We should fear a sticky inflation mess

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In January 1919, a 12,000 ton tank of molasses burst in Boston’s hilly North End, sending a slow-moving wave of the sticky syrup right into the heart of the neighbourhood. 

The Great Molasses Flood claimed the lives of 21 Bostonians, trapping them in a viscous river of the refined sugar cane. Its legacy lives on in Boston lore, with residents of the North End claiming they can still smell the molasses on a summer’s day.

The tragedy goes to show that “sticky” — despite seeming a less potent state of matter than “sharp” or “spiky” — can be dangerous. That’s particularly true for inflation. And stickiness of price growth may be fated to remain longer than central banks are anticipating, especially if previous economic trends hold in the coming years.

A recent report by the Bank for International Settlements has explored this issue in depth. MainFT wrote up the headline findings last week, but the paper is interesting enough to warrant a fuller write-up.

Basically, the BIS points out that services inflation has historically been structurally higher than goods inflation, running at about 1 percentage points above core goods inflation in the two decades leading up to the pandemic.

Its economists attribute this to two main factors, with Alphaville’s emphasis in bold below:

First, a higher income elasticity of services: as income per capita rises, so does the relative demand for services and hence their relative price. Second, in what is commonly known as the Baumol cost disease, rising wages in higher productivity sectors push the costs in labour-intensive services sectors up, while lower productivity growth in the services sector then leads to higher services prices.

In other words, as people get more discretionary income, they spend more on services, like nicer hotels or fancier barbers. The Baumol disease might sound like an unpleasant bowel affliction, but it is essentially posits that the contagion of higher wages makes services more prone to price growth.

This trend was well documented across many countries over the past two decades, but was disrupted by the Covid-19 pandemic, when consumers couldn’t spend money on services and instead went on a frenzy of buying Instagram-peddled clothing, home gyms and more Zoom-friendly furniture, straining international shipping lanes and driving up prices.

Goods prices have remained high in the wake of that shift, as record pent-up demand and Russia’s war in Ukraine contributed to the surge in inflation. But goods prices have started to come down, while services have remained high.

Many have already commented on the stickiness of services inflation, including the ECB, and have opined over whether it is caused by a structural delay in services price changes or greedy consumers (including Catherine Mann, in a surprise “eat the rich” turn).

But the BIS report argues that services inflation could reassert its previous structurally higher growth trend, causing central banks to delay rate cuts or requiring them to take even more aggressive measures. Once again FTAV’s emphasis below:

Importantly, these scenario-based higher growth rates of services prices would imply overall inflation rates that are roughly 1 percentage point above inflation targets. However, the scenario embeds the implicit assumption that central banks will not react; this is not going to be the case if inflation remains above target.

This would be akin to dunking the economy in a slow-moving tide of molasses. To illustrate this scenario the BIS created this graph, which shows OECD services inflation remaining above target until the end of 2025:

And this one, showing what the ratio of core goods to services in advanced economies would be if they were to resume their pre-pandemic trend:

Unfortunately, there could be more bad news. Some economists are sceptical of the implied assumption in these forecasts that goods prices will revert to the happy pre-pandemic trend of generally being a disinflationary force.

In other words, services inflation may run hotter for longer but goods inflation could very well be uncomfortably hot as well, due to some pretty important structural economic changes since Covid. As Oliver Rakau of Oxford Economics puts it:

The integration of emerging Asian markets into trade over the last two decades drove down prices for goods, as well as general productivity growth in manufacturing and other industries. This is arguably much less the case looking ahead given de-globalization efforts between the West and China.

This would be a very awkward situation for many central banks, which would then not be able to simply rely on slower or even negative goods inflation counteracting faster services inflation — which is what in practice many could do in the last two decades.

But the worst scenario is if uncomfortably high services and goods inflation start to feed on each other and Baumol’s cost disease really starts to manifest itself in a major way. The BIS nods to this danger at the end of its paper:

While goods prices in some jurisdictions in late 2023 and early 2024 are below previous trends, global forces can structurally alter the dynamics of inflation in the longer term. Climate change could create upward pressures on goods prices through more severe disruptive weather events or drought-induced restrictions on freight shipping in waterways. Geopolitical tensions could add to these pressures, including through a reorganisation of global value chains. This means that, all else equal, services price growth may have to be much lower than it was in the decades that preceded the pandemic if inflation targets are to be achieved.

Which the BIS clearly doesn’t think is going to happen. Yay.

The BIS does cursorily wave at some reasons for optimism, namely that gains in productivity on the back of AI could structurally lower services price growth, or that labour markets might readjust. But just as the good people of Boston learned as the saccharine ooze swept them down Commercial Street, we should all fear hot sticky messes.