By Patrick Coate and Francesco Renna
Posted Date: September 8, 2021
Is Inflation Back?
In 2021, price levels rose dramatically after growing slowly or even falling early in the pandemic. Prices for energy and goods, especially goods affected by supply chain disruptions, increased substantially and were major drivers of consumer price inflation.
The pandemic had less effect on two price categories particularly important to workers compensation: wages and medical costs. Wages increased rapidly in 2021 after growing slowly at the start of the pandemic, netting out to a similar rate of wage growth following the pandemic’s onset as before it. And medical costs are up in 2021, but this is due to changes in Medicare rules, not the pandemic.
Pandemic-related price inflation is more impactful for property lines such as home and auto, because replacement costs of homes and vehicles are higher. Because the main drivers of price growth are transitory, we expect today’s high rate of price inflation to moderate in 2022, but still to exceed pre-pandemic inflation rates that stayed at or below 2% per year.
Consumer Prices: Pandemic Timing and Growth
The Consumer Price Index (CPI) showed year-over-year price growth of 5.4% in both June and July 2021, over two and a half times the annualized increase for the five years preceding the pandemic. Rapid price growth is also seen in the Personal Consumption Expenditure Price Index (PCE). The two indices differ in scope, product weighting, and consumer substitution, but they both point to two key elements of price changes during the pandemic.
Current year-over-year measures are high not only because prices rose during recent months, but also because prices fell at the onset of the pandemic. Cumulatively, price indices during the pandemic grew more than their pre-pandemic averages, but not as fast as headline year-over-year growth would suggest.
A large share of price deviation from long-run averages are due to sharp increases in a narrow set of consumer products, especially used cars and fuel.
For consumer prices, timing matters. The figure below shows the cumulative price change in the CPI and PCE since February 2020. There is also a dotted line representing average CPI growth over the prior five years. At the pandemic’s onset, prices declined. Prices began to rise again around June 2020 and continued to increase through the third quarter before slowing toward the end of the year.
Price growth picked up again in 2021. In the first half of the year, the CPI increased by 3.6% and the PCE index by 2.8%. Cumulative price growth since February 2020 caught up to the pre-pandemic trend in March 2021 and greatly surpassed it in the following months through July.
Which prices are driving the CPI? To better understand the drivers of overall consumer price inflation, we break down the contribution of CPI components to price growth.Results are similar for components of the PCE. In the figure below, we examine the four major components of the CPI: food, energy, all other goods, and all other services. Food and energy prices are known to be volatile and are often broken out from other products when examining price growth. We look at contributions to price changes during four separate time periods: pre-pandemic, the pandemic’s onset, the early part of the recovery in the second half of 2020, and the continued recovery in 2021 to date.
Before the pandemic, services were the major driver of consumer price growth. Services make up over half of the CPI by weight, and in the years leading up to the pandemic, prices rose faster for services than for other components. Goods prices did not grow at all in the five years before the pandemic. And food and energy prices made only a small contribution to price growth.
During the pandemic, goods and energy prices played a major role driving the CPI. Falling energy prices explain most of the dip in the CPI during the pandemic’s first few months; and recovering energy prices explain a lot of consumer price inflation later in 2020. In 2021, all four components contributed to price growth. Energy and goods had the fastest rates of price growth, but prices for services also contributed due to its higher component weight. Both grocery and restaurant prices also increased in 2021.
Two key sub-categories drove most consumer price increases. Gas prices rose by nearly 30% between December and July and are responsible for 80% of the year-over-year CPI price increase within energy. Prices for used cars and trucks also increased 30% in 2021, accounting for 60% of year-over-year CPI growth for goods excluding food and energy. These two categories together make up only 7% of the CPI by weight but account for over half of all price growth above trend. In addition to these direct effects, CPI price increases are well above the overall CPI trend in related categories such as car rentals, motor vehicle parts and repairs, and auto insurance.
