According to Labor Department data released on Wednesday, US inflation has hit 7 per cent, the largest 12-month gain since June 1982.
The metric used to measure inflation, the consumer price index (CPI), climbed 0.5 per cent in December, exceeding forecasts.
Despite a drop in fuel prices, higher costs were driven by rent, used vehicles, food, and apparel.
So, where is inflation coming from, and what does it mean for the US economy?
What’s causing US inflation?
The US economy faces a perfect storm of inflation from both the demand and supply sides.
On the demand side, the country’s unemployment rate fell to 3.9 per cent this week, fuelling wage growth and contributing to inflationary pressure.
In December 2021, 200,000 jobs were added to the US economy, pushing wage growth up 4.7 per cent over the year. This figure beat the market estimate of 4.2 per cent and was well above pre-pandemic rates of wage growth.
The relationship between low unemployment and rising inflation is well documented. When demand for labour is high, as it currently is in the US, wages are pushed up. The extra money is funneled into the economy through consumer demand.
In moderation, wage growth is a good thing for the economy, as it contributes to economic growth. Yet, when coupled with a supply shortage, wage growth can contribute to runaway inflation.
On the supply side, the US is dealing with an unprecedented supply-chain breakdown.
The last two years have seen dozens of ships left stuck at port, a shortage of truck drivers, and factories slowing down production because of the pandemic, all leading to empty shelves across the country.
When supply is short, and demand is high, prices rise as consumers and retailers compete for available goods.
The Omicron variant of COVID-19 is expected to cause more disruption to the already fragile supply chains, as quarantine and illness prevent employees from going to work.
Consequences of inflation
The latest jump in the country’s cost of living index will undoubtedly have consequences.
Historically US policymakers have preferred the prospects of runaway inflation compared to deep recession.
However, the US central bank, the Fed, cannot ignore the risks of a wage-price spiral developing, where wages/prices simultaneously push each other higher. Eventually, inflation will force policymakers to act.
Increases in interest rates are an inevitable result.
Bank of America Global Research’s US and Global Economist Aditya Bhave said the US inflation figures now almost certainly mean the Fed will start hiking interest rates in March.
“We have argued repeatedly in recent months, the surge in inflation is not just due to Covid and other distortions. There is a strong underlying cyclical pickup in prices as well,” Mr Bhave said.
He continued: “The breadth of the inflation supports our call for four Fed hikes this year.”
However, there are risks associated with a rate rise. An over-aggressive approach to inflation could send Wall Street into chaos and heavily impact the US Stock Market.
There is also concern over how vulnerable emerging and developing economies that have borrowed heavily in US dollars would be impacted by higher US rates.
Fed Chairman Jerome Powell has made it clear that the central bank will start shrinking its balance sheet soon after raising rates.
Mr Powell told Congress earlier in the week, “If we have to raise interest rates more over time, we will”.
It would seem the days of cheap money and cheap goods are quickly ending in the US.