The Illusion of 3% Inflation

David Paul
7 min readJul 18, 2023

The desire in the country to put inflation in the rearview mirror is palpable. Last week, the Dow Jones leapt, Wall Street traders rejoiced, and interest rates tumbled, when the Consumer Price Index for June came in at 3%. It looks like, to use technical market jargon, the Goldilocks Scenario: the economy is not too hot, it’s not too cold; the Federal Reserve Bank has done things just right, and brought down inflation without throwing the economy into a recession. Victory is at hand.

The notion is out there — and it gained steam with the inflation report this week — that after one final Fed rate hike in July, we are going to return to the status quo ante and things will return to normal. But there has been a significant dissenter to that view: Fed Chair Jerome Powell. For months now, Powell has insisted that the Fed has a long way to go to bring inflation down to the Fed’s 2% target, and, in particular, to restore the balance between supply and demand in the labor market. And if these are indeed his goals, they will not be achieved easily.

While a 2% inflation target is part of that status quo ante many imagine lies just around the corner, those who embrace the 2% inflation of the past fifteen years as an historical norm are mistaken. For the half-century preceding the 2007–2008 Global Financial Crisis, inflation in the United States, as defined by the Consumer Price Index, exceeded 2% in every year except for 1986 and 1998. And as much as Paul Volker is revered as the man who conquered inflation in the post-Vietnam War era, the CPI only dipped to 2% for one year during his eight-year tenure as Fed Chair, and hovered around 4% when he stepped down. From the time Volker left the scene in 1987 to the global financial collapse two decades later, the CPI averaged over 3% annually.

The 2007–2008 Global Financial Crisis changed everything. It was the most severe economic collapse since the Great Depression, and central banks across the globe had to shift their strategy from fighting inflation to fighting deflation. In the years following the 2008 collapse, the central banks across the globe introduced Zero and Negative Interest Rate Policies in a coordinated effort to keep the world from falling into a deflationary spiral. Put simply, the past fifteen years of 2% inflation is not a case of central bank success in keeping inflation under control, rather it was the product of countries trying to push inflation up, rather than keep it down. Deflation, rather than inflation, was the problem they were grappling with.

No doubt the 3% inflation number released this week is good news One can only imagine the market turmoil and despair, had the number come in a point or two higher. But, in a sense, the number did come in higher. Hidden behind the 3% headline was the fact that core inflation — which is calculated to exclude traditionally volatile food and energy prices — continues to perk along at nearly 5%. A quick dive into the numbers released last week suggests that inflation falling to 3% was largely a product of the 17% decline, year over year, in energy prices. Indeed, much of the decline in inflation over recent months appears to reflect the resolution of a number of forces that had been the drivers of inflation in the first place, including Covid-related global supply chain issues, the Ukraine war impact on global food and energy prices, and even the avian flu.

Inflation may have come down over the past year and a half, but it is hard to assess the extent to which the Fed’s aggressive rate hikes have contributed to that success. The premise of the Fed’s ability to fight inflation is that increasing interest rates will suppress economic activity, and in turn employment and demand for goods and services will decline, bringing prices down in their wake. But even as the Fed has raised interest rates at an historically rapid pace, the impacts across the economy have been muted. While job growth slowed this month to 209,000 jobs, the pace of job growth remains strong, and the unemployment rate remains only marginally higher than the historic low of 3.4% reached earlier this year.

For anyone running an organization of most any type, the notion that inflation is down to 3% seems ludicrous. After all, labor costs — salaries and benefits — constitute over half of GDP, and well more than half of the costs for many organizations. Finding and keeping employees today has become a challenge for organizations of all types, as nearly a third of American workers changed jobs last year in search of greater opportunity and higher pay. And it does not look like the situation will get better anytime soon, as a recent LinkedIn study suggests that 70% of younger workers are considering changing jobs this year. Indeed, the same government agency that told us that inflation has declined to 3% reported recently that the Employment Cost Index, which measures hourly labor costs to employers over time, is chugging along at nearly 5%.

