Inflation Risks and Their Lessons

Inflation may be transitory, but it can teach us a lot about U.S. economic policy.

Dear Capitolisters,

As you’ve probably noticed, things are getting more expensive out there. (I, for example, thought I might need to take out a loan to pay for my last trip to Costco.) What was once supposed to be a short spike in consumer prices—tied to economic reopening and pandemic-related shortages—has persisted for much longer than most policymakers expected and thus turned into a major economic and political story. It’s also sparked an increasingly heated debate among economists about what caused the current bout of inflation and whether it’s the new U.S. normal or just “transitory.” I, for one, tend to think it’s more likely the latter, but this honestly misses the point—about the risks now out there and the broader lessons that the current moment can teach us about U.S. economic policy.

Rhetoric Meets Reality

Regardless of whether you think inflation is temporary or longer-lasting, there’s little doubt that U.S. policymakers have repeatedly been too sanguine about how hot prices would get, how broad these price pressures would be, and how long they would stay that way. The Federal Reserve, for example, projected in March that its preferred measure of inflation, the personal consumption expenditures (PCE) index, would hit 2.4 percent for full-year 2021. And that same spring, various Fed officials and other economists told us that “transitory” price pressures would abate by the summer as supply adjusted and workers returned. Shortly thereafter, however, the Fed upped its 2021 PCE forecast to 3.4 percent, while Chairman Jerome Powell even in August maintained his view that recent spikes—in things like used cars—were isolated and abating, and thus that broader inflationary pressures were contained.

In late September, however, the Fed again raised its 2021 PCE forecast, this time to 4.2 percent—indicating, once again, more significant and persistent price pressures than earlier forecasts. They haven’t yet updated the September figures, but professional forecasters surveyed by the Philly Fed on Monday now see the 2021 PCE index coming in at 4.9 percent—another large upward revision.

Given the new data from a separate inflation gauge, the consumer price index (CPI), it’s easy to see why. Although year-over-year data (blue lines below) showing “record” CPI prints suffer from “base effects” because inflation was basically negative when the pandemic first hit, the monthly data (red lines) justify renewed concern. For example, in the four years preceding the pandemic, monthly CPI gains averaged about 0.2 percent. Since April of this year, however, the average has more than tripled at a little over 0.6 percent per month, and the late-summer CPI swoon that had “Team Transitory” taking a victory lap has disappeared.

As helpfully calculated by CFRB’s Marc Goldwein, we're now looking at full-year 2021 CPI growth to clock in at more than 6 percent—again well above where basically anyone on Team Transitory thought we’d be in March or April of this year:

Furthermore, price increases aren’t isolated like Powell and others predicted this summer. As explained in a recent Reuters piece, for example, alternate CPI measures from the Cleveland Fed that are intended to account for volatile items (gas, food, etc.) or isolated factors (hotels, rental cars, etc.) are also showing significant and persistent upticks and even a little acceleration this fFall:

Median CPI—an alternative measure that many economists like because it trims the highest and lowest figures—now annualizes at 5.1 percent for 2021 because price increases have broadened out:

Of particular concern going forward is housing, as these prices account for a large portion of the overall CPI print and are—as was expected—finally catching up to the on-the-ground rent and home price realities we’ve been seeing in many U.S. housing markets. Another concern is that higher labor costs and historically frothy producer prices (driven in part by higher import prices) will get passed on to consumers in the coming months:

Today, the expectation—even among many inflation doves—is that this “transitory” inflation will be with us until at least early next year and could actually accelerate in the next few months: “It won’t be until the first quarter, when demand for consumer goods is much lower, that supply constraints might ease. If inflation looked hot in October, just imagine what November and December might bring." Other experts, however, see potential supply-side constraints lasting through the end of2022

Given these concerns, the tone in Washington has abruptly changed, as Reuters notes: “For both the Fed and the Biden administration, what was an adamant faith in transitory inflation has been tempered”—to say the least.

So What Happened?

I dare not get too far into the weeds as to why the confident “transitory” predictions seem to have fallen so flat, but a few things are worth noting:

First, per Harvard’s Jason Furman (repeatedly, in this Twitter thread), the U.S. experience right now really is, contra Paul Krugman and others, unique:

Furman also notes in that series of charts/tweets and in a separate series teaching some broader macroeconomic points that the common argument from Team Transitory that all of this is just supply-side stuff—pandemic-related shortages of workers/output or supply chain problems at ports and elsewhere—just doesn’t hold water. For example, all of the countries above are dealing with similar pandemic and supply-side issues, yet the U.S. experience still stands out (a lot). (Feel free to click through the links to learn more—the last one is particularly useful.) 

Furman—who was most definitely not an inflation hawk earlier this year and generally supports Biden’s agenda—therefore argues in a new Wall Street Journal op-ed that, while there are some supply-side constraints, most of the blame for the current inflationary situation in the United State should fall to the demand-side, i.e., the U.S. fiscal and monetary response to the pandemic:

Inflation in the U.S. was similar to what the euro area experienced going into the pandemic, but prices have risen a cumulative 4% more in the U.S. over the past two years. The oversize and poorly designed $2.7 trillion fiscal stimulus passed in December and March is at least partly to blame for the divergence. The Federal Reserve has continued de facto to loosen, with the Goldman Sachs Financial Conditions Index showing that the combination of lower long-term rates, higher stock prices and other financial changes has been the equivalent of more than a percentage point cut in the federal-funds rate since November 2020.

In other words, we spent a ton of deficit-financed money, and the “real” (inflation-adjusted) federal funds rate (the rate the Fed sets for overnight bank lending) actually fell—right in the middle of an already-strengthening economic recovery. Ther result: “uncomfortably high” inflation that’s likely to persist into next year.

Others share Furman’s diagnosis and conclusions. For example, AEI’s Jim Pethokoukis recently pointed out this handy chart and quote from hedge fund Bridgewater: “Today, demand is surging, and supply is also growing, but it just can’t keep up with demand. There are not enough raw materials, energy, productive capacity, inventories, housing, or workers.” 

Such analyses seem to vindicate the relatively few Beltway voices in early 2021 who were urging caution on—if not outright opposition to—the American Recovery Plan. As you’ll recall from my cautionary contribution in February, there were plenty of signs at that time that (1) with vaccines proliferating and restrictions easing, the U.S. economy was on its way to recovering; (2) that the pandemic recession bore little resemblance to the deeper, more systemic Great Recession (and thus called for a different policy response); and (3) the ARP’s fiscal stimulus far exceeded the “output gap” between current and pre-pandemic-trend production and, when combined with previous trillions in pandemic spending and super-easy Fed policy, could produce inflationary pressures. As I noted then, “[e]ven some left-leaning economists,” such as Treasury Secretary Larry Summers and former IMF chief economist Olivier Blanchard, “warn that even more front-loaded stimulus, plus the aforementioned economic conditions (consumer spending, etc.), could spark a serious bout of inflation, thus triggering a harsh response from the Federal Reserve (higher interest rates, monetary ‘tightening’), and possibly causing another painful recession.”

In the last week, both Blanchard and Summers have taken their victory laps. And others are joining in.

Why It Matters

Maybe they’re all wrong and inflation will subside relatively soon, thus vindicating Team Transitory” (at least using a very liberal interpretation of that adjective), but plenty of risks remain.

This post is for Dispatch Members only