Is Inflation About to Get Much Worse? The Structural Case

The Inflation Problem Is Bigger Than an Energy Shock

Brent crude above $125 a barrel. US consumer sentiment at a 74-year low — worse than during the 1973 oil embargo, 9/11, or the global financial crisis. The closure of the Strait of Hormuz, through which roughly 20 million barrels of oil move daily, has delivered a visceral economic shock. But if you're waiting for the geopolitical dust to settle before declaring the inflation threat over, you may be waiting a very long time.

The energy shock is real, but it's acting as an accelerant on a fire that was already burning. Several credible economists — including Adam Posen, president of the Peterson Institute for International Economics, and Peter Orszag, CEO of Lazard — were warning before any missiles flew that US inflation could hit 4% by year-end. That's double the Federal Reserve's official target, and their case rested entirely on structural domestic pressures with no reference to Middle East conflict. The war simply made an uncomfortable argument impossible to ignore.

Understanding why inflation may prove stubbornly persistent — and potentially worse — requires looking past the daily price ticker and into the architecture of the global economy itself.

The 30-Year Demographic Tailwind That's Now Gone

For roughly three decades beginning around 1990, central bankers in the US and Europe presided over an era of remarkably stable prices. Inflation stayed low. Interest rates stayed manageable. Economists wrote papers about the "Great Moderation." Central bankers accepted a great deal of credit.

According to economists Manoj Pradhan and Charles Goodhart, that credit was largely misplaced. Their core argument: from approximately 1990 onward, the global economy benefited from a once-in-history demographic gift. Three massive forces converged simultaneously:

• The baby boomer generation entered peak working years, dramatically expanding the domestic labor supply
• Female labor force participation surged, adding tens of millions of additional workers to Western economies
• China and Eastern Europe joined the global trading system, effectively doubling the available global labor pool almost overnight

This structural surplus of labor kept wages suppressed and consumer goods cheap. Central banks didn't conquer inflation — they simply happened to be steering during the calmest stretch of ocean in modern economic history.

Now that demographic tailwind is reversing. China's population is aging faster than nearly any major economy. Its workers are shifting from export-driven manufacturing into domestic services. Meanwhile, tariffs and trade barriers are actively blocking whatever cheap goods China does still produce from reaching Western consumers at the old prices. The structural force that quietly underwrote three decades of price stability hasn't just faded. It's being dismantled simultaneously by demographics, geopolitics, and deliberate trade policy.

Why the Phillips Curve Wasn't Dead — It Was Just Hiding

During the 2010s, a strange thing appeared to happen in macroeconomics. Unemployment in the US and UK fell to multi-decade lows, yet inflation barely moved. The traditional relationship between labor scarcity and rising prices — the Phillips Curve, first observed by economist A.W. Phillips in 1958 — seemed to have broken down. Economists published papers declaring it dead. Central banks pointed to this as evidence of their superior management.

Pradhan and Goodhart offer a more precise explanation: the Phillips Curve wasn't dead. China had put it in a coma.

The key insight is that inflation is not one monolithic number. It's composed of at least two distinct dynamics running in parallel:

1. Domestic services inflation — your plumber, physiotherapist, solicitor, restaurant server. These workers must physically be present. Their wages are governed entirely by local labor market conditions. This relationship never broke down. Services inflation was ticking along at a steady clip the entire time.

2. Goods inflation — televisions, clothing, electronics, household items. For 30 years, these prices were effectively set in Chinese factories. The deflationary force from offshored manufacturing was so powerful that it dragged the headline consumer price index downward, masking the underlying services inflation that was quietly compounding.

In practice, Western central banks were outsourcing their inflation mandates to Shenzhen and Guangdong. Now that outsourcing arrangement is ending, both dynamics will push in the same direction — upward.

Baumol's Cost Disease and the Fiscal Trap Governments Can't Escape

Even if every geopolitical tension resolved tomorrow, governments would still face a structural fiscal problem that makes sustained lower inflation extraordinarily difficult. The mechanism was identified by economist William Baumol in the 1960s through a deceptively simple observation.

