The Big Inflation Debate of 2021 … as seen by Prof. Ilir Miteza
In the spring of this year, former Treasury Secretary, and prominent academic economist Larry Summers, sparked a fierce debate when he called inflation the “primary risk to the US Economy.”
In the spring of this year, former Treasury Secretary, and prominent academic economist Larry Summers, sparked a fierce debate when he called inflation the “primary risk to the US Economy”:
“Inflationary pressures are mounting from the boost in demand created by the $2 trillion-plus in savings that Americans have accumulated during the pandemic; from large-scale Federal Reserve debt purchases, along with Fed forecasts of essentially zero interest rates into 2024; from roughly $3 trillion in fiscal stimulus passed by Congress; and from soaring stock and real estate prices.” (The Washington Post · May 24, 2021)
Other prominent economists have chimed in, often disagreeing with this reading of the economy, but with inflation data trending higher for much of the summer 2021 and persisting in the fall, the profession has grown more divided in its opinions about the nature of the inflation we are seeing: is it temporary or embedded?
Apart from all the known income erosion and distortionary effects of inflation, an increase in inflation and a de-anchoring of inflation expectations could exact high costs for the economy. In particular, embedded inflation is very costly to bring down. This is especially true after a long period where the Philips curve has become flatter than ever, which entails a high sacrifice ratio of employment for a given reduction in inflation.
What can we see in the data? CPI and PCE core inflation were growing too fast for comfort in the second quarter. Though their advance has slowed somewhat, data from the last two months continue to show increases unseen since the early 1990s. Most importantly, this time, the usual measures are ambiguous in ways we have not seen before: core PCE and Trimmed-mean CPI for example are too high and trending higher.
The Fed’s own forecast for core PCE inflation in 2021, jumped from 3.0% in June to 3.7% in September. The same inflation measure forecast for 2022 is now at 2.3%. These are the highest forecasts since the Fed decided to start publishing them in 2007. Naturally, what was believed to be transitory inflationary pressures earlier in the year, may be turning into a different story.
How are economists dealing with this uncertainty? We have seen several reactions to these signs of higher inflation. Some have talked about unfounded reasons for worrying about inflation. For example, addressing Larry Summers’ concerns, some economists have countered that piled up savings cannot cause inflation, spending does; massive reserves parked at the Fed have the potential to be lent out and fuel spending, but there are policy mechanisms in place to slow or stop that flood if it started. Also, with employment to population ratio 2.6 percentage points below its pre-pandemic level and with about 5 million fewer working today than in 2019, labor markets cannot be considered tight.
Other economists, such as Paul Krugman, emphasize that our traditional measures of core inflation (e.g. PCE excluding food and energy) were intended to be only a crude approximation of a sticky price index, which is what the Fed should be focusing on. In that sense, we should use other more appropriate measures of “supercore” inflation, better suited for tracking more inert prices. According to this camp, any increases in inflation measures outside of the supercore should be ignored by the Fed as transitory. With the rising core inflation indexes in the fall, how does this approach remain relevant?
A different flank of economists is concerned that a lax institutional attitude toward inflation – particularly after the Fed’s adoption of Average Inflation Targeting – is reason to doubt the Fed’s inflation fighting credibility. Have these concerns materialized in the bond markets? On October 15, with an expected inflation of 2.7 percent, according to the 5-Year Breakeven Inflation Rate (T5YIE), we have no reason to expect runaway inflation, but the expectation is surely higher than the Fed’s 2% target.
Is what we know about the current state of the economy helpful in resolving this inflation debate? What we know about how the economy works is less useful in this type of environment, where so much has changed and is continually changing. Data on spending has been generally recovering at a fast clip, but it is the supply side that is creating the most uncertainty with inflation. Beyond the often talked about supply chain bottlenecks -- which many thought would have started to improve by now – there is a long list of supply-side risks weighing on the global economy.
Some medium- and long-horizon supply risks include rising protectionism or deglobalization, the Sino-American tensions, demographic aging in advanced economies, climate change, growing cybersecurity threats, and a pandemic that could stick around a while longer. If these risk sources continue to spawn more supply shocks, the inflationary pressures we are seeing will likely be of a more permanent nature. That may force the Fed to tighten in order to keep inflation expectations anchored and prevent a wage-price spiral similar to that of 1970s. In this very unusual economy, the adoption of Average Inflation Targeting gives the Fed some added flexibility to wait a little longer either for more data clarity, or for the supply shocks to pass. It seems likely that the Fed will weigh the risk of tightening too early and choking the recovery, against the risk of waiting too long and allowing inflation to become embedded. It may be fair to say that this will be one of their toughest policy dilemmas in a long time.
-Prof. Ilir Miteza