When inflation first started kicking up its heels last summer, there was a dispute over whether it was likely to be temporary or permanent. The argument for “temporary” went along the following lines: the underlying causes of the inflation were a mixture of factors like supply chain disruptions, the fact that people shifted to buying goods rather than services during the pandemic recession, and federal government overspending earlier in 2021. Inflation has been stuck at low levels for several decades now, and as these underlying factors fade, this temporary blip won’t alter people’s long-run expectations about future inflation. The argument for “permanent” sounded like this: the supply chain and spending pressures would fad only gradually. In the meantime, rising inflation could become embedded in the expectations of firms as they set prices and workers as they looked for wage increases. In this way, the surge in inflation could become self-sustaining.
Of course, that argument happened before Russia decided to invade Ukraine. The supply chain disruptions that we were concerned about in summer 2021 were epitomized by lines of cargo ships waiting to be unloaded in west coast ports. But the current supply chain disruptions are about the waves of sanctions being imposed on Russia, the loss of agricultural output, spikes in energy prices, and a COVID outbreak in China that threatens supply chains there. So what’s the current thinking? The stable of macroeconomists at the Peterson Institute for International Economics have been been posting a series of working papers and essays on the prospects for future inflation. The full range of views are represented, just in time for the meeting of the Federal Open Market Committee meeting happening today and tomorrow (March 15-16).
David Reifschneider and David Wilcox contributed “The case for a cautiously optimistic outlook for US inflation” (Policy Brief 22-3, March 2022). For background, here’s a graph of inflation rates since 1960 using the Personal Consumption Expenditures price index (the one on which the Federal Reserve focuses):
Reifschneider and Wilcox spell out an overall macroecoomic model, and along the way offer an interesting calculation about the connection between short-term inflation changes and what happens in the longer-term. On the horizonal axis of this graph, each point represents a 20-year period. The question is: During this 20-year period, if there was a one-time jump in inflation, did it portend a higher inflation rate for the longer-term. Back in the 1960s and 1970s, a short-term movement in inflation pretty much always translated one-to-one into a longer term move. But in the last 20 years, short-term shocks to inflation have typically faded away quickly, having little or no longer-term persistence.
As you look at this figure, an obvious question is whether 2021 looks more like the late 1960s–that is, a run-up to lasting and higher inflation–or whether it looks more like an unclassifiable pandemic blip. I should add that the authors
The statistical analysis in this Policy Brief was conducted before Russia invaded Ukraine. As a result of the war, the inflation situation will probably get worse during the next few months before it gets better, and could do so in dramatic manner if Russian energy exports are banned altogether. Nonetheless, if the key considerations identified in this Policy Brief remain in place, and if monetary policymakers respond to evolving circumstances in a sensible manner, the inflation picture should look considerably better in the next one to three years.
For a gloomier view, Olivier Blanchard responded in “Why I worry about inflation, interest rates, and unemployment” (March 14). Blanchard points out that when inflation rises, the Fed typically raises interest rates. This graph shows the inflation rate in red. The blue line shows the real policy interest rate–that is, the federal funds interest rate set by the Federal Reserve minus the rate of inflation. Because it’s a real interest rate, the spike in inflation in the 1970s and more recently push the real interest rate down into negative territory. You can see back in the late 1970s and early 1980s that as the real policy interest rate rose, inflation came down–albeit at the cost of a severe double-dip recession in 1979-80 and again in 1981.
In short, Blanchard argues that the Federal Reserve is “behind the curve” as it was in February 1975 when inflation had already hit double-digits and would do so again in the later part of that stagflationary decade.
Of course, historical comparisons always require some interpretation. Given that short-term inflationary blips have tended to fade away for a few decades now, why won’t it happen this time? Blanchard makes a case that this time is different:
The issue, however, is how much the past few decades, characterized by stable inflation and nothing like COVID-19 or war shocks, are a reliable guide to the future. There are good reasons to doubt it. What I believe is central here is salience: When movements in prices are limited, when nominal wages rarely lag substantially behind prices, people may not focus on catching up and may not take variations in inflation into account. But when inflation is suddenly much higher, both issues become salient, and workers and firms start paying attention and caring. I find the notion that workers will want to be compensated for the loss of real wages last year, and may be able to obtain such wage increases in a very tight labor market, highly plausible, and I read some of the movement in wages as reflecting such catchup.
https://www.piie.com/blogs/realtime-economic-issues-watch/will-anchored-inflation-expectations-actually-anchor-inflationJason Furman offers his take in “Will anchored inflation expectations actually anchor inflation?” (March 10, 2022). Like Blanchard, Furman focuses on the issue of whether inflation expectations are “anchored” at low levels, which would help a short-term inflation blip fade away, or whether such expectations have become unanchored.
