Partly cloudy, with a chance of inflation

Still, there are storm clouds on the horizon. Concerns about disruptions caused by the continuing pandemic have weighed heavily on forecasts going forward. Though there are many, the major concerns regard coronavirus variants, supply chain disruptions, labor supply issues and the potential for inflation.

The emergence of strong coronavirus variants has caused great concern among workers and employers. During most of the second quarter, cases fell in the nation and region, as vaccination uptake grew. However, toward the end of the quarter, as the Delta variant took hold, the trend reversed, and case rates began to increase. Especially important for labor markets, “breakthrough” infections of previously vaccinated individuals began to increase (although breakthrough cases tend to be much less serious). This implies that the vaccination program may not offer as much immunity as once thought.

In terms of supply chain issues, the Institute for Supply Management has reported that more than half of the firms it surveyed reported some disruption in supply chains, with longer lead times for deliveries and inabilities to secure necessary inputs to the production process. Though surveys later in the pandemic cycle have indicated that firms are adjusting to these issues, they remain a major roadblock to returning business to normal.

Labor supply has been reduced dramatically during the pandemic. The Labor Force Participation Rate, calculated by the U.S. Bureau of Labor Statistics (BLS), is 1.6% lower than it was in February 2020 (Figure 2). Using BLS estimates of the civilian non-institutionalized population, this equates to more than 4 million people fewer in the labor force, meaning that they are neither working nor looking for work. Combining this with strong demand for jobs as businesses recover, as indicated by 3 million more job openings at the end of Q2 as compared to February 2020, there is a mismatch between the quantity of labor supplied and demanded - especially in occupations hit hard by the pandemic.

There have been many theories made explaining the reduction in labor supply including workers’ health-related concerns about returning to work, enhanced unemployment benefits enacted during the recession, and households saving money from pandemic relief distributions and therefore not feeling the need to go back to work quickly. Whatever the cause, the effect could be to raise wage and benefit packages for workers. If labor cost increases are greater than the rate of productivity, that will disadvantage businesses and may lead to slower future economic growth.

Supply chain and labor force issues have fed into a larger concern about the possibility of seeing higher inflation rates. This concern is enforced by a perception of unprecedented fiscal and monetary support to address the pandemic. The Congressional Budget Office has projected that the federal budget deficit for fiscal year 2021, which ended on June 30, will be 13.4% of GDP. This is down only slightly from a post-World-War II record 14.9% in fiscal year 2020.

While the deficit is projected to shrink during the current fiscal year to 4.7% of GDP, that is still much above the average deficit since World War II. The Federal Reserve has also increased the supply of money by a third since the start of the pandemic through assets purchases.

There is some evidence that inflation fears are being realized through increases in producer and consumer prices (Figure 3). Consumer prices (measured by changes in the Consumer Price Index - CPI) were up an average of 5.4% year-over-year in June, producer prices (PPI) were up an average of 7.3% over the same period.

However, recent increases may not indicate a permanent increase in the rate of inflation. The price increases over the last few months have been driven by large increases in some categories which are either recovering from depressed levels during the pandemic (car rentals, lodging) or are experiencing strong but temporary disruptions (used car prices, driven by demand increases because reduced production of new cars due to supply chain disruptions for semiconductors that go into onboard electronic systems).

The Center for Inflation Research at the Cleveland Federal Reserve Bank calculates two measures that factor out “outliers” such as this (their Median CPI and Trimmed Mean CPI). Those two measures indicate inflation levels higher than during the pandemic but at levels comparable to those in the pre-pandemic period. Whether the changes shown in the raw CPI data are permanent or transitory will go a long way in predicting future actions by the Federal Reserve and the Biden administration.

The sideways nature of the regional economy is reflected in our “Return to Normal Index.” The index shows how regional economies are recovering from the COVID-induced recession using "high frequency" time series of economic activity (high frequency means that the data is available more frequently than traditional economic indicators released, at most, monthly). The index suggests no real trend during the period from mid-March to mid-May (which continues the pattern from the first quarter), but then a downtrend in the regional economy from the end of May through June (Figure 5). This may have been caused by the turnaround in COVID infection rates we noted earlier.

The sideways nature of the regional economy is reflected in our “Return to Normal Index.” The index shows how regional economies are recovering from the COVID-induced recession using "high frequency" time series of economic activity (high frequency means that the data is available more frequently than traditional economic indicators released, at most, monthly). The index suggests no real trend during the period from mid-March to mid-May (which continues the pattern from the first quarter), but then a downtrend in the regional economy from the end of May through June (Figure 5). This may have been caused by the turnaround in COVID infection rates we noted earlier.

As we move into autumn 2021, there is tremendous uncertainty going forward, both in terms of the virus and the condition of the macroeconomy. There is some indication that the national economy may not suffer much, at least in the near term. Early “nowcasts” of third quarter real GDP growth are in the range of 4% - 7%. Recently released data from the Philadelphia Federal Reserve Bank’s Survey of Professional Forecasters indicates increasing confidence that economic growth will continue throughout 2021 and into 2022. However, there is more uncertainty among the forecasters surveyed regarding inflation and unemployment rates going forward. As has been the case since the first quarter of 2020, the ultimate growth path of the economy, labor market conditions, and inflation will depend strongly on the virus, vaccines, and government intervention.