A year ago I warned that “there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflation pressures of a kind we have not seen in a generation.”
Where did the consensus go wrong? What are the implications for judging the current economy? And what must be done now to contain inflation?
The largest errors a year ago came from a deep faith in inertia. After 40 years of almost totally stable inflation, most observers failed to recognize that pursuing fiscal and monetary policy on a transcendent scale to increase demand, at a time when covid-19 was likely to curtail the supply of labor and goods, risked generating a huge overflow of demand. Similarly, after an extended post-financial-crisis period of sluggish growth, they failed to appreciate just how quickly the economy could shift from being demand-constrained to supply-constrained.
It is wrong to blame inflation on the slower-than-expected retreat of covid. Indeed, Jason Furman, chairman of the Council of Economic Advisers under President Barack Obama, has raised the serious possibility that inflation would have been even higher in 2021 without the delta variant’s negative effect on demand for services.
Now, the consensus view is that inflation will fall below 3 percent by the end of the year as unemployment continues to decline. Unfortunately, I fear that is likely a repeat of last year’s wishful thinking.
Some elements of the high inflation encountered, such as used car prices, are sure to turn out to have been transitory. Unfortunately, given developments in China and energy-market bottlenecks, other drivers of inflation might get worse before they get better. And housing — one-third of the CPI — has been a transient factor holding down measured inflation, as the CPI’s housing component has increased less than the overall index even as measures of homes prices and rents have risen at rates approaching 20 percent. Even if all other prices were flat and housing prices stabilized, housing alone will likely be enough to push core CPI above 2 percent in 2022.
But the key to understanding medium-term fluctuations in inflation is labor costs, which represent more than two-thirds of all costs across the economy. Everyone wants a raise, but periods when wages rise rapidly can also be periods when workers’ purchasing power falls sharply due to inflation — as the experience of this past year illustrates.
Labor costs are rising at close to 5 percent and accelerated throughout 2021, according to the best available data, which is the Employment Cost Index for private-sector workers after taking out the highly volatile incentive-pay component. This should not be surprising, given the unprecedented ratio of job openings to unemployed workers. Wage growth is likely to keep accelerating. Unless productivity skyrockets or businesses cannot pass on cost increases to customers — all contrary to recent experience or the testimony of business leaders — we now have an underlying inflation rate of 6 percent or more.
There are many who embrace super-tight labor markets on the grounds that they empower workers, and particularly disadvantaged workers. This benefit is real and significant for as long as it lasts. If a bit of extra inflation were the price of enjoying the worker benefits of red-hot labor markets, it would be a price clearly worth paying.
The rub comes in a principle enshrined in almost all economics textbooks but largely forgotten during the recent decades of price stability. Macroeconomic policies that push demand well past the economy’s capacity, such as those we have pursued over the past year, do not just lead to inflation but rather to increasing inflation — with the inflation rate accelerating for as long as the economy overheated. The painful lesson of the 1960s, 1970s and the 1982 recession is that excessive demand stimulus leads not just to inflation, but to stagflation and ultimately recession, as inflation must eventually be brought under control. Overly easy policies also lead to bubbles in financial markets that ultimately burst with catastrophic consequences for unemployment and poverty.
Just as driving 100 mph is not the fastest way to get from Point A to Point B because it raises the risk of an accident or being stopped by police, maximum economic stimulus is not the way to maximize employment, living standards or gross domestic product over time. I have been a strong proponent of ideas such as secular stagnation and hysteresis that warn of the long-run consequences of insufficient demand. There is nothing in them or any other economic theory I know to suggest that excessive support for demand is anything but counterproductive.
The good news is that, judging by Federal Reserve Board Chair Jerome H. Powell’s latest news conference, the Fed has explicitly recognized the gravity of the inflation problem and — with his vow to be humble and nimble — implicitly recognized the inappropriateness of the Fed’s current policy framework. This is all good. It should be reassuring that inflation is a primary priority. And, in a world where we have just seen the difficulty of forecasting, there is no reason for the Fed to lay out a detailed policy path going out months.
History teaches that stronger deterrent military forces credibly deployed are less likely to be called on. In the same way, strength in word and deed from the administration and Fed about the importance of keeping the economy from overheating raises the prospect of containing inflation without causing recession.
To this end, policymakers should avoid presenting the idea that supply improvements will magically bring down inflation as anything more than a highly optimistic scenario. The administration should also cease making diversionary claims that policies meant to promote competition, make public investments or combat corporate greed can meaningfully impact inflation over the next several years and instead emphasize its support for Fed inflation-control efforts and a strong dollar. The Fed should emphasize the key asymmetry in its dual mandate — there is no prospect of maximizing employment without achieving price stability.
The past 60 years of economic history record few if any instances of inflation declining substantially without significant slowdown. Policymakers can either learn from that history or repeat it.