Inflation won’t come down magically

To appreciate the strength of economic recovery from the sharp 2020 COVID-19 recession,  look no further than the labor markets. Unemployment rates around the world have fallen toward pre-pandemic lows. In most developed markets, pretty much anyone who wants a job can find one.

Fewer workers are participating in the labor force than before the pandemic, and the higher wages they can secure as employers compete for them threaten to take already accelerating inflation to a new, more worrisome level. Wage inflation is “sticky.” Although it takes time for wages to climb in tandem with broader prices, when they do, they’re fully along for the ride and ready to jump into the driver’s seat.

Central banks have underestimated this strength in labor markets and the growing wage pressures. In my view, markets are underestimating the degree to which central banks will need to use their powerful tools to pull inflation back to acceptable levels.

Higher rates are in the U.S. economy’s best interest, a point I emphasized in a previous commentary. Vanguard believes that the Federal Reserve may need to raise its target for short-term interest rates to 3% from its current range of 0%–0.25%. That would require steady rate hikes over the next few years, to a degree that markets haven’t priced in beyond 2022.

(In a Q&A, Vanguard economists Josh Hirt, Asawari Sathe, and Adam Schickling discuss labor, inflation, our 3% figure, and the potential risks of the Fed moving too aggressively or not aggressively enough.)