A string quartet playing Beethoven requires exactly four musicians today. It required four musicians in 1900. Their productivity — output per hour — has not improved by a single note. Yet we pay them dramatically more. Why? Because the rest of the economy got more productive, raising wages broadly, and musicians have to be paid enough to not abandon the violin for a better-paid career.

This concept — Baumol's Cost Disease — explains why ticket prices for live performance feel absurd. More critically, it explains the structural nightmare in government budgets, because the two biggest items in almost every developed nation's public spending are healthcare and education: both highly labor-intensive, both delivered in person, both structurally resistant to productivity gains.

Consider the numbers:

• A factory worker today can produce roughly 10 times the output per hour compared to 50 years ago, thanks to automation and technology
• A nurse can still care for approximately the same number of patients per shift as a nurse in 1975
• An aging population doesn't need more primary schools — it needs exponentially more medical care, from neurological services to long-term residential support

Japan, which confronted demographic aging first, has invested billions in healthcare robotics. The result: only 2% of its caregivers regularly use them. Human care requires humans, and those humans will command rising wages as the broader economy grows more productive around them.

This creates a fiscal trajectory that is largely independent of which political party holds office. In the US, the nonpartisan Committee for a Responsible Federal Budget estimates that recently passed legislation will add approximately $4 trillion to the national debt over the next decade. Social Security's trust fund is projected to be depleted by 2033, at which point benefits would face automatic cuts of around 24% — a politically inconceivable outcome for the most reliable voting bloc in American politics. The bail-out, when it comes, will be expensive.

The US deficit is currently running at over 7% of GDP — a figure typically associated with wartime or deep recession, not full employment.

Why Tighter Monetary Policy Isn't Working the Way It Should

The Federal Reserve has raised rates aggressively by historical standards. Yet the economy, by most measures, hasn't really noticed. Understanding why matters enormously for anyone tracking inflation's trajectory.

Posen identifies several reasons financial conditions remain loose despite headline rate increases:

• Credit spreads are tight, meaning corporate borrowers face relatively little premium for risk
• Household wealth is at record levels, driven partly by equity markets that continue pricing near all-time highs
• Private credit markets now supply close to $2 trillion in alternative financing that sits entirely outside traditional banking channels — and therefore largely outside the Fed's direct influence

The transmission mechanism that central banks rely on — raise rates, tighten credit, cool demand — is partially short-circuiting. High-net-worth households and large corporations with access to private markets are insulated from rate hikes in ways that weren't true in previous tightening cycles.

Meanwhile, inflation expectations are showing early signs of drift. When consumers experience repeated price increases on highly visible, frequent purchases — eggs, fuel, home repairs — they begin pricing in future increases. They demand wage rises pre-emptively. Businesses raise prices ahead of anticipated cost increases. The dynamic becomes self-reinforcing. This is precisely the mechanism Paul Volcker warned about in 1979, and it's the reason the Fed's credibility on its 2% target matters so much. We are entering an energy shock having never truly returned to that target after the pandemic surge — not an ideal starting point.

The Short-Term Debt Trap and What It Means for Borrowing Costs

One response to ballooning deficits is to manage the debt's maturity structure — specifically, to borrow more at the short end of the yield curve, issuing Treasury bills rather than long-dated bonds. Short-term rates are currently lower, so the immediate interest bill is smaller. If rates fall significantly in the future, you also avoid having locked in today's long yields.

US Treasury Secretary Scott Bessent has adopted this approach. The irony, extensively noted by financial observers, is that Bessent was among the most vocal critics of his predecessor Janet Yellen for doing essentially the same thing. His critique then was substantive and serious: the US Treasury market commands uniquely low borrowing costs because it is the deepest, most liquid, and most reliable asset market on Earth. Investors accept lower yields in exchange for that stability and predictability. When you begin engineering the maturity structure for short-term political convenience, you gradually erode the premium that makes US debt special — and that erosion tends to surface eventually as higher long-run borrowing costs.

It was a compelling argument in opposition. It remains a compelling argument now.

The practical risk of heavy short-term borrowing is straightforward: you have to keep rolling the debt over at whatever rate the market is charging. If rates don't fall as anticipated, the refinancing cost can rise sharply — compounding the deficit rather than containing it.

