In 2021, inflation returned. After a year-long debate, nobody can any longer deny this. Next year, we will discover whether it’s here to stay and how much bitter economic medicine will be required to quell it.
On this vital issue, opinion is as divided as ever. Optimists still maintain that even if inflation has turned out to be more than a transitory blip, it will soon die down. Whether they’re right depends on the outcome of some of capitalism’s most profound conflicts.
A number of factors will indeed combine to push downwards on inflation next year. Used-car prices doubled and gasoline prices rose by 50% last year. That’s not going to happen again. Bottlenecks in global trade have already begun to loosen up a little. And there is ample room for central banks to tighten monetary policy; so far, there has been no attempt to reduce demand by raising the price of money or cutting back on its supply.
It’s encouraging that the bond market expects inflation to barely exceed 2% five years from now and the Fed’s interest rates not to rise even that high. Consumer expectations aren’t much different. If they were to change and become entrenched, then inflation would be hard to dislodge. But for now, investors believe that price rises can and will be brought under control relatively painlessly.
Still, permanently higher inflation remains a possibility. Whether it comes to pass will depend on two core questions that have long plagued capitalism: Will labor gain a greater share at the expense of capital? And, if so, will companies absorb higher wage costs or pass them on to customers?
Labor vs. Capital
Since the 1980s, capitalism has evolved to keep inflation under control. The risk now is that capitalism has embarked on a regime change.
Labor’s share of GDP held stable at somewhat higher than 60% for the five decades after World War II. But it started to decline sharply after the dotcom bubble burst in 2000 and fell further after the financial crisis in 2008. As Ellen Zentner, chief economist at Morgan Stanley put it, the historically “unprecedented” plunge in the labor share of GDP “marks a break in the fundamental structure of the economy.”
The increasing powerlessness of unions has made it harder for workers to negotiate collectively. Demographic factors have similarly diminished their bargaining power. While the baby boom generation was at peak working age, labor supply was ample. Companies’ ability to outsource production to countries with lower wage bills, particularly China, further inhibited wages, as did the influx of migrants from Mexico.
What was already a bad deal for the worst-paid became a terrible one in the years after the 2008 financial crisis, as companies made increasing use of part-time workers who had fewer benefits and could be dismissed cheaply. For several years under President Barack Obama, part-time workers’ wages lagged far behind those of full-time workers, and also behind inflation:
This malaise led to populist anger and the ascent of President Donald Trump. In the last year, though, the pandemic appears to have turned the labor market on its head. Following virus-related shutdowns, job vacancies have surged to near-record levels as companies have tried and failed to fill low-paid jobs.
The low-skilled, under-educated and poorly paid have gained more negotiating power — and used it. Now, they are getting the best wage deals in a generation; their salaries are rising faster than for the well-paid and expensively educated. Wage growth for women and non-whites has overtaken that for men and whites. Unfortunately for them, another pattern has also reversed. The extra wages they’ve negotiated are nowhere near enough to cover fast-rising inflation. Data produced by the Federal Reserve Bank of Atlanta show a sharp decline in real wages.
That gives workers even more incentive to push for higher wages next year, which would be a crucial building block for embedded inflation. It was data like this that prompted Jerome Powell, head of the Federal Reserve, to say at the central bank’s last meeting of the year, “The labor market is by so many measures hotter than it ever ran in the last expansion.”
If capitalists are forced to pay their workers a greater share of their revenue, they have two alternatives. One is to take the hit themselves, leave prices unchanged and make do with a tighter profit margin. The other is to pass on the wage increases to consumers by raising prices, if they can.
Will they, and do they have the power to do so? As Morgan Stanley’s Zentner puts it, this is the “thread the needle” moment for the Federal Reserve, which aims to balance full employment with price stability. If companies decide to take the hit, accelerating wages need not spill over into rising price inflation.
Until the last decade or so, history provided clear guidance. Over time, profit margins have been an almost perfectly cyclical, mean-reverting phenomenon. Margins improve when times are good and decline during recessions, as companies elect to take some of the hit from the economic downturn themselves.
But something has changed since the financial crisis. Margins for S&P 500 companies rebounded swiftly after 2008, aided by the stagnation in wages. On the eve of the pandemic, margins had avoided a major fall for a decade and reached a record.
Since the pandemic, margins have strayed even further from the traditional pattern, suffering a mild decline (thanks to sweeping layoffs early on) and now surging back to reach a level of profitability never before seen.
At this point, however, companies have to recruit more people to raise production. And it looks as though they will be unable to do so unless they raise wages.
Executives are assuring investors that they are confident in their pricing power and Wall Street projects that margins should rise further next year. This provokes complaints from politicians, who suggest that heavy industry concentration, thanks to the mergers and acquisitions of the last few decades, have left companies with the discretion to charge whatever prices they like.
This argument, long the stuff of academic papers and Davos panels, will come to a head next year. In the last few decades, the balance of capitalism has tilted sharply in favor of capital. One effect of this has been to keep inflation under control. Now, after a once-in-a-generation pandemic has roiled labor markets, workers, particularly the lowest paid, appear to be regaining strength.
The story of inflation in 2022 will also be the story of whether the regime of capitalism is really changing and returning to an arguably healthier balance. We should be watching prices not just for their impact on the economy, but for what they’ll tell us about the future of our societies.
John Authers is a senior editor for markets.
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