Supply Issues Create More Inflationary Pressures Than Strong Labor Market

Inflation – the change in overall prices – is back in the news again. After a persistent decline from a year over year high of 9.0% in June 2022 to a recent low of a year over year increase of 3.1% in January 2024, inflation recently has stopped falling. Prices were 3.5% higher in March 2024 than in March 2023. This “not quite falling, not quite rising” pattern of inflation is something that happens even in a very low inflation environment and follows from isolated bumps in prices that have little if anything to do with more demand. Instead, they are related to supply shocks and possibly companies’ market power that keep prices from falling further. This also means that further tightening monetary policy – higher interest rates – will unnecessarily cause economic pain. Fighting climate change through regulations and investments in renewable energy, increasing the supply of housing, enforcing antitrust rules and fighting junk fees will be more productive ways to reduce inflationary pressures, even in the short and medium term.

The basic theory of demand driven inflation goes something like this. Strong hiring lowers unemployment. Low unemployment gives workers more power to ask for higher wages. More jobs and higher wages drive demand higher for a wide range of goods and services. The additional demand translates into higher prices – inflation. The Federal Reserve then supposedly has to slow demand by raising interest rates and reduce inflation since higher interest rates cut economic activity, increase unemployment and lower demand.

Inflation Not Demand Driven

The data has not supported this argument for the past few years. Most importantly, unemployment has stayed below 4% for more than two years – the longest such period in over 50 years – even amid rapidly rising interest rates. Yet, non-inflation adjusted wage growth has slowed as has inflation. Demand growth has stayed strong. In the end, a strong labor market has become consistent with slowing, not rising inflation.

The most recent data for March 2024 is also inconsistent with an argument that more demand is driving prices higher. The data should show strong and accelerating price increases in goods and services that people would want to buy when they have a better paying job.

Food Prices In Grocery Stores Change Little And Rental Inflation Decelerates

That would mean faster price increases for food, for instance. Yet, prices for food at home grew by an annualized rate of 1.2% in March 2024 after being flat in February. For the past year, food prices went up by 1.2%. Price changes for food at home has hovered around 4% without a clear trend over the past year.

Renters may also want to move to a better place if they have more income. This should then translate into faster inflation for rents. Importantly, this argument only applies to new rental agreements. After all, property owners raising rents for existing tenants has nothing to do with demand – tenants are not volunteering to pay more just because they have larger paychecks. Those rent increases for existing renters instead reflect the pricing power that owners have over tenants. Yet, Zillow’s index for new rents, for instance, does not show a sustained acceleration in prices for new rents. The index is not seasonally adjusted and thus jumps around from month to month. Calculations need to look at changes over a 12-month period to see trends that are not influenced by seasonal fluctuations. Those calculations show that rents for newly listed apartments have gone up by 3.6% from March 2023 to March 2024, close to the recent low of 3.3% from October 2022 to October 2023. The current rental price inflation for units on the market is also well below the 5.8% increase from March 2022 to March 2023. There is little evidence that people are moving to different and more costly rental units as wages and employment are going up.

The price increase for currently available rental units is also well below the rental inflation for all rents, including those where rents are renewing. This price index, which follows changes for new rents, went up by 5.7% over the past year. Importantly, rental price increases for all rents have gradually slowed over time, following the pattern of new rents, as expected. The data suggest that this pattern of slowing rental inflation will likely continue for some time, reducing inflationary pressures. Not only is rental inflation not driven by demand, it is also on a downward trajectory.

Supply Side Disruptions Push Prices Higher In Some Areas

Factors other than demand are driving inflation right now. Motor fuel prices jumped by an annualized rate of 14.4% in March alone. They have gone up by 6.3% over the past twelve months, well above the price changes for all other goods. The main driver of higher gasoline prices are higher petroleum prices in the global markets. Those price increases follow from the ongoing war in Ukraine and turmoil in the Middle East such as attacks on shipping routes in the Red Sea, the war in Gaza and military strikes against Iran and Israel. Over time, investments in renewable energy sources will be the primary way to insulate the US economy against such price spikes.

Medical services also saw a substantial jump in March. They increased by an annualized rate of 7.2% that month, but that followed months of subdued price increases for hospitals, doctors and other specialists. Health care services only grew by a modest 2.1% over the twelve months that ended in March.

Higher prices in health care are difficult to square with a demand side story. People are not all of a sudden going to check into hospitals and seeing more doctors if they get a raise, largely because most health care expenditures are covered by insurance. Rather, hospitals and medical professionals often raise prices because they can charge more in a less competitive environment. Most likely, though, the bump in prices in March 2024 reflects volatile price measurements that often jump around a lot. The price increase over the past year after all was modest.

Finally, prices for car insurance surged, too. They went up by an annualized 31.2% in March 2024 alone and by 22.2% over the past twelve months. It is again hard to imagine that people wanted to spend more money on car insurance over the past year because they had higher incomes from work. Rather, the jump in car insurance prices may reflect increasing claims, possibly related to a higher frequency of climate change related events such as wildfires, floods and hurricanes.

The recent bump in inflation follows from a range of factors that have more to do with the supply of goods and services. This includes still too few affordable rental options, renewed oil price spikes, climate change related events and possibly market concentration. The solutions will then have to focus on the supply side as well. This means addressing climate change and the effects of more severe weather, enforcing antitrust, fighting hidden fees in all industries, increasing the supply of housing and building up renewable energy sources.