Producer Prices: Shortages and Bottlenecks
The Producer Price Index (PPI) measures prices that producers receive for their output. There are two families of producer price indices:
The PPI for final demand includes output sold to consumers, government, and foreign countries
The PPI for intermediate demand includes only materials and components sold to other firms
The PPI for intermediate demand can illustrate how bottlenecks in the supply chain and a shortage of commodities are driving the increase in prices of finished goods to consumers. Because of these shortages and bottlenecks, goods have been a major contributor to CPI growth. New home construction and automobile manufacturing are examples of this phenomenon.
Amid a shortage of lumber, the prices for framing boards soared by 228% from April 2020 to April 2021. This increased the cost of single-family homes by about $36,000.“Skyrocketing Lumber Prices Add Nearly $36,000 to New Home Prices,” National Association of Home Builders, April 28, 2021. This increase in the price of new homes caused the value of existing homes to appreciate by $13,000 and the monthly rent of new apartments to increase by $119. Together, these two categories account for one-third of the CPI basket. While the recent boost in the production of lumber dramatically reduced the price of framing boards, the construction sector is facing new challenges from shortages in windows and doors, copper wiring, and vinyl siding.“Record Number of Builders Report Material Shortages,” National Association of Home Builders, June 2, 2021
Many producers of durable goods are also affected by shortages and bottlenecks in the supply chain. Global shortages of plastics and semiconductors are disrupting production of vehicles, appliances, smartphones, food packaging, and exercise equipment. These issues are particularly severe for automobiles, leading some manufacturers to halt production due to lack of materials and components.“Semiconductor Shortage Hammering Automakers, Costing Billions in Lost Production and Sales,” The Washington Post, July 28, 2021.As the inventory of new cars dwindled, consumers turned to the used car market. So far in 2021, the CPI for used cars and trucks has increased by 30%.
The Price of Labor: What Has Been Happening to Wages?
The price of labor – wages – is particularly important to workers compensation. Overall wage levels affect premiums, and individual wage changes affect indemnity benefit payments. In this discussion of wage inflation, we focus on changes to worker wages and salaries, which is separate from the mix effect of average weekly wage growth during the pandemic.Average weekly earnings rose sharply at the beginning of the pandemic, mostly because job losses were concentrated among low wage workers. “Average Wages During the Coronavirus Pandemic,” Quarterly Economics Briefing, NCCI, October 30, 2020.
The figure below shows quarterly changes in the wage and salary component of the Employment Cost Index (ECI), a measure that holds industry and occupation mix of workers constant. As with CPI and PPI, wage growth slowed at the pandemic’s onset and began recovering soon thereafter. However, swings in wages were smaller than for consumer prices and producer prices. Unlike the CPI, overall wages never declined at the start of the pandemic; they only grew more slowly. Wage growth in 2021 is only a little higher than the pre-pandemic trend, in contrast to very rapid consumer price growth.
In the five quarters since the pandemic’s onset, the annualized increase in the ECI is 3.2%, matching its pre-pandemic trend. In contrast, consumer price growth exceeded its pre-pandemic trend.
There is no strong evidence of upward pressure on wages generally. Recent wage growth is concentrated among low-wage positions and new hires in service sectors, especially Leisure & Hospitality. Many of these wage gains were a one-time boost in the form of a signing bonus, which suggests employers are trying to attract workers without committing to a permanently higher wage.“Is there a Labor Shortage?”, Quarterly Economics Briefing, NCCI, August 11, 2021.As with consumer prices, wage growth is likely to resume a normal trajectory in 2022 and beyond.
Medical Inflation and Workers Compensation
Inflation matters for workers compensation when it affects wages and medical care costs. Although wage growth has fluctuated during the pandemic, overall growth has matched the pre-pandemic trend. However, the PPI for health care services has increased by 4.3% at an annualized rate since December 2020 and 2.7% from February–December 2020. These numbers compare to 2.2% in the 12 months before the pandemic, raising some concerns about the impact of medical inflation on workers compensation.We use PPI rather than CPI for medical price changes because PPI measures the full cost of services, not only what is paid by consumers out of pocket. This difference is important for medical care, where consumers and insurers share the cost of the services.
The substantial increase in the PPI for health care services was not due to pandemic-related inflationary pressures, but rather changes to reimbursement rules and rates for medical services set by the CMS, which took effect at the beginning of 2021:These changes are discussed in more detail in “2021 Medicare Fee Schedules and Workers Compensation,” NCCI, March 2021.
