Inflation may be even higher than it seems

Consumer price inflation in April blew by the consensus forecast of economists. In the U.S., prices rose by 4.2 per cent — the most since September 2008 — while in Canada the CPI rose by 3.4 per cent, its highest reading since September 2011. The surprising results reflect both the chronic difficulty economists have in forecasting and the impact that recovering from the pandemic is having on boosting demand while supply remains disrupted by shortages of material and workers.

Economists’ forecasts are missing the mark more than usual in the current environment. The miss on inflation follows an even larger error in forecasting the U.S. jobs report for April, when the consensus forecast of an employment gain of one million far exceeded the actual increase of 266,000. Economists simply have little understanding of how an economy performs in a pandemic when government edicts can change the fortunes of an industry overnight and household behaviour has shifted in ways no one predicted.

Not that economics ever had a good track record at forecasting. As Niall Ferguson observes in his recent book Doom: The Politics of Catastrophe, “economic forecasters are in reality far worse at their jobs than weather forecasters.” Economists routinely miss such major events as an economy falling into recession. The IMF predicted only four of the 469 downturns in national economies between 1988 and 2019. As the economist John Kenneth Galbraith quipped, “Pundits forecast not because they know, but because they are asked.” (Even less charitably, he also said “The only function of economic forecasting is to make astrology look respectable.”)

The April surge in prices showed demand is accelerating while supply lags. The rapid recovery of demand in 2021 is being fuelled by an international economy driven by growth in the U.S. and China, a huge reservoir of pent-up demand and savings carried over from the lockdowns in 2020 and early 2021, and unrelenting monetary and fiscal stimulus. The housing market is Exhibit A for monetary stimulus, with even the Governor of the Bank of Canada admitting soaring house prices are “not normal” — which is hardly surprising since there is nothing normal about seemingly permanent record low interest rates.

Meanwhile, it is becoming increasingly clear that the pandemic has disrupted the supply of products people want to buy. Surging global demand caught many commodity markets off guard, sending metals and lumber prices to record highs. Equally problematic is a global shortage of semiconductor chips after the industry scaled back production early in the pandemic just as the world going online ignited the demand for its product.

Chip shortages have crimped the production of everything from automobiles to TVS. Shortages were clearly a factor in the U.S. auto market, where buyers unable to order a new vehicle instead turned to the used vehicle market and bid up prices by 22 per cent. (The split between new and used vehicle prices is not available in Canada, but the same process very likely is happening here).

Shortages are also appearing in the labour market. Although the recovery of employment to pre-pandemic levels is far from complete, employers everywhere bemoan a lack of people available to work. U.S. Federal Reserve officials said they are lowering job forecasts for May as business hiring plans continue to outstrip the supply of people willing or able to work. Many older workers who left the labour force last year evidently have either retired or are afraid to return until the virus is eradicated. Meanwhile at least some younger workers are happy to live on generous government subsidies for as long as possible.

Another consideration in analyzing the April inflation rate is that supply shortages mean the official statistics probably understate inflation. The CPI does an excellent job of measuring prices in normal times, with the consensus of experts being that it usually slightly overstates inflation slightly. However, the CPI is not designed to capture the impact of supply shortages. For example, the shortage of semiconductor chips has curtailed production of printers for home offices; when recently trying to order one, I was told my preferred inexpensive model would not be available until September. This left me with the choice of having no printer for months or ordering a more expensive model. Since waiting is a cost for consumers and therefore represents a price increase, both choices are equivalent to higher prices. This effect does not show up in the CPI, however, since it only compares prices of the same products over time.

The difficulty of forecasting in the current environment means widespread assurances that the spike in inflation is temporary are questionable. The CPI is going to continue to rise this year because of the soaring cost of commodities and housing. Whether higher inflation continues into next year depends both on whether higher prices become embedded in expectations and wages but also on when and how quickly stimulus is withdrawn. Because demand isn’t holding the economy back, supply is, some of the artificial stimulus could be withdrawn without slowing the recovery. That would begin to normalize monetary policy and financial markets and would reduce inflationary pressure.

FORECASTS ARE MISSING THE MARK MORE THAN USUAL IN THE CURRENT ENVIRONMENT.