A surge in prices during the last few months has riven the Federal Reserve and put the Biden White House on the defensive. Policymakers insist this spurt of inflation is transitory, but if they’re wrong, the economic recovery could abruptly slow and the stock market sell off.
The good news, however, is that the very way we measure inflation will likely bring relief from rising prices in 2022. The most intuitive way to think about inflation is the year-over-year increase in prices. On that basis, annual inflation is now 5%, the highest level since 2008. A few items have posted eye-popping price gains. Lumber costs 49% more than a year ago. Used cars are up 30%. Energy is up 29%. Airfares are up 24%.
The biggest driver of inflation right now is what economists call “base effects.” The base is the price 12 months ago, which for many goods and services was artificially depressed because of the coronavirus pandemic that kept everybody home. So double-digit inflation now may actually overstate how expensive things are. Price trends for airfares nicely illustrate this phenomenon, as this chart shows.
Compared with the base—the price level a year ago—airfares are up 24%. But they’re still lower than they were before the pandemic, and if you change the base to February 2020, before the pandemic exploded, airfares are down 12%.
Lumber prices give some idea what might be in store for next year. Lumber prices actually rose at the start of the pandemic, as mortgage rates came down, demand for real estate picked up, and homebound consumers began to splurge on home improvements. Then prices exploded in March, as mills couldn’t keep up with soaring demand. That produced an annual price hike of 49% in May, as this chart shows.
Lumber prices are beginning to settle, however, as some buyers balk at sky-high prices and more supply comes online. Since there’s no fundamental change in supply or demand, prices will probably return to normal levels. But let’s say lumber prices only retrace half the of this year's gain by this time next year. Prices would still be higher than historical averages, but the year-over-year price change would be a decline of 15% or more. In other words, deflation, not inflation.
Goldman Sachs calls this dynamic “extreme base effects,” mainly affecting goods and services disrupted by the pandemic. “We expect these categories to undershoot their normal inflation rates over the next two years as price levels return to trend,” Goldman explained in a June 29 research note. If that’s what happens, most of the price hikes causing worry now will dissipate, bringing overall inflation back near the 2% range just about everybody is comfortable with.
Two categories could be exceptions: Housing and gas prices. Home prices have risen 14.6% during the last 12 months, with little relief in sight. Permitting difficulties and land shortages in some areas constrain supply, while super-low mortgage rates juice demand. If interest rates rise, which is inevitable at some point, demand could cool and prices relent a bit. But this is a long-term trend that’s difficult for policymakers to reverse. Home owners don’t mind, of course, since the value of their principal asset is skyrocketing. But first-time buyers are getting locked out and missing the chance to become home owners.
Gas prices are more of a political risk for President Biden and the Democrats who narrowly control Congress. Demand for gas did plummet last year, as everybody holed up at home. That’s the main reason gas prices are up 56% during the last year, to around $3.15 per gallon. But gas is a unique product dependent on oil supplies and other factors unrelated to the pandemic, and prices could keep rising.
Bank of America recently predicted that strong demand for travel, coupled with supply constraints, could push oil prices from current levels of around $75 to $100 or more by next year. That could push U.S. gasoline prices close to $4 per gallon, a pain point for many American drivers. High oil and gas prices often rectify themselves, since higher prices create more of an incentive for producers to drill. But that can take time, and voters, meanwhile, tend to blame politicians.
Rick Newman is the author of four books, including "Rebounders: How Winners Pivot from Setback to Success.” Follow him on Twitter: @rickjnewman. You can also send confidential tips, and click here to get Rick’s stories by email.
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