Goods versus services inflation and the transitory problem

 

Fed and market behavior is closely tied with the issue of whether inflation is transitory or not. The Fed does not like to use the word transitory since it has been burned by their poor inflation forecasts. Instead of inflation declining, it has continued to move higher. The supply chain story has unraveled. The return to normalcy story has been shredded. The measurement problem between pre- and post-pandemic inflation is suspect now that we are in 2022.

Inflation is likely to go down in the second half of the year given the excessive increase in goods prices and the reduction in stimulus. Of course, this is unlikely to happen immediately if producer prices continue to increase at a higher rate than consumer inflation. 

However, the issue of further service inflation increases seems likely if there is a need to pay higher wages to workers. The lower services inflation has been dampening the overall inflation rate. 

Employment costs are running higher albeit with higher measurement volatility. If higher wages are necessary to entice workers into the labor force or to convince them to come to the office, we will see a change in the inflation mix - lower goods and higher service inflation. The overall mix may be lower than current prints but above the target level.

The dirty secret is that inflation will come down sharply if there is a decrease in aggregate demand. For this to happen the Fed must switch from a growth bias to an inflation control bias.