Will the statistical relationships of the 25 years leading up to the pandemic reassert themselves in 2022? They may. But it would not be my central case: Short-run inflation expectations and wage- and price-setting behavior indicate a degree of inflation inertia that is closer to what was experienced in the 1960s–1980s than the low inflation of recent decades. Moreover, counting on inflation to fall could lead to policy errors that could actually prevent it from happening. … Over the last two years, productivity rose at an annual rate of 2.3 percent, only slightly above trend, while compensation per hour rose at 7.0 percent per year, far above the trend rate … As a result, unit labor costs are up 4.7 percent per year, a rate that is consistent with a similar rate of inflation if the labor share is unchanged. … Given that wages can be sticky and are adjusted only periodically, it is likely that much of the big price increases will show up in wages going forward. It is likely that nominal wage growth over the next year or two will be at least 5.5 percent, given the combination of catch-up for past price increases, staggered wage setting, and tight labor markets. A reasonable forecast is that annual productivity growth will be about 1.5 percent. …
Furman also suggests that it may be time for the Fed to change its inflation target from 2% to 3%.
Inflation coming under control need not be strictly defined as 2 percent inflation or 2 percent average inflation. Stabilizing inflation at 3 percent would itself be an accomplishment. If inflation does settle there, it would be very painful to bring it down much more: With a flat Phillips curve, doing so would likely require a recession. The ideal outcome could be inflation settling at 3 percent—and the target resetting in the Fed’s next framework review—a measure that could improve macroeconomic stability by giving the Fed more scope to cut nominal interest rates to combat future recessions.
How high will the Fed need to raise the federal funds interest rate, the “policy” interest rate that it targets? The current target rate for this interest rate is near-zero: specifically, in the range of 0-0.25%. Karen Dynan (who was on the staff of the Fed for 17 years) discusses “What is needed to tame US inflation?” (March 10, 2022). She argues that the Fed needs to raise its policy interest rate dramatically and to do so soon, because it’s better to risk a recession now than to risk an even bigger recession from not acting quickly enough. She writes:
To keep inflation expectations anchored (or reanchor them) and restore slack, the Fed will need to tighten policy considerably, moving from its very accommodative current stance to a neutral stance and perhaps beyond. Doing so will entail both reductions in the size of its balance sheet and significant increases in the federal funds rate. If the equilibrium real funds rate is 0.5 percent, as currently implied by Fed projections, and expected inflation is just 2 percent, the funds rate would need to reach 2.5 percent to achieve a neutral stance. Because relevant inflation expectations are probably higher and a tighter-than-neutral stance may be needed, the Fed should move toward a federal funds rate of 3 percent or higher over the coming year. Such an increase would create a material risk of a sharp slowdown in economic activity—but not tightening policy significantly now would increase the chance that inflation stays high, which would require even tighter policy later.
Joseph E. Gagnon largely concurs in “Why US inflation surged in 2021 and what the Fed should do to control it” (March 11, 2022), although he seems to think it is possible to constrain the increase in inflation–keeping it in low single-digits if not all the way back down to 2%–without cause a recession. He writes:
In response to the 2020 pandemic-induced recession, the Fed quickly adopted an ultra-loose policy stance, dropping short-term interest rates to zero and buying bonds to pull down long-term rates. In retrospect, it should have begun returning to a more neutral policy stance after the passage of the American Rescue Plan, in March 2021. But neither the Fed nor most private forecasters began to predict an overheating economy until much later in the year. As the magnitude and persistence of the rise in inflation became apparent in late 2021, the Fed appropriately signaled a tightening of policy, beginning with a tapering of its bond purchases. These purchases will have ended by March 16, when the Fed is expected to announce the first increase in its short-term policy rates. The Fed should project a steady rise in policy rates to a neutral level, just over 2 percent, by January 2023. It should also announce that it will soon start to allow some of the bonds it purchased to run off its balance sheet as they mature. These runoffs should increase over the summer and reach a peak of $100 billion per month by the fall. That would be twice as fast as the reduction in bond holdings after the Fed’s last bout of bond buying, and it would hasten a return to neutral conditions for longer-term interest rates. …
If PCE inflation settles in much above 2 percent by the end of 2023, the big question will be whether the Fed needs to slow the economy further, risking a recession, to get all the way back to 2 percent. As some economists have argued, the evidence of the past 25 years shows that an inflation rate of 2 percent is too low for many reasons, all of which lead to higher unemployment rates than necessary. It would be a mistake to cause or even risk a recession to get inflation down to a level that is too low. … The Fed should take this opportunity to raise its inflation target to 3 percent.