Supply chains are healing, so why is inflation still so high?

Supply chains are healing. Shipping costs have plummeted. Commodity prices have fallen sharply. The congestion that clogged the oceans has dissipated. But prices remain stubbornly high.

U.S. Consumer Price Index numbers for September came in hotter than expected this week.

“Despite a pullback in gasoline costs … price pressures showed little sign of subsiding,” wrote BMO economist Sal Guatieri. “Core prices jumped a larger than expected, 0.6 per cent for a second straight month, spiking the yearly rate to a fresh 40-year high of 6.6 per cent.”

Economists usually split inflation numbers into two main groups. The first is “core” inflation, which strips out more volatile components like gasoline and food. The other, “headline” inflation, measures the total rise of prices on a broad basket of goods.

Headline inflation is falling. That’s being driven by global factors.

Prices falling from peaks

The price of oil peaked in June at slightly more than $123 per barrel. This week, that same barrel traded for about $86, a fall of more than 30 per cent.

The price of lumber surged in the early days of the pandemic, driving up costs (and availability) of supplies for all those backyard DIY projects spurred on by early lockdown measures. By the end of September, lumber futures were trading 70 per cent below where they were at the peak.

The price of corn, gas, steel, beef and even microchips has fallen this year, as the world now braces for a potential recession in early 2023. 

That’s why headline inflation is falling.

But core inflation is moving in a decidedly different direction. Shelter costs pushed that measure to a 40-year high.

Cost of labour rising 

It’s not just a single component driving this new wave of inflation. Economists say inflation has shifted from a mostly global story about the price of goods to a domestic story about services.

The first wave was driven by the input cost of stuff we buy. As prices rose, workers demanded higher wages to keep up.

That in turn has forced up the cost of services, everything from your local barber to high-priced consultants.

“The same thing that we saw for goods we’re now seeing for services,” said RBC economist Claire Fan. “For services, it’s not raw material that matters more, it’s labour, it’s employees.”

Even as the economy has slowed, the labour market has remained exceptionally tight. The unemployment rate sits at a level we haven’t seen in 50 years. Job vacancy rates have never been this high.

So, it’s never been a better time to be looking for a job. 

And yes, wages are up, but not nearly as much as inflation. “Real wages” are calculated by subtracting the rate of inflation from wage growth. So real wages remain in firmly negative territory.

Economy playing catchup? 

Besides, not everyone agrees this next wave of inflation is being driven by an increase in wages.

“In a way, we’re just seeing the rest of the economy catching up a little bit to what was happening in the more volatile parts of the economy,” said Jim Stanford, an economist and director of the Centre for Future Work.

Stanford says there’s no proof another wave of inflation is even happening.

The way he sees it, core inflation always lags behind headline inflation. It lagged behind headline on the way up, and now he says it’s lagging behind on the way back down.

“It’s going to take some time,” he said. “And we all have to be a bit patient in understanding that inflation isn’t going to disappear overnight.”

Bank of Canada aggressively hiking rates

That’s not how the Bank of Canada sees it. It’s moving aggressively to raise interest rates. The bank has moved its key overnight lending rate from 0.25 per cent to 3.25 per cent in just a matter of months.

Just last week, Bank of Canada governor Tiff Macklem said he wasn’t done yet.

“We do think further interest rate increases are warranted to get inflation all the way back down to target,” Macklem said at a news conference in Halifax.

Stanford says that will lead to “a cure that’s worse than the disease.”

He says higher interest rates are already slowing the economy. In fact, he says there were clear signs of weakness in the second quarter. 

“And it’s quite possible in the third quarter that our economy has in fact shrunk,” he said.

The debate over what to do about inflation highlights just how serious a threat rising prices pose to the broader economy.

Understanding what prices are doing is difficult during the best of times. Trying to decipher trends while the world is still emerging from a global crisis is a nearly impossible task.

Both paths come with a certain degree of risk. You can do nothing and hope prices come down on their own. But if you’re wrong, the task of dragging down entrenched inflation is even harder than whatever this is.

The Bank of Canada seems to have chosen a path of pushing rates higher. Its next interest rate decision comes on Oct. 26.