purchase have increased more rapidly in recent months as supply has not been able to keep up with very strong demand. Inflation will remain high in the near term but will slow in 2022 and 2023 as the recovery continues and firms boost output. With the Federal Reserve on the watch, inflation is unlikely to get out of control. But rising prices for many of the inputs businesses use, including labor, will force firms to adjust.
Inflation is a broad increase in consumer prices across the entire economy. Some prices are more obvious: the price of a gallon of gasoline or a dozen eggs. But inflation includes all types of goods and services, not just a few that are closely watched. In fact, services make up the bulk of household purchases (more than two-thirds in 2019) and are much more important in measuring consumer inflation than goods.
The Federal Reserve has set an inflation objective of 2%. That is, the central bank would like inflation to average 2% over the long run, as measured using the personal consumption expenditures price index. According to the Fed, average inflation of 2% is the best way to achieve stable economic growth and a strong job market. Inflation has been below this objective for most of the past decade, and was especially weak in 2020, when many businesses cut prices during the pandemic as demand for their products plummeted. Between 2011 and 2020 inflation averaged just 1.6% annually, as measured using the core personal consumption expenditures price index (excluding volatile food and energy prices). Thus, to get the average back up to 2%, the Fed would like inflation to run a little bit higher over the next few years.
Inflation has picked up in recent months. Demand is very strong for some consumer goods and services, and in a few key industries—new and used cars, rental cars, airlines—businesses have not been able to increase supply enough to keep up with demand. Other goods are in short supply because the pandemic has disrupted global supply chains. This imbalance between supply and demand has allowed some firms to institute big prices increases. Through April, prices excluding food and energy were up 3.1% from one year earlier, the strongest inflation since the early 1990s. But that figure is misleading, because prices fell in April 2020 with the pandemic. Prices in April 2021 were up 2.5% from February 2020, before the pandemic. That’s still higher than the recent trend, but not nearly as worrisome.
Consumer inflation will remain elevated in the near term, in part because of comparisons with the period of weak inflation in 2020, and because of high prices for some pandemic-related goods and services.
But these factors will fade over the course of 2021 as businesses increase supply in response to high prices, and consumer spending growth shifts from goods to services as consumers feel more comfortable going out and states further relax restrictions on economic activity. Inflation over the next couple of years will slow to the Federal Reserve’s 2% target. And if inflation does get too high for the Fed’s liking, the central bank has the tools to deal with it; it can raise interest rates to weigh on economic growth and reduce inflationary pressures.
Although consumer inflation will remain contained, some businesses are being squeezed by rising input costs. The producer price index for intermediate processed goods, those goods used as inputs to other goods and services such as steel and semiconductors, was up almost 22% in May from one year earlier. And prices for unprocessed goods used earlier in the supply chain, like crude oil, lumber, and iron ore, were up almost 58% over the same period. At the same time labor costs are rising for many businesses because of difficulties in finding workers.
Businesses will have to decide how much of their higher costs to pass along to their customers. Very strong demand and limited supply for many goods and services are giving businesses a greater ability to raise prices. But this strategy holds potential problems: after years of low inflation buyers are wary of paying more, and the internet provides consumers with more access to pricing information. If businesses do decide to hold the line on price increases, one source of flexibility is generally high profit margins throughout the economy. These high margins will allow them to absorb higher input costs without doing too much damage to their bottom lines.
These input price pressures are likely temporary. Supply chains will normalize and firms will ramp up production, gradually allowing demand to catch up with supply and reducing input price pressures. Also, labor cost growth is likely to slow later this year as more people decided to reenter the workforce with declining COVID-19 cases, a return to in-person schooling, and the expiration of extra unemployment insurance benefits. This will help alleviate labor shortages and wage pressures.
Both consumer and producer inflation have accelerated in mid-2021 as the recovery from the Viral Recession has picked up steam. But much of this acceleration is due to temporary factors that will dissipate over the rest of 2021. In the short run, businesses will need to decide how to deal with rising input and labor costs, and how much of their higher costs to pass along to the customers. And assuming the Federal Reserve does its job, inflation is unlikely to get out of hand over the longer run.
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