Update 535 — Optimal Levels of Inflation:
What to Hope For and Expect in Recovery
The May jobs report, out today, reflects an economy in transition, headed steadily toward recovery. U.S. employers added 559,000 jobs last month and the unemployment rate went down by 0.3 percent. The favorable trajectory still leaves open the length of recovery — too many countervailing signs from hiring to consumer spending cloud the macro view.
The inflation story is part of the picture. Though reflexive hysteria in some quarters muddies the view, rising consumer prices are consistent with a nascent robust recovery — here, a slight and short-term uptick is nothing to cry about.
Today’s update examines the causes of inflation and whether there is cause for concern about it, whether the inflation rate is excessive, healthy, or actually insufficient for optimal growth in a rapid recovery.
Good weekends all,
Inflation: Causes and Cures in Recovery
Inflation is measured using the Consumer Price Index (CPI). Consumer prices move for a myriad of reasons — mainly changes in supply and demand, federal fiscal and monetary policy, supply shocks, and technological innovation. Inflation speculation also has its own feedback loop that can have an exaggerated effect on consumer prices.
- Policy Causes: Changes in federal spending levels and tax rates affect demand for goods and services and, in turn, inflation. But even as the federal government has run record deficits over the last decade — which should drive up prices — inflation has remained unusually low.
- Congress: Congress determines tax and spending policy through legislation and appropriations.
- The Federal Reserve: During times of economic contraction, the Fed usually cuts the federal funds interest rate to spur borrowing and spending. In periods of economic expansion, the Fed tends to raise interest rates, targeting a certain inflation rate measured by the Personal Consumption Expenditures (PCE) Index.
- Market Causes: Inflation can be triggered by external market factors often influenced by policy decisions. For instance, labor shortages in certain sectors can drive wages up, increasing prices. Changes in the supply chain can also impact inflation, as seen by recent global shortages in computer chips. During the last decade, a glut of domestic supply in the energy sector put downward pressure on energy prices.
- Market/Mass Psychology: Public expectations about future inflation affect how businesses and consumers behave in the present. When expectations are properly “anchored” to the Fed’s inflation targets, short-term supply or demand shocks are absorbed. However, if inflation expectations are high, wage-price spirals create a self-fulfilling prophecy. When market participants believe higher inflation is around the corner, interest rates and bond yields increase to make up for the perceived erosion of future purchasing power — leading to higher costs for businesses and mortgage holders.
Source: Federal Reserve Economic Data
Expected Effect: a Transitional Bump
April’s 4.2 percent annualized increase in the CPI is not a cause for acute concern. As the economy recovers, starting with a period of rapid growth, some inflation may in fact signal an effective recovery.
The Great Recession was followed by a slow, “L-shaped” recovery, while inflation remained well below the Fed’s two percent target rate — a trend found during similarly drawn-out recoveries. But moderate levels of inflation can be a good sign. In the case of a faster, “V-shaped recovery,” higher inflation is explained by pent-up demand built up during the recession. For example, prices rose quickly for a brief time following the post-war recession of 1948-9 — the result of pent-up demand and effective governmental response.
The Federal Reserve insists that current inflation levels are temporary — a view recently reiterated by Fed Governors Quarles and Brainard. Market indicators of long-term inflation expectations, such as the breakeven rate, remain tempered. Indicators of transitory inflation include:
- Low-Price Baseline: April’s CPI 4.2% increase can partly be explained by looking at year-to-date data. April 2020 marked the low point of a significant drop in prices caused by pandemic shutdowns. Prices remained low throughout the pandemic, and as a result, the modest increases in prices occurring as a result of the recovery appear significant.
- Price Equilibrium: Consumer demand is being boosted by economic reopenings and the successful vaccination push. Individuals disproportionately saved their income during the past year, giving consumers significant pent-up resources to spend on services such as restaurants, hospitality, and travel. As expected, this growing demand has caused price increases in those sectors. Many supply shortages have arisen as manufacturers struggle to keep up with demand — a temporary factor that should resolve itself.
As the Fed and White House economists argue, high levels of demand for services like travel will not be permanent, and suppliers will increase production, which should cause prices to stabilize. A similar dynamic is occurring in the labor market: job openings are spiking, but many individuals remain unable or hesitant about rejoining the labor force. This phenomenon should likewise be temporary, as rising wages and declining concerns about the virus will draw more individuals back to work.
- Energy Prices: CPI reflects aggregated price changes and can mask significant differences among sectors. According to the April data, food prices increased by 2.4 percent over the past year, while energy prices increased by 25.1 percent — a number accounted for by abnormally low energy prices last year. From January 2020 to April 2021, energy prices rose 7.5 percent. When accounting for pre-pandemic prices, the only other consumer goods that have seen a significant price spike are used cars and trucks. Fears of widespread inflation are premature at best.
Inflation in a V-Shaped Recovery
With more price increases expected, policymakers and investors alike will determine the path of inflation:
- The Fed: The Fed normally responds to inflation by raising interest rates. By incentivizing saving and tightening the money supply, the Fed’s goal in such cases is to “cool” the economy and stabilize prices. Fed officials are confident they have the tools necessary to keep prices stable if necessary.
- Credit Markets: Investors respond to inflation by demanding higher yields from government bonds, corresponding with a drop in the price of bonds as investors expect the Fed to stop purchasing them. If bond market investors believe the Fed’s target interest rate is too low, long-term interest rates increase compared to short-term rates. But in recent days, bond yields have stabilized, indicating that investors believe the Fed will maintain its dovish stance on monetary policy and do not fear inflation as much as before.
Reversion to the mean is currently a key objective of the Federal Reserve. For years, the U.S. has unfailingly undershot the Fed’s inflation target of two percent. Prices have been much lower than what the Federal Reserve wanted. The Fed recently revised its monetary policy framework toward average inflation targeting (AIT). Under the AIT framework, the Fed will allow inflation to exceed two percent for a period of time to offset inflation under two percent. The new framework allows the Fed to maintain control over inflation while not pulling the trigger on rate hikes too soon.
Staying the Course at the Fed
A panicked decision by the Fed to raise rates may run a severe macroeconomic risk in the current context. Given the rapidity of the recovery, a “hot” economy could help shorten the recovery. Prices have been low for decades, as the economy has experienced deflationary pressures. Some inflation this year may signal that the economy is bouncing back quickly, and does not justify scaling back needed government investments in the economy.
Continuing an accommodative monetary policy is the promised, and soundest, course. Consumption of goods fell by 1.3 percent in April, while consumption of services increased by 0.6 percent. People are resuming out-of-the-house activities such as sporting events and dining. Some months of higher inflation are bound to occur. Meanwhile, expected output has been constantly revised downward since 2010 after an inadequate response to the Great Recession and the deep scars left across the economy. As the economy finds a post-pandemic equilibrium, barring the unforeseen, inflation will soon revert to the mean. The Fed is justified in staying the course amid expected — and temporary — inflation.