It is hard to overstate how different the labor markets are today from any other time in recent memory. Over the post-Covid period, the number of available job openings across the country began to rise in early 2021, and by last spring had skyrocketed to over 12 million. As shown as the blue line in the graphic here, this represented more than a doubling in the number of job openings across the economy compared to any time over the past quarter century. All the while, setting aside the peak Covid months, the number of unemployed workers (shown in the red line) has continued to trend downward.

And it is not as though people don’t want to work. While it had become a meme of sorts that Covid stimulus funds were paying people to stay home, that time has passed. Although personal savings skyrocketed in 2020, giving people the latitude to stay home, as illustrated in the graph here, those savings have not only been spent, but personal savings nationally are now below pre-Covid levels. Americans have returned to work, and today, across nearly every demographic category — the exceptions being white men and older white women — labor force participation rates (the percent of the working age population that is working or seeking work) are now higher than pre-Covid levels, and the overall labor force participation rate is nearly as high as the historical peak reached in the late 1990s.

Finding ourselves in a world where the number of job openings exceeds the number of unemployed people across the economy may mark an historical shift in the labor markets, but it should not have come as a surprise. In the wake of the tightening of U.S. immigration laws in 2017 and the ensuing out-migration of millions of long-time workers from the U.S. to their country of origin, employers from rural farmers to urban restaurateurs found themselves starved for workers. The Great Resignation may now be over, as people have spent down their personal savings and headed back to work, but the excess of unfilled jobs relative to the number of people available to do them remains.

And as workers continue to change jobs at historic rates, employers have gotten the message. Rather than seeing increasing rates of layoffs by businesses in the face of the Fed’s efforts to slow down the economy, Bureau of Labor Statistic data suggests that the rate of job separations has declined. Labor “hoarding” has emerged as an increasingly common practice, as companies have become loath to lay off workers even when business is slack, for fear of not being able to fill positions down the road when they need to.

It is hard to imagine where Jerome Powell decides to go from here. Notwithstanding the decline in inflation to 3%, the Fed’s limited ability after a year and a half of aggressive tightening to curtail job growth, raises questions about the effectiveness of the limited tool kit the Fed has at its disposal. Taking credit for a victory over inflation that the Fed did little to produce could backfire in short order, as Saudi plans to cut oil production and Russia’s exit from the Ukraine grain deal could quickly reignite upward pressure on commodity prices.

There is no obvious path forward to returning inflation to 2% — and it seems largely an arbitrary number — that does not begin with restoring what Powell views as balance in the labor markets. But that will be easier said than done. Short of a politically untenable reversal of immigration policies, it is hard to imagine restoring a world where there are five million more people seeking jobs than job openings — where things stood a decade ago — without forcing the country into a protracted recession.

And then there are the equities of the situation. Powell’s language about imbalances in the labor markets may be about the Fed’s ability to do its job, but it is also the language of class warfare. After decades of watching income inequality grow steadily in the United States — inequality that has been exacerbated by Fed policies — workers have newfound power in the marketplace. “The restoration of balance between supply and demand in the labor market” as Powell describes his objective, is surely understood by many — including those who support the objective and those who oppose it — as code for crushing that power.

One has to wonder whether Powell has the stomach for what it would take to achieve his stated goals. The Fed is in uncharted waters, and something is going to have to give. Perhaps he will stall for time, and argue that the Fed needs to allow some months to pass to assess whether the tightening to date has had an impact. Perhaps he will stick to his guns and plough forward, bearing the slings and arrows of those who claim that the economic price will be paid by those least able to afford it, and that once again the Fed is doing the bidding of the Plutocrat class. Or perhaps, with all that good data suggesting inflation is coming down — whatever the cause — Powell will take the easy way out: join the crowd, declare victory, and move on.



David Paul

Financial advisor to city and state governments. Lifelong Red Sox fan (don't hold it against me).