This inflationary moment

Analysis

By Dylan Barry, GCPPP staff, July 8th, 2021

It is widely accepted that after the 2008 financial crisis in America and Europe a key policy mistake was made, namely the early withdrawal of fiscal and (to a lesser extent) monetary support and the adoption of austerity. This slowed the recovery, prolonged joblessness and exacerbated inequality.

During this pandemic crisis, evidence so far suggests that in fiscal policy at least, the lesson has been learned and expansionary stances are likely to be maintained for longer. That is one reason why forecasts for economic growth for the second half of 2021 and for 2022 are now looking so strong, especially in the United States. But the task for monetary policy looks trickier, for that rapid rebound is bringing with it a rapid rise in prices across all the advanced economies.

Is this inflation ‘temporary’, as the major central banks, led by the US Federal Reserve, are describing it? Or might the Fed and other central bankers have to intervene sooner than expected to halt an inflationary spiral, risking a repeat of the post-2008 disappointment?

The key difficulty of central banking is that such questions cannot be answered with certainty in advance, but by the time the evidence is clear, it is likely to be too late.

This ANALYSIS seeks to identify what is known about the recent surge in price inflation in the United States, taking the US as the test-case for other advanced economies, as well as exploring the pressures and considerations the Federal Reserve will face in deciding its posture. It is impossible to predict what will happen, but we can offer a guide to what to look for and to what factors promise to be most important in determining policy.

The current price situation

The United States Department of Labour reports that its headline Consumer Price Index (CPI) has risen by 5.0% in the last 12 months, before seasonal adjustment—its highest rate of increase in over a decade. This burst of inflation is attributed to three main factors.

The first is the rising price of oil. The price of a barrel of Brent Crude collapsed from US$65 in January 2020 to around US$20 in April 2020—a 70% decline. That led OPEC to make significant cuts to global oil production. The price of oil has steadily recovered since. It now sits at approximately US$75 a barrel, almost quadrupling since its lowest ebb a year ago. Out of the 5.0 percentage point increase in the CPI over the last year, energy costs (mostly oil, but also natural gas and electricity) are responsible for a full 2.0 percentage points— 40% of total headline inflation.

The second is the rising price of used cars, up 29.7% year-on-year. As people postponed major new investments during the pandemic, and with many working from home, the demand for vehicles (both new and old) cratered. That depressed vehicle prices, but also saw the supply of used vehicles plummet as fewer people parted with their old cars.

Now that consumers are flush with cash and beginning to invest in cars again, demand for used vehicles is confronting those supply shortages—resulting in skyrocketing prices. Out of the 5.0 percentage point increase in the CPI, the price of vehicles (new, used and insurance) is responsible for another 1.27 percentage points—25%.

The rest of the price pressure appears to be due to a combination of supply bottlenecks, as manufacturing gets back up to speed, and pent-up consumer demand outpacing supply. A global semiconductor shortage is limiting production and supply of everything from smart-phones, computers and new cars to smart-toothbrushes and tumble dryers.

The shipping industry is also suffering the consequences of choices made early in the pandemic to cut freight services, orders and new investments to avoid a glut. That has meant global networks were caught wrong-footed by the resurgence in consumer demand—with shipping prices now soaring as a consequence.

The Federal Reserve’s considerations

How does a monetary authority like the Federal Reserve go about interpreting the current inflationary moment?

First, by trying to judge whether the reported data is accurate and meaningful. The current headline rate of CPI inflation is somewhat misleading. This is because the most recent numbers are measured against an unnaturally depressed May 2020 baseline. That can be corrected by instead choosing February 2020 for comparison and adjusting to account for the 15-month (rather than 12-month) window. By that truer measure, year-on-year CPI inflation is closer to a slightly less scary 3.25%.

The Federal Reserve actually uses a different measure, the core Personal Consumption Expenditures (PCE) Price Index, to track inflation. The current level of PCE inflation is 3.9%, year-on-year. But adjusted like the CPI above, true PCE inflation is probably closer to 2.54%—above the Federal Reserve’s 2% long-term average inflation rate target, but not egregiously so.

Second, by seeking to judge whether the major drivers of rising prices are temporary or might be longer-lasting. In the case of oil, supply is known to be responsive to higher prices: OPEC is considering production hikes (but so far failing to agree on them) and many US shale-oil producers will have been brought back to viability by the price recovery so far. This should put a cap on future price rises.

Similarly, many of the current glitches in global supply chains will eventually be ironed out, stabilising prices. Semiconductor and shipping capacity take time to adjust, but adjust they will, as will the prices of new and used cars, houses and other previously postponed fixed-capital investments. The Economist’s dollar all-items commodity price index on June 29^th stood 70.4% up on a year ago but had fallen 3.7% in the past month.

Where the judgement will be harder concerns the impact of pent-up consumer demand. The Federal Government’s fiscal stance beyond 2021 will affect this, as, crucially, will the behaviour of wages. That stance remains undetermined, since it depends on negotiations with Congress over infrastructure spending and future welfare reforms, as well, ultimately, as on the mid-term Congressional elections in November 2022.

