US inflation rises to its highest level since the 1980s

The US rate of inflation reached 7 per cent on Thursday 13 January – the highest it has been for 40 years. From a low of 1.4 per cent in January 2021 the US inflation rate has increased each month this year reaching its 7 per cent high in December. This is a pattern reflected in other countries with EU inflation running at 5.2 per cent and the OECD (which represents more than 30 of the world's largest economies) saying inflation among its members had hit its highest rate in 25 years in November.

The causes of inflation in the US can be looked at by considering demand-pull and cost-push factors. The US economy is currently growing at an annualised rate of 5.6 per cent which is significantly above its trend rate as the US economy has recovered from the incredible fall in GDP in 2020 (32 per cent) caused by the Covid 19 pandemic and the resulting lockdowns. A significant rise in US consumption and investment expenditure in 2021 has increased aggregate demand and pulled up prices.

The supply side of the US economy has also been a significant driver of higher consumer prices. As the world economy recovered from the pandemic slowdown in 2020 energy prices started to increase dramatically with oil prices increasing by 50 per cent. Higher oil prices have led to higher petrol (gas) prices for US drivers which is a key component of the US Consumer Price Index (CPI). Household energy costs also have a high weighting in the US CPI, and these have been pushed higher by rising natural gas prices. As the US labour market has recovered wages have increased significantly in nominal terms with some major employers increasing pay by 10 per cent although most workers have seen any gains in pay eroded by rising inflation. Higher nominal wages have put upward pressure on business costs and increased prices in some cases.

One interesting economic effect of the pandemic was a switch in consumer spending away from services such as restaurants, bars, and cinemas towards consumer goods. Consumer spending on furniture, electronics, and clothing all increased significantly as households switched away from services towards goods. The surge in demand for goods put lots of pressure on supply chains which were also struggling to deal with constraints put on due to lockdown restrictions. The supply chain constraints have filtered through to higher production costs and consumer prices. Shipping container costs, for example, have increased by 500 per cent over the last 12 months.

Inflation of 7 per cent is a new situation for many US households. A whole generation has grown up with inflation running at a 2 per cent average. Historically inflation can be very difficult to reduce once it because established in the economy. The US central bank will start to increase interest rates through 2021 as it tries to bring the rise of inflation under control, and this will come with its own costs to borrowers – particularly households with large mortgages.

It remains to be seen whether the rise in inflation in the US is a painful hangover that with dissipate quite quickly or whether it will linger.

Discussion questions

1. Explain why rising inflation in the US might be a problem for US households and businesses. 

2. Explain how cost-push and demand-pull factors might have caused the rate of inflation to rise to 7 per cent.

3. Evaluate the view that contractionary monetary policy might be the best way to reduce inflationary pressures in the US.

• Contractionary monetary policy means the US central bank will increase interest rates to reduce inflationary pressures in the US. Higher interest in the US will reduce consumption and investment in the US which will reduce aggregate demand and lead to a fall in the average price level. Higher US interest rates may also lead to an appreciation of the value of the US$ which will lead to a fall in US import costs which could lead to a reduction in cost-push inflationary pressures.
• The problem with using a contractionary monetary policy is the higher interest rates in the US may lead to a fall in aggregate demand which causes US economic growth to slow down and the negative impact this might have on US incomes and employment. Higher interest rates could also cause business costs to rise which adds to US cost-push inflation. Similarly, US household interest payments will rise and this reduces household disposable incomes.