Inflation is Here to Stay | Opinion

Last week, Federal Reserve chair Jerome Powell changed his tune about inflation, saying that inflation will run a bit higher and last a bit longer than he expected. Get used to hearing this, because he'll probably have to repeat it over and over during the next few years.

It's not that the Fed doesn't understand what is causing inflation to rise. It sees the basic problem as a surge in demand that the supply side isn't equipped to handle, and that is correct. But the Fed has seriously underestimated the scope of this problem, which goes well beyond the snarled traffic in our ports and the shortage of computer chips. Almost no part of the supply side of the American economy is equipped to respond to the unprecedented rebound in demand, and this will lead to much higher inflation for at least a few years.

Part of the reason the supply side isn't ready for a strong recovery is that American companies have lacked enthusiasm for investing. After the financial crisis, households had to cut back in order to pay off debts they accumulated during the good times, and these lackluster years made many firms cautious about getting ahead of demand. The rise of online shopping also blew up many retail business models, leading to caution among the survivors. And shareholders have been aggressive about demanding higher cash payouts from companies, leaving less for investment. On the eve of the pandemic, companies were being rewarded for the "discipline" they showed in resisting the temptation to sink money into new projects with uncertain returns.

The result is that many businesses now lack the extra capacity needed to meet an unexpectedly large increase in demand. It's not that companies can't or won't respond to these increases, but adding capacity takes time. And after decades of not being able to raise prices at all, most companies are in no hurry to return to those days. Chances are, they'll take their time and only invest where they are highly certain that demand will persist.

The housing market—one of the main engines of economic growth—tells a similar story. Home construction never recovered from the financial crisis. Again, households' weak financial position was a big reason why, but banks also shied away from mortgage lending. Home builders shifted from mass-market houses toward custom, high-end homes with fewer buyers but fatter profit margins. Longstanding housing shortages in markets like California have only become worse. Pre-pandemic migration to big cities grabbed the headlines while the gap between demand and supply in single-family homes quietly grew.

Now that the pandemic has made people rediscover the joys of backyards and extra bedrooms, the move back to the 'burbs is in full swing—but home prices have skyrocketed. This means that millions of families will have to rent instead, and this market is cramped as well. Rents are now rising fast, and unlike home prices, rental rates feed right into the inflation data. We've barely begun to see the impact of rising rents in the inflation numbers—but they'll be making a big contribution going forward.

And how about the commodity markets? During the past decade, companies in mining and energy production learned the hard way that overinvestment could drive prices down and cause big losses. Now they're acting much like other manufacturing and service industries. They drastically cut back their investments and have no plans to expand production. In the meantime, the changeover to renewables taking place worldwide has made electricity generation and distribution a lot less dependable, leading to sudden spikes in demand for American fossil fuels. Producers don't want to disappoint customers in the lucrative export market, so these sales take priority over satisfying American demand—at least until local consumers match the foreigners' offers.

Finally, there's the weather—or the climate. One of the big questions the American economy faces is whether the severe drought affecting the West is just part of a normal weather cycle, or a taste of permanent changes to the climate that will disrupt food production for years to come. If the climate really is changing, American farmers will surely adapt—eventually. But in the meantime, food prices are also in for a wild ride.

All of these factors were starting to nudge inflation higher in early 2020, as the American economy inched closer to full capacity. This should have prompted a gradual process of supply-side adjustment, as rising prices gave more companies confidence that investing in new products and new capacity would pay off. But the pandemic prevented this investment from getting started, plunging us into the sharpest recession on record instead. To pull us out of this tailspin, fiscal and monetary policy stomped hard on the accelerator, and rightly so.

But the cost of averting a depression is that we've engineered a massive surge in demand the economy wouldn't have been able to handle even before the pandemic. The most fragile parts of the supply side—the highly choreographed and delicately interwoven supply chains we created during the past two decades—would still have been overwhelmed, and broken, without the bust-to-boom whiplash. And now it's the rest of the supply side's turn to be swamped.

The federal stimulus was so large, and so much of it was saved (over $1.5 trillion), that demand could be elevated for years. And that doesn't include the trillions of dollars of infrastructure proposals under consideration. With this much extra demand and very limited capacity to expand supply quickly, there's really no place for prices to go but up. The longer it takes supply to catch up to demand—and for the Fed to catch up with reality—the more inflation we're in for.

Connel Fullenkamp is professor of the practice of economics at Duke University.

The views expressed in this article are the writer's own.