Inflation trends will persist unless the Fed acts quickly

MAY 12, 2022 — Editor’s note: This op-ed by Tom Tunstall, economist and senior research director at The University of Texas at San Antonio Institute for Economic Development, originally appeared in the San Antonio Express-News.

Two narratives currently compete with regard to inflation forecasts for later this year. The first—and for a while, certainly the most dominant—is that inflation is largely COVID-induced, and that as we get a handle on the virus, supply chains will heal and rising prices will subside. Who could blame economists and policymakers for thinking this way—inflation hasn’t been a serious problem in the U.S. since the 1980s. The second narrative—which becomes more apparent by the day—is that inflation pressure will persist into the rest of this year and beyond.

Energy prices—particularly transportation fuels such as gasoline and diesel—have not yet fully worked their way into the Consumer Price Index numbers. No doubt we have seen many immediate effects, but other developments will lag and only show up in the official inflation numbers months later—with gasoline and diesel prices merely among the most obvious at present.

“For the present, consumers should plan to hunker down and prepare for additional upward price shocks in the coming months.”

Another driver of inflation will be China’s continuing impact on the global supply chain. Shanghai is currently on a COVID lockdown, which is China’s preferred method to stem outbreaks. The vaccines in use in China appear to be less effective than U.S. versions—perhaps far less so—which means that if the lockdowns fail to stem the spread of COVID, their export hubs of Shenzhen, Guangzhou and Hong Kong along the Pearl River Delta are at risk of shutdowns or slowdowns as well. This will serve to exacerbate global supply chain woes even more.

Perhaps the most concerning aspect propelling inflation centers on the Russian-Ukrainian conflict. Planting season for wheat in the northern hemisphere is underway if circumstances allow. Because of the war, Ukraine’s harvest for export will shrink or disappear altogether for 2022, perhaps longer, due to the widespread inability to sow. For different reasons, Russia’s wheat exports will decrease significantly also—in its case due to international sanctions and the perils associated with Black Sea shipping.

The other concerning issue deals with the interruption of fertilizer exports from Russia, Ukraine and Belarus. Fertilizer shortages emanating from supply chain interruptions will also take some time to work their way through the system and cause prices for food to rise even further before it’s over. While the U.S. is a significant exporter of wheat, global shortages will mean higher prices for consumers everywhere.

In addition, the Biden administration announced that it will allow the use of higher ethanol blends over the summer by providing waivers to refiners. Though this is expected to reduce the price of gasoline at the pump by around 10 cents per gallon, it will also drive up the price of corn, which would otherwise be used for other industrial processes.

Some relief from high gasoline prices has come in the form of a million barrels a day of crude oil released from the strategic petroleum reserve (SPR). This will help. Unfortunately, tapping the SPR is not a long-term solution. If crude prices remain elevated for a year or longer, the SPR strategy will no longer be viable.

Meanwhile, despite recent harder-line jawboning by Chair Jerome Powell, the Federal Reserve has taken only a tepid approach to raising interest rates as a means to quell inflation. It’s not hard to see why. Rapidly raising interest rates in half-point increments could slow the economy enough to cause another recession—something the Fed fears almost as much as inflation itself. In effect, the Federal Reserve finds itself caught between a rock and a hard place.

Given recent global developments across supply chains—whether the result of COVID variants, or the Russian-Ukrainian war—it’s hard to paint a very rosy picture for the rest of 2022. Beyond that, we can only speculate about what other unhappy surprises await on the horizon. But even if nothing unexpected happens, peak hurricane season is rapidly approaching and holds the potential simply to make matters worse.

While the ongoing effort to repatriate supply chains will add stability to U.S. markets, it will take time to implement and will further add to inflationary pressures. For the present, consumers should plan to hunker down and prepare for additional upward price shocks in the coming months by doing things like substituting more expensive items for less costly ones.

Although longer-term consumer inflation expectations remain muted, that situation could easily change, particularly if the Federal Reserve refuses to take a tougher stance to combat the threat. It seems the writing is on the wall—if the Federal Reserve Board of Governors choose to read it.