We need higher unemployment if inflation is to remain low. That’s the message of bond markets.
In the US, the five-year breakeven inflation rate is at a 16-year high despite the fact that the official unemployment rate is 2.6 percentage points above its pre-pandemic low. And in the UK, breakeven inflation is now half a percentage point higher than it was before the pandemic even though the unemployment rate is a percentage point higher.
Bond markets in both countries, therefore, are telling us the same thing – that the trade-off between unemployment and inflation has worsened. Before the pandemic sub-4 per cent unemployment rates were consistent with low inflation. Today, they are not. In the ugly jargon, Nairus have risen.
Why?
The biggest reason is that the pandemic and the policy responses thereto have shaken up patterns of supply and demand, causing mismatches between the two.
In the US for example, housing starts have soared to close to their highest level since 2005. That’s causing shortages and hence rising prices of some raw materials such as timber, and some shortages of construction workers – and hence rising wages.
And in the UK some of the pubs and restaurants that are reopening are finding it hard to recruit workers. Many of the young people who used to work for them have gone back to studying: the number of students has risen 321,000 in the last 12 months. And many of their immigrant workers have returned home: we don’t know exactly how many as the Office for National Statistics has suspended its reporting while it improves its data gathering, but it could be a lot. Such recruitment difficulties, allied to cuts in capacity caused by the need for social distancing, could raise prices and wages.
Because prices and wages tend to be more upwardly flexible than downwardly so, such localised inflation can cause a rise in the overall price level. This is especially likely given that the Fed and Bank of England will tolerate a little above-average inflation while unemployment is still high.
But this only a short-lived problem. It’s normal for inflation to rise early in a recovery simply because recessions shake up patterns of supply and demand, thus causing mismatches between the two. In 2011, for example, CPI inflation hit 3.5 per cent in the US and over 5 per cent in the UK. But it soon fell back.
And that’s the point. Such mismatches are only temporary. Eventually, workers retrain or move to where there are jobs, and employers overcome staff shortages by training people, becoming less sniffy about whom they recruit, or even by investing in labour-saving technology.
Shortages and rising prices trigger increases in supply and changes in demand. Unless there is persistent and generalised excess demand – and high unemployment tells us we are a long way from that – inflation is only temporary.
For those of us formed in the 1980s, this leaves a paradox. We’ve been told for decades about how great flexible markets are in solving the problem of localised shortages. And yet it now seems that investors have forgotten that.