Some labour shortages that lie behind current upward pressure on wages could prove transient as vaccinations spread, welfare subsidies are removed and businesses and households adjust, bringing more people back into the labour force. On the other hand, changes in bargaining power and employers’ attitudes, rises in state minimum wages and other factors could in time produce more long-lasting effects.

The underlying reality is that recovery of the United States economy remains in its early days. The unemployment rate is still 5.9%—two percentage points above pre-pandemic levels. There continues to be notable friction in matching workers to jobs, although the pace of job creation in June stepped up markedly from May. The labour market and wages will both be key areas that the Fed will watch closely.

The Fed’s stance

Amid this uncertainty and criss-crossing of temporary adjustments with some longer-lasting effects, the Federal Reserve has chosen largely to sit tight, waiting and watching as recovery progresses and maintaining its current ultra-low interest-rate regime and the bond-buying that underpins it.

Nevertheless, on June 16^th, the Federal Open Market Committee (FOMC)—the decision-making body of the Fed—adopted a slightly more hawkish posture. The Fed’s so-called dot plot—which illustrates the individual interest rate forecasts of the 18 FOMC policy-makers—suggests that the median policy-maker now anticipatesthat due to a stronger economy and higher inflation interest rates may need to rise twice before the end of 2023. That remains quite a way ahead, but is sooner than previously forecast.

In a statement after the meeting, Fed Chair Jerome Powell explained that the Federal Reserve is entertaining the possibility that inflation may yet turn out to be both higher and more persistent than it had initially expected. To that end, Powell reaffirmed the Fed’s commitment to changing its monetary policy stance when the economy is closer to full employment and it feels appropriate to rein in inflation. However, Powell strongly emphasised that the updated FOMC dot plots do not represent any FOMC decision on current monetary policy, and should be viewed alongside the uncertainty about what the state of the economy will be in two years’ time.

The market response was jittery. The yield on two-year Treasury bonds almost doubled, while the yield on 30-year Treasury bonds, a better proxy for inflation expectations, slid. Any thought that US interest rates might rise, or growth slow, also has global implications. The dollar appreciated markedly, while emerging market currencies depreciated—sparking fears of inflation in the developing world due to more expensive imports as well as higher interest rates on dollar-denominated debt. That led both Brazil and Hungary to immediately raise interest rates, with others likely to follow suit.

Following that reaction, however, markets have steadied. At times like this, what markets begin to wonder is whether the Federal Reserve might know something that they don’t. But reassurance that this change of stance concerned only projections up to two years ahead serves to convince that there cannot be such knowledge. All the Fed was saying was that its forbearance could not last forever, which once digested is not all that surprising.

The role of inflationary expectations

There is also a behavioural consideration, however. In recent months, indices measuring inflationary expectations have risen sharply. In contemporary macroeconomic theory, expectations about the future play an outsized role in the aggregate behaviour of an economy. More specifically, the view is that expectations are frequently self-fulfilling. For example, when people foresee rapid economic growth, they spend and invest more—creating a burst of growth in the process. The role of expectations is even greater in the case of inflation.

This fits with a belief that both individual and institutional behaviour affect price movements. If prices are expected to be stable or to fall, people will defer purchases and moderate their wage demands. When prices are expected to rise, they may accelerate their purchases and individually or collectively demand higher wages, in the belief that this is necessary to protect against inflation. This is how inflationary and deflationary spirals work. Businesses too can act to anticipate inflation, seeking to pass rising costs onto consumers, instead of allowing a fall in their margins. Guesses about changes in aggregate demand, prices and wages can become self-fulfilling, in either direction.

A basic tenet of modern central banking has been the need to keep inflation expectations well anchored. But that is especially difficult in disruptive, highly uncertain times such as the emergence from a pandemic. These recent statements by the Federal Reserve about interest-rate rises in 2023 appear to have been an attempt to soothe those fears, but without kindling anxieties about bringing recovery to a premature end.

That the difficulty is high and the result was mixed is shown by the fact that on June 22^nd, less than a week after the FOMC meeting, Jerome Powell almost immediately had to clarify the Federal Reserve’s position in order to pacify interest rate anxieties.

The fog of post-pandemic policy

Of one thing, we can be sure: both the debate and the uncertainty will continue. This is a moment when there are unusually large variables influencing the future course of economic activity: domestic politics, affecting public spending and borrowing in factors of trillions of dollars as well as wage determination through minimum wages and welfare subsidies; public health, in the form of unknowable viral variants in a race against a remarkable but still formidably difficult global vaccination programme; international relations, affecting the course of oil and commodities but above all relations on security, technology and trade between the world’s superpowers; and, lest we forget, a breakdown in trust inside the advanced democracies over data, expertise, science and even basic issues such as who really won elections.

With that background of uncertainty, we can all feel a little sympathy for central bankers.