Over the past few months, several clients have asked our investment team about inflation and why it has stayed moderate while both employment and economic output have dropped off.

One prominent reason is that inflation is extremely dependent on the public’s expectations of what inflation will or should be. Further, expectations are anchored in past experience and generally do not change quickly. Another reason is that labor force growth has outpaced demographic projections. A third explanation is that labor productivity growth has offset some of the increases in labor costs. Nonfarm business labor unit costs have seen a five-year annualized increase of only 1.1%.

That said, the law of supply and demand has not been repealed. At some point, labor force growth will slow down and wage increases will become a problem even with improved growth in productivity. If aggregate demand for goods and services continues to outstrip growth of the economy’s productive capacity, businesses will step up price increases pushing demand downward to match output capacity.

For the near-term, however, inflation should remain moderate. Core PCE inflation will be closer to 2.0%, with core CPI inflation a few tenths of a percentage point higher. Headline rates will be more or less, depending largely on the behavior of oil prices.

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