Inflation and expectations at NRO

Essay at National Review Online. 

Inflation: The Ingredients Are in the Pot, and the Fire Is On. (But will it boil?) 

John H. Cochrane and Kevin A. Hassett

The end of the COVID-19 recession is in sight. If the Atlanta Fed’s real-time estimate of 8.3 percent Q1 growth proves accurate, real GDP is only four-tenths of a percent below the all-time high from Fall 2019. And the vaccinated, post-COVID boom is on the way. Most people have money, and are ready to spend it. Yet unprecedented fiscal and monetary “stimulus” continues.

Is persistent inflation around the corner? Inflation and commodity prices are up sharply. The latest Michigan survey shows people expect 3.7 percent inflation next year. Shortages of everything from lumber to semiconductors have raised input prices for businesses, while the percentage of small businesses reporting that they cannot find qualified workers is at a record high. The ingredients are in the pot, and the fire is on.

But will the pot boil? Since 2008, observers have warned of imminent inflation, yet inflation has barely budged.

Inflation is hard to foresee, because inflation today depends in large part on what people expect of inflation in the future. If businesses expect higher prices and wages next year, they raise prices now. If workers expect higher prices and wages next year, they demand higher wages now.

Inflation has been so low for so long that most Americans understandably see persistent inflation as ancient history, and that any blip up today will quickly be reversed.

Yet faith that our government will take prompt action to reverse inflation seems increasingly unfounded.

The Federal Reserve’s new policy framework and its officials’ speeches are eerily reminiscent of the early 1970s, and repudiate the standard lessons of that experience. One may rightly worry that should inflation emerge, the Fed could repeat mistakes of the 1970s.

The Fed has returned to the view that it can and should strive to eliminate “shortfalls” in economic activity. But in the 1970s we learned that economies can run too hot as well as too cold.

The Fed intends to deliberately let inflation run above target, in the belief that this will drive up employment, especially among disadvantaged groups. But in the 1970s we learned that there is no lasting trade-off between inflation and employment. Sustainable employment and wages result only from microeconomic efficiency, better incentives, and well-functioning markets. The record employment and fast-rising wages just before COVID-19 struck, especially among disadvantaged groups, were not the result of inflation or of monetary policy.

The Fed now believes that the “Phillips curve,” linking inflation and unemployment or output, is “flat” and “anchored,” meaning the Fed can run the economy hot for a long time with little inflation, and that a little inflation will buy a lot of employment, not the stagflation of the 1970s.

The Fed has announced that it will delay interest-rate hikes until inflation substantially and persistently exceeds its target, just as it delayed responses in the 1970s.

If they return to the beliefs of yore, central bankers are likely to react as before. Inflation will be quickly dismissed as “transitory pressures” or “supply disruptions.” The Fed will respond slowly, always concerned that really nipping inflation will cause too much economic damage. Officials will give lots of speeches, but take little action.

Unlike in the 1970s, the Fed now knows how important inflation expectations are. But the Fed seems to think expectations are an external force, unrelated to its actions. Expectations are “anchored,” Fed officials say. Anchored by what? By speeches saying expectations are anchored? The Fed has “tools” to fight inflation, it says. What tools?

There is only one tool, but will the Fed use it? Will our Fed, and the government overall, have the stomach to repeat 20 percent interest rates, 10 percent unemployment, disproportionately hitting the vulnerable, just to squelch inflation? Or will our government follow the left-wing advice of 1980, that it’s better to live with inflation than undergo the pain of eliminating it?

Moreover, stopping inflation will be harder this time, in the shadow of debt. Federal debt held by the public hovered around 25 percent of GDP throughout the 1970s. It is four times that large, 100 percent of GDP today, and growing. The CBO forecasts unrelenting deficits, and that’s before accounting for the Biden administration’s ambitious spending agenda.

If the Federal Reserve were to raise interest rates, that would explode the deficit even more. Five percent interest rates mean an additional 5 percent of GDP or $1 trillion deficit. The Fed will be under enormous pressure not to raise rates.

More starkly, any effort to combat inflation will have to involve a swift fiscal adjustment. Inflation comes when people don’t want to hold government bonds, or Fed reserves backed by government bonds, because they don’t trust the government to repay its debts. Stopping inflation now will mean a sharp reduction and reform of entitlement spending programs, a far-reaching pro-growth tax reform, and no more bailouts and stimulus checks. And all this may have to be implemented in a recession. Almost all historic inflation stabilizations required far-reaching fiscal and pro-growth reforms.

But the Fed dares not even dare say what its “tool” is, let alone promise any such painful action. Fiscal policy is busy throwing money out the door and incentives out the window. Once people ask the question, how long will they believe that inflation will provoke such a sharp retrenchment?

When demand soars and supply is constrained, inflation will rise. When people question policy and find it feckless, they expect more inflation, and inflation grows more and becomes entrenched. Persistent inflation grows suddenly, unexpectedly and intractably, just as it did in the 1970s. Some worry that a burst of inflation will lead the Fed to raise rates and thereby stymie the recovery. It is a far greater worry that the Fed will not react promptly, thereby letting inflation and inflation expectations spiral upwards.