What This Means for Investors and Consumers

None of this is inevitable catastrophe. But the prudent approach is to take the structural case seriously rather than waiting for definitive confirmation in the data — by which point the adjustment is already well underway. A few clear-eyed takeaways:

• Services inflation is structural, not transitory. Haircuts, legal fees, medical appointments, home repairs — expect persistent price pressure in anything requiring local labor.
• The goods deflation subsidy is fading. The three-decade era of falling prices for electronics, clothing, and household items is structurally constrained by demographics and trade policy.
• Fiscal deficits running at 7% of GDP during full employment are unusual and worth monitoring. Historically, large peacetime deficits during low-unemployment periods have been inflationary.
• Inflation expectations matter as much as inflation itself. Watch consumer surveys and breakeven inflation rates embedded in bond markets — both are early indicators of whether the self-reinforcing dynamic is taking hold.
• Private wealth and asset prices are partially insulating higher earners from tighter monetary policy, which has distributional consequences and may limit the Fed's effectiveness.

The structural tailwinds that made the last 30 years of monetary policy look deceptively simple are gone. Demographics, geopolitics, and trade policy have collectively reversed them. The string quartet is playing on — it's just becoming dramatically more expensive to keep it in the room.

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This article is for informational purposes only and does not constitute financial advice. Always consult a qualified financial professional before making investment decisions.

Frequently Asked Questions

Q: What is the main structural reason inflation could stay elevated long-term? The primary structural driver is the reversal of a 30-year demographic tailwind. From roughly 1990 onward, the simultaneous entry of baby boomers, women, China, and Eastern Europe into the global labor market kept wages and goods prices suppressed. That labor surplus is now shrinking due to aging populations globally, China's own demographic slowdown, and trade barriers that limit cheap goods from reaching Western consumers. Without that deflationary anchor, both goods and services prices face upward pressure simultaneously.

Q: What is Baumol's Cost Disease and why does it matter for government spending? Baumol's Cost Disease, identified by economist William Baumol in the 1960s, describes the phenomenon where labor-intensive service sectors must pay rising wages even without productivity improvements, simply because workers have the option of moving to more productive parts of the economy. Healthcare and education — the largest components of government spending — are classic examples. As populations age and demand for medical care rises exponentially, governments face structurally expanding costs that are largely independent of political choices, making fiscal consolidation extremely difficult.

Q: Why hasn't the Federal Reserve's rate tightening brought inflation back to 2%? Several factors are blunting the traditional transmission mechanism. Household wealth is at record levels, partly due to elevated equity prices. Credit spreads remain tight. Most significantly, private credit markets now supply approximately $2 trillion in alternative financing that operates outside the traditional banking system and is therefore less sensitive to Fed rate decisions. High-net-worth borrowers and large corporations with access to private markets are partially insulated from rate hikes in ways that weren't true in previous tightening cycles.

Q: What is the Phillips Curve and why did economists think it was broken? The Phillips Curve, first described by economist A.W. Phillips in 1958, captures the relationship between labor market tightness and inflation: when unemployment falls and workers become scarce, wages rise and prices follow. During the 2010s, unemployment reached multi-decade lows in several countries with minimal inflation response, leading many economists to conclude the relationship had broken down. Pradhan and Goodhart argue it wasn't broken — cheap goods from China were so powerfully deflationary that they masked the domestic services inflation that was actually ticking along normally throughout the period. As that Chinese deflationary force fades, the Phillips Curve is reasserting itself.

Q: What is the risk of the US Treasury borrowing heavily at short maturities? Borrowing heavily at short maturities reduces the immediate interest bill when short-term rates are lower than long-term rates. The risk is rollover exposure: short-term debt must be refinanced continuously at whatever rate the market is charging. If rates remain elevated or rise further, the government finds itself repeatedly refinancing at high cost rather than having locked in lower long-term yields. Additionally, actively managing the maturity structure for short-term convenience can gradually erode investor confidence in the Treasury market's reliability — which is the very quality that allows the US government to borrow more cheaply than almost any other entity on Earth.