Feb 3, 2022

Inflation: Did Team Transitory Lose?

Our inflation blog last March was a warning to Millennials who have never experienced inflation that price stability should not be taken for granted. Still, we concluded that a repeat of the inflation experience of the 1970s was unlikely because the Federal Reserve has successfully anchored inflation expectations and technology trends continue to hold prices down. We were concerned about influences of the pandemic on inflation, but I was reluctant to take issue with the consensus view that pandemic related supply shortages and surges in demand were temporary.

The typical forecast in the spring was that CPI inflation for 2021 would be about 2.5%, somewhat more than the Fed’s 2% target. The accepted wisdom through the spring and summer was that inflation was temporary; once supply chain kinks were ironed out and goods producers caught up with demand, inflation would fall back to its pre-pandemic level or just a little bit more. That interpretation even earned a nickname – team transitory. On the other side there is the view that inflation is here to stay for some time. Team persistent includes some heavy hitters – former Treasury Secretary Lawrence Summers, former IMF chief economist Olivier Blanchard – as well as the monetarist cranks who have seen inflation lurking since the monetary expansion started with the financial crisis over a decade ago.

CPI inflation for December was announced a this month. Inflation for the 12 months ending December 2021 was a whopping 7.0%. Inflation is back. But who won: team transitory or team persistent?

Jay Powell, the Fed Chair, was one of team transitory’s strongest cheer leaders. In his August Jackson Hole speech, Powell ticked off all the reasons why he was confident in the Fed’s forecast that inflation was already on its way down, that team transitory was ahead. Three points stand out. First, the pandemic inflation was concentrated in a few sectors that were affected by supply chain problems. Second, wages were quiescent. And third, expectations were firmly anchored. Less than six months later, it would be hard to argue that any of the three are still true.

Inflation has already spread into most sectors of the economy. The detailed CPI data pointed to only a few sectors with moderate inflation rates such as rent, medical care, and air fares. The Atlanta Fed’s wage growth tracker showed wages growing around 3.3% in the first half of 2021 and increasing to 4.5% by year end. Inflation expectations have not changed a great deal but there are signs that things are pulling on the anchor. The five-year breakeven inflation on TIPS was 1.65% before the pandemic and is now 2.75%. The median inflation expectation from the NY Fed’s Survey of Consumer Expectations was about 2.5% before the pandemic for both a one-year and three-year horizon; it is now 6.0% and 4.0% respectively.

Team transitory misjudged the path of inflation in 2021. It was far larger and more persistent than anticipated. The fact is inflation is back and we need to reckon with it.

The pandemic inflation was triggered by some unusual and temporary phenomenon, but team transitory did not realize that once set in motion the inflation process is off and running. By the end of 2021, inflation had spread to all sectors of the economy. Wage inflation started to increase, possibly because of pass-through effects from prices and also as a result of the unusual pandemic labor market. Although there are now 3.3 million fewer people employed than before the pandemic, the labor markets are tighter than at any time in recent history. People are quitting jobs for higher paid positions in unprecedented numbers, workers have stayed out of the labor force and firms are desperately looking for applicants. The inevitable increase in wages will feed back on to the inflation rate this year.

Team temporary fans point to earlier inflation episodes that were driven by supply constraints such as the few years after World War II when price controls were relaxed, returning soldiers were eager to spend and production was only slowly shifting to a peace time setting. Inflation quickly rose to 20% very briefly in 1947 and disappeared by the end of 1948.

The analogy is far from perfect. The current inflation episode has been spreading through the economy even as supply chain problems ease. There is an inflation dynamic rippling through the economy. It will be pushed forward by wage inflation and barely held back by the Fed. As businesses and individuals experience this, they will adjust their expectations, and the inflation anchor might break loose.

Inflation is back. We said so hesitantly in the spring; we are sure of it now. Prior to the pandemic, policy makers fretted about their inability to get inflation up to the 2% target. Those days are gone. But I don’t think we are on our way to a decade of punishing inflation like the 1970s. Although the Fed might be reluctant to withdraw support for the economy, it has a much better understanding of how to conduct policy and much greater credibility than it did 50 years ago. Nevertheless, the policy tightening that is widely expected to begin in a few months will take at least year to impact inflation. With the dynamic underway, the new normal inflation rate will probably be in the range of 3-5% for the next several years.


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