A substantial increase in payment rates for evaluation and management services
Removal of approximately 300 musculoskeletal-related services from the inpatient-only list
The increased rates for evaluation and management led to a 3.3% increase in the cost of physician care between December 2020 and July 2021. The PPI for hospital outpatient care rose by 4.5% in the same period. Because the two categories have similar weights, increases in the price of physician care and hospital outpatient care account for about 30% and 45% of the total increase in the PPI for health care services in 2021, respectively.
Although not directly linked to the pandemic, these changes are still relevant for workers compensation for two reasons. First, many states have fee schedules related to Medicare reimbursement rates. Thus any increase in the rates for Medicare evaluation and management will affect the size of workers compensation medical claims. Second, medical expenditure on hospital outpatient care (and ambulatory surgical centers in particular) has been growing faster than other categories in recent years.“The Impact of Fee Schedule Updates on Hospital Outpatient Payments,” NCCI, August 2020. The removal of some musculoskeletal-related services from the inpatient-only list will accelerate this trend. To the extent that outpatient care remains less expensive than inpatient care, this move can still reduce medical expenditures.
It is difficult to say how these changes will affect medical prices and worker compensation beyond 2021. The changes in the physician fee schedules for 2021 were tied to the Consolidated Appropriations Act. Further, due to some concerns about the safety of Medicare beneficiaries, on July 19, 2021, the CMS announced the reinstatement of musculoskeletal-related services to the inpatient-only list in 2022. This created some confusion about when to implement the new recommendation and what effect it may have on prices for the remainder of the year.“CMS to Reinstate Inpatient-Only List”, ICD10 Monitor, July 19, 2021.However, it is clear that the impact of medical costs on workers compensation claims for 2021 is the result of rule changes rather than general inflationary effects.
What Does Inflation Mean for Insurance Lines Beyond Workers Compensation?
Other lines of property and casualty insurance will be affected by inflation to the extent that their business involves prices that rose substantially during the pandemic. Large pandemic-related increases in the costs of building materials and motor vehicle parts and accessories led to increases in home and car prices. These increases result in higher replacement costs for homeowners insurance and auto insurance, which can lead to higher claim costs and premiums.“Inflation Starts to Hit Auto and Home Insurers,” The Wall Street Journal, May 24, 2021. The CPI for motor vehicle insurance increased 7% in the first half of 2021, reversing 2020 premium declines or refunds that were caused largely by decreases in miles driven. According to the PPI, premiums for homeowners insurance have increased steadily throughout the pandemic as housing prices have increased. The higher cost of construction material will affect the severity of property loss claims, although some carriers anticipate this effect will fade away in 2022.“Inflation impacts: short-term claims spike in US property insurance, longer-running headwinds for casualty,” Swiss Re, July 15, 2021.
The effect of the pandemic on other prices, including wages, medical care, and most services, has not been as large as on goods such as cars and building materials. Thus, the inflationary effects of the pandemic on claims even in long-tailed lines of property insurance is likely to be comparatively small, as long as there is not more widespread inflationary pressure in the near future.
What’s Next? Transitory or Permanent Price Changes
Recent price increases are mainly driven by two forces: 1) a quick rebound in demand after a year of suppressed discretionary consumption, and 2) a series of shortages created by the pandemic. As supply chains catch up with demand over time, pressure on prices will ease. But how long that process takes will depend on the nature of supply bottlenecks and how quickly demand returns to something like a pre-pandemic state.
Some supply shortages are not expected to resolve quickly. The current shortage of semiconductors may last beyond 2022.Transcript: The Path Forward: Digital Innovation with Intel CEO Pat Gelsinger, The Washington Post, August 4, 2021.This will directly affect the production of new cars and indirectly affect the market for used vehicles and rental cars. Industry analysts do not expect prices for new cars to decline before 2022.“The Car Market Is Insane. It Might Stay That Way for a While,” Slate, July 14, 2021.The Institute for Supply Management (ISM) Price Index, the share of manufacturing firms facing price commodity increases, peaked at 92% this June. Following some improvement in the commodity market, the Index dropped to 86% in July, its lowest level since last March.Generally, an ISM Price Index above 52.7 is considered to predict increases in the PPI for Intermediate Materials.In the lumber futures market, July prices were down 70% compared to May.“Lumber Prices Are Way Down—but Don’t Expect New Houses to Cost Less,” The Wall Street Journal, July 14, 2021.
