Is the US Moving Back to Pre-Covid Low Inflation?

Summary

• It is not my base case scenario, but the combination of resource pressures and disinflation suggests a risk the US could be going back to pre-pandemic low inflation.
• A recent paper by two Federal Reserve (Fed) economists argues low inflation pre-pandemic reflected low worker bargaining power and high business market power.
• If so, neither of these have changed much, and therefore the pre-pandemic low inflation trends could reassert themselves.
• This would likely play out through 2025 and manifest itself through several macro and market changes.

Market Implications

• Based on current information I continue to expect the Fed to cut twice in 2024.

US Disinflation Has Been Easier Than I Expected

In this note, I discuss the risks the US could be headed back to the low inflation regime prevailing before the pandemic. It is not my base case scenario, but the risk is not zero either and the market implications would be profound.

US disinflation has been less painful than I expected. Coming into 2023, I expected core and energy inflation to remain correlated. This is because I believed the pandemic had shifted the economy to a high inflation regime where inflation signals such as energy prices get quickly transmitted to the whole price structure.

The high energy-core inflation correlation had prevailed during the high inflation period of the 1970s and 80s (Chart 1). I was therefore expecting the recovery in energy prices to pull up core inflation.

Unfortunately, that is not what the data showed. Energy inflation has turned up since mid-2023 while core Personal Consumption Expenditures (PCE) has continued to slow.

In addition, I had expected the widening trade balance, a sign of demand outstripping supply, to be accompanied by an acceleration of inflation (since there is an accounting identity between the external balance and the domestic savings/investment balance. To the contrary, the external imbalance has continued to widen while disinflation has continued (Chart 2).

This combination of resource pressures and disinflation is similar to the pre-pandemic combination of very low unemployment and underperforming inflation, though pre-pandemic the resource pressures were on the labour rather than currently on the goods market.

In my view, this begs the question of whether the US is going back to the low inflation regime prevailing before the pandemic.

Low Inflation: Weak Worker Power?

In response to persistent inflation underperformance, in August 2020 the Fed switched to Flexible Average Inflation Targeting (FAIT). It announced, ‘following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.’ At the same time, the Fed did not provide an explanation for the persistent inflation underperformance.

In late 2022 however, two Fed economists, Ratner and Sim, published a formal model (not the Fed’s official view but rather ‘to stimulate discussion and critical comment’) showing inflation underperformance could reflect a loss of bargaining power on the part of workers and an increase in market power on the part of businesses.

Their model fits the facts rather well. The weakening of worker bargaining power can be seen in the decoupling of real wages from productivity since the late 1970s (Chart 3). In turn, this decoupling reflects globalization, technical change, and a number of pro-employer legal and regulatory changes that saw a collapse in union power and militancy (Charts 4 and 5). At the same time, the US economy became more concentrated.

The Ratner/Sim model explains the decline in labour income share and the increase in profit share, as well as the rise in the ratio of equity market capitalization to GDP (Charts 6 and 7).

Less obvious, the model also predicts the secular downtrend in hires relative to vacancies and in unemployment per vacancy (the outward shift in the Beveridge curve, Chart 8). The intuition is that employers’ strong market power makes the hiring of extra workers very profitable – real profit per worker is almost three times as high as in the 1980s – and gives them an incentive to increase vacancies.

Most importantly, the model also explains the low U* (i.e., the combination of low unemployment and v low inflation before the pandemic). High profitability gives firms an incentive to search for all the workers willing to work at the admittedly low wage they are offering. This lowers frictional unemployment (i.e., U*).

Furthermore, workers’ weaker and firms’ greater market power imply the economy adjusts to shocks more through changes in employment than in inflation. The intuition is that with weak market power, workers are not able to obtain much higher wages when the economy is hit with a positive demand shock. Instead, because hiring extra workers is so profitable, employers react by expanding employment. As a result, smaller changes in inflation are associated with larger changes in employment (i.e., the Phillips curve tends to be flat). The authors tested their models with US and UK times series as well as with a cross section of Metropolitan Statistical Areas (MSAs) and find evidence that stronger worker power steepens the Phillips curve.

Pandemic Inflation: Stronger Worker Power?

The Ratner/Sim model provides an alternative narrative for the recent inflation cycle. Worker bargaining power increased in 2020-21 due to a shortage of workers and the high pandemic benefits. As a result, union militancy increased and workers were able to demand higher wages, which led to higher inflation. In 2022 however, household participation and incomes started to normalize, worker bargaining power weakened and by end-2023 union militancy was back to pre-pandemic trends.

Workers’ income share did not increase during the pandemic which likely reflects that employers also received large public support. With employers’ strong market power, an increase in the budget deficit tends to benefit profits, rather than wages (the Kalecki profit equation).

Of course, this view is not exclusive of the role played by positive supply shocks, especially the increase in immigration, as well as by Fed tightening in stabilizing inflation expectations and bringing down inflation.

But if the Ratner/Sim view of the world is correct, there is a good chance we could be going back to the pre-pandemic inflation underperformance. Unions have vowed to expand their membership, but this will take time. And while the Biden administration has resuscitated antitrust policies, it will also take time to change the balance of power between employers and workers, assuming the next administration continues this path.

Market Implications

The market implications of a return to inflation underperformance would be profound. On the short end of the curve, because of the Fed aversion to below target inflation, a return to the Federal Funds Rate (FFR) levels prevailing before the pandemic (i.e., sub 2%) would be likely. By contrast, markets see the Fed cutting to about 3% by end-2025 and the June SEP shows the long-term FFR at 2.8%.

On the long end, yields would also fall though perhaps not to pre-pandemic levels as US Treasury debt has increased sharply and the term premium could remain higher than pre-pandemic. The curve could be steeper than pre-pandemic.

A lower inflation regime would also benefit equities. And with economic shocks consisting largely of growth rather than inflation shocks, the negative bond-stock correlation could make a comeback.

As mentioned earlier, a return to pre-pandemic low inflation is not my base case scenario.  But if I am wrong and this is what is happening, we should see the following:

• Continued disinflation.
• Fed dots moving closer to market expectations.
• Combination of resource pressures (e.g., low unemployment, large external deficit) and low inflation.
• Continued low union militancy.
• Stable-to-higher profit share and profit per worker (assuming no fiscal consolidation).
• Resumption of downtrend in the JOLTs hire-to-vacancies and unemployment-to-vacancies ratios.
• Continued curve steepening.
• Bond-stock correlation turning negative.

These are likely to play out over 2025.

Meanwhile, based on current information, I continue to expect the Fed to cut this month and twice in 2024.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)