Normative Narratives


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Inflation: Keep Calm and Let the Fed Carry On

Anticipating concern over recent inflation numbers, the White House Council of Economic Advisors (CEA) put out a useful historic primer on recent periods of higher inflation:

“Supply chain disruptions are having a substantial impact on current economic conditions. Economy-wide and retail-sector inventory-to-sales ratios have hit record lows; homebuilders are reporting shortages of key materials; and automakers do not have enough semiconductors. Elevated consumer demand is adding fuel to the fire. Travel demand, for example, has returned much more sharply than expected, which is straining airline operations. Similarly, total vehicle sales in April more than doubled from a year prior, which is leading to empty dealer lots. The combination of a spike in consumer demand and a supply chain that is not fully operational has contributed to rising prices.

If actual inflation is affected by inflation expectations—and if expectations are in part formed by recent experiences (what economists call “adaptive” expectations)—then one risk is that transitory supply constraints and pent-up demand could have more persistent effects by raising longer-run expectations of inflation. On the other hand, businesses and consumers may “see through” supply disruptions and not change their longer-run expectations significantly.

In this blog post, we examine previous periods of heightened inflation and see what they can teach us about inflation in 2021…No single historical episode is a perfect template for current events. But when looking for historical parallels, it is useful to concentrate on inflationary episodes that contained supply chain disruptions and a spike in consumer demand after a period of temporary suppression. The inflationary period after World War II is likely a better comparison for the current economic situation than the 1970s and suggests that inflation could quickly decline once supply chains are fully online and pent-up demand levels off. The CEA will continue to carefully gauge the trajectory of inflation.”

How people expect prices to behave can actually affect price levels. If people think prices will continue to rise, and increase their purchases beyond what they normally would to hedge against expected future increases, that itself can lead to greater inflation. If you (as I) believe the forces of supply and demand will eventually even out any market mismatches, then expectations are arguably the “most variable” of the variables affecting inflation right now (at least in an advanced economy like America’s.)

One important difference today compared to earlier periods examined by the CEA is the hyper-partisan nature of all policy debates, and how that plays out in the news and ultimately affects peoples’ beliefs. When people are subjected to continuous fear-mongering about inflation it is likely to impact their expectations, leading to greater inflation than the underlying economics alone would have yielded. In our world of social-media fueled “echo chambers” and the confirmation bias it enables, psychological forces could play an outsized role in the levels of inflation we ultimately realize.

For what its worth–hopefully a lot–most economists believe current high inflation figures are partially due to the “base effect” (lower inflation in 2020 due to pandemic related shutdowns making over-the-year increases look larger than they otherwise would be) and will be “transitory” (shorter-term, subsiding once the effects of supply chain bottle necks and pent-up demand work themselves out.)

Monetary policy is one area where we should trust the experts; it is inherently complex, and there is good reason to think ideology won’t dominate. Why? Because inflation has the ability to hit peoples’ wealth and sense of financial security in ways that taxes cannot; regardless of your political affiliation, you probably have no interest in seeing your lifetime of hard earned savings inflated away due to mismanagement. So we have Fed Chief Jerome Powell (a Trump appointee) working closely with former Fed Chief Secretary Yellen (who was appointed to her various roles by Obama and Biden.) The two have historically had very different views on appropriate monetary policy, but as dedicated public servants with “skin in the game”, they both want to get monetary policy right.

There is also little reason to think the types of spending Biden is proposing would be particularly inflationary. The administration is actually framing its proposals as inflation reducing in the middle-to-long run. They argue that by investing in our infrastructure, human capital, and the burgeoning green economy, gains in productivity will allow businesses to pay higher wages and stay profitable without needing to drastically increases prices.

The spending in Democratic proposals would also be spread out over time, meaning any inflationary aspects (should they be felt before productivity boosts are realized), mainly occur after the transitory post-COVID pressures subsided. It would not be inflation on-top of what we are currently experiencing.

The Federal Reserve has the “dual mandate” of promoting price stability and full employment. In determining appropriate monetary policy, context matters—despite a growing economy and low interest rates, America has experienced lower-that-desired inflation (below the 2% annual target) for much of the past decade. This is another reason the historically hawkish Powell is comfortable letting inflation “run hot” for a little while in order to help return the labor market to full employment. This strategy, championed by the unsung hero of the Great Recession Ben Bernanke, is known as “temporary price level targeting“.

In other words, keep calm and let the Fed (and CEA) carry on. It knows what it is doing. It proved that during the Great Recession when it ignored these same disingenuous warnings and saved our economy, while conservatives fear-mongered about inflation and obstructed an adequate fiscal response in Congress. Sound familiar?

Fools, Fanatics, and Wiser People

“The whole problem with the world is that fools and fanatics are always so certain of themselves, and wiser people so full of doubts.” — Bertrand Russel

I cannot tell you with certainty how long higher inflation will last–no one can. Uncertainty about how COVID variants will disrupt operations in countries with lower vaccination rates makes it difficult to predict exactly when global supply chains will normalize. The possibility that different components of the basket of goods that make up the topside inflation number may experience price increases at different points in time could also draw out this transitory period.

Even with those uncertainties, I can say with confidence that I think any higher-than-desired inflation will be transitory, and that the Fed has the tools to bring inflation down if need be. I can tell you there are real costs to people and our economy from unnecessarily tightening monetary policy too soon. I can also tell you that those who are saying with certainty that a sustained period of high inflation will (or already has) taken off–so called “Bidenflation”–have ulterior motives for doing so. They also have a terrible track record of predicting these sort of things; remember “Obamaflation“? Probably not, because it never actually materialized.

Most importantly, forgoing this historic opportunity to pass the biggest investment in America and its people since The New Deal in the name of sustained higher inflation that will likely never materialize, and if it does can be managed, would be the height of stupidity–the type of stupidity that would reverberate through history. Can you imagine America without The New Deal or Great Society (or the world for that matter, considering what their absence likely would have meant to the the Cold War effort?) No, you cannot–it is inconceivable. America again finds itself needing to prove democracy can work not only for its own people, but as part of a new “Cold War” against the forces of authoritarianism—the stakes for getting these things done could not be higher.

Senator Joe Manchin, the man who above anyone else needs to be convinced of this so these plans can be passed via reconciliation, recently said he is “going to talk to some economists” about the possible inflationary effects of these proposals. Look, if he wants to find economists to tell him to moderate due to inflationary concerns, he will find them. However those views would not represent the beliefs of most economists, and run counter to the lessons of recent history and the demands of the moment.

Most economists (like most subject matter experts), due to some combination of integrity and ego, actually care about being right. They agree the benefits of expansionary fiscal and monetary policy right now far outweigh the unlikely costs of runaway inflation. Recent history tells us we should not believe the people who fear-mongered about inflation during The Great Recession for the same regressive reasons they are today. Those opposed to Biden’s proposals believe if they can delay them long enough, they can kill them by flipping the balance of power in Congress back to the GOP. They are right, and that cannot be allowed to happen.

Ultimately the need to act now and adjust later comes down to how fiscal and monetary policy are passed. There is a small window to act on fiscal policy; when is the next time America will emerge from a such a crisis, with people demanding these sort of large scale investments, and with the party that is willing to pursue them controlling all the levers of federal policy-making? In the context of our grossly and increasingly uneven electoral playing field, probably not again in the foreseeable future. Monetary policy on the other hand, by virtue of being passed relatively smoothly by the independent Fed, is much more nimble and can be adjusted to meet any inflationary consequences of this spending should they ever come to pass.