Meanwhile, consumers are slowly moving back toward pre-pandemic spending patterns in two ways. First, they are spending more of their disposable income. The personal saving rate during the pandemic has averaged around double the pre-pandemic rate. But the June personal saving rate of 8.8% was the lowest it has been since the beginning of the pandemic, only half a percentage point higher than the 8.3% rate in February 2020.
Second, the distribution of consumer spending across categories is becoming more similar to the pre-pandemic distribution. Spending dropped precipitously for all personal consumption at the pandemic’s onset. It remained well below trend throughout 2020 for services, but not for goods. At the height of the pandemic, many discretionary services and high-proximity services were shut down or unappealing. So consumers instead bought goods, especially durable household goods such as furniture, appliances, and electronic equipment.
In March 2021, all categories of personal consumption expenditures spiked due in large part to government stimulus checks. But spending on services continued to increase every month since, while purchases of durable goods peaked in March and April. Although real service spending is still lower than before the pandemic and goods spending is still higher, despite goods becoming relatively more expensive, the past few months have shown significant movement toward the pre-pandemic equilibrium.
Supply bottlenecks and pent-up consumer demand remain important factors to prices now, but they are both easing with time. This suggests that price increases will remain above trend throughout 2021 but later move toward their long-run equilibrium. The pace of returning demand for discretionary services will also matter a lot in the coming months. Service prices drove most of pre-pandemic price growth and rising service prices could be a countervailing force to the easing of other inflationary pressures.
What Are Inflationary Expectations?
Most other observers also believe that the rapid price growth in 2021 is going to slow down soon but will remain somewhat above the pre-pandemic trend in the next few years. These estimates, however, come with a higher degree of uncertainty than usual about the size and timing of these changes. The New York Fed’s Survey of Consumer Expectations for July reported that inflation uncertainty among respondents is nearly twice as high now as it was before the pandemic.July 2021 Survey of Consumer Expectations, Federal Reserve Bank of New York, August 9, 2021.
The Survey of Professional ForecastersThird Quarter 2021 Survey of Professional Forecasters, Federal Reserve Bank of Philadelphia, Aug 13, 2021.produced a median estimate of 5.2% annualized CPI growth for the third quarter of 2021—partly reflecting price jumps we have already observed for July—but only 2.6% for the fourth quarter. Median projected annual CPI growth for 2022 and 2023 is 2.4% and 2.3%, respectively. This would be about half a point above average inflation in the five years before the pandemic, but much less than CPI growth in the first half of 2021 alone.
Financial markets also seem to believe that recent price increases are temporary. The 5-Year Breakeven Inflation Rate is a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities. This rate is currently about 2.5%.5-Year Breakeven Inflation Rate retrieved from FRED, Federal Reserve Bank of St. Louis, September 8, 2021.
Other estimates expect prices to fall later and somewhat less. A Kiplinger forecast tells a similar story that easing bottlenecks will help bring down inflation, but the report projects that year-over-year inflation will remain above 5% through 2021 and decline to 3% in 2022.“Price Pressures Will Stay a While,” Kiplinger, August 11, 2021. A Bloomberg survey of economists reported about half a point increase in inflation expectations in the month between the July and August surveys. The surveyed forecasters still expect a sharp decline in inflation from 2021 to 2022, but a higher baseline in each of the next four quarters.“U.S. Inflation Forecasts Keep Rising as Supply Constraints Loom,” Bloomberg, August 13, 2021.
Most forecasts and expectations tell a generally similar story: Price growth will not reverse in 2021, but inflation will move toward its pre-pandemic trend in 2022. However, continuing pressure from supply chain shortages and increased consumer demand, including recovering demand for services, drive the current uncertainty about how much and how quickly this movement will occur.