Quick Bites | What Next for Inflation and Jobs?

The biggest story in investment markets over the last couple of years has been the sudden rise of inflation, followed by central banks raising rates to reverse that. For the last 6 months or so, the fall in inflation has been disappointingly slow and bumpy. To fully understand what it will take to achieve the “last mile” of bringing inflation down to normal, say around the 2.5% level (in an Australian context), it is useful to understand why it shot up so quickly in the first place. 


Ben Bernanke (former US Federal Reserve chair) and Olivier Blanchard (the former International Monetary Fund Chief Economist) have published a paper looking at that issue. They consider why global inflation took off in the early 2020s and conclude that inflation can end with less pain for workers than in the 1970s and 1980s. 


Not surprisingly, Bernanke and Blanchard find that the global inflation shock started with pandemic-affected supply chains and was exacerbated by Russia’s invasion of Ukraine. But more interesting was their assessment that tight labour markets and rising wages were not a primary cause. They find that most developed countries will need to see some weakening in labour markets to fully quash inflation.  


Perhaps this is part of the reason the ASX reacted so positively to the small rise we saw in Australian unemployment to 4.1%: a weaker labour market is necessary for achieving the last-mile reduction in inflation and increases the odds of the Reserve Bank of Australia cutting rates. So, a moderate rise in unemployment is being viewed positively by both bond and equity markets. 



Source: Trading Economics 


Bernanke and Blanchard say that as the initial sources of price shocks disappear, tight labour markets have become a bigger inflationary driver in many countries. “Labor markets became tight almost everywhere but played almost no role in the inflation take-off… However, the inflation effects of tight labour markets are persistent, so that, as the shocks to prices (e.g., for energy and food) have reversed, the wage pressures from hot labour markets have become a more important source of inflation“. 


In many countries, demand for workers still notably exceeds the supply of them relative to before the pandemic. Labour market cooling is therefore required to get inflation down. “Wage inflation has become the larger factor behind the remaining price inflation, which may make further reductions in inflation more difficult to achieve,” the authors write. Encouragingly, they say, there is little evidence of a wage-price spiral, a phenomenon that made inflation particularly difficult to stamp out in the ’70s.  

Bernanke and Blanchard note that “the unemployment costs of the last mile could be limited” in the US as job market dynamics normalize in such a way that suggests demand could come down without a huge spike in joblessness. This is the “soft landing” scenario that the market was looking for.