Jan. 19, 2021
The warnings that higher inflation lurks around the corner are starting to show up everywhere.
They are appearing in some business surveys, with companies looking to raise prices as they prepare for a post-pandemic economy. They are showing up in the bond market, where price moves in the last few months imply that big-money investors expect consumer prices will start to rise faster. And they are apparent in the news media, from magazine covers to financial news segments.
But inflation itself is not showing up: The Consumer Price Index in December showed only a 1.4% rise in what Americans paid for goods and services over the last year. And top Federal Reserve officials made clear in recent days that they (still) viewed too-low inflation as the bigger risk to the economy, not soaring prices.
High inflation causes its own sort of pain, as the purchasing power of money falls. But persistently low inflation is a worry, too, often a reflection of weak growth and stagnant wages — the predominant problem for the United States and other advanced economies for more than a decade.
How can one reconcile the inflation talk — and in some quarters, alarm — with the absence of actual inflation? It’s easier than you might imagine.
It helps to think of not a single inflation risk ahead, but of four distinct ones. In terms of significance, these range from mere statistical anomaly to a huge shift in the global economy. In terms of likelihood, they also range from near certainty to completely speculative.
Each of these four inflations has different implications, both for how ordinary people making economic decisions should react to them, and how policymakers, particularly at the Fed, should approach their work in the months and years ahead. One of the concerns is that policymakers will conflate one inflation risk with another, which could lead to bad decisions, either choking off a recovery prematurely or, on the flip side, allowing a 1970s-style vicious cycle of inflation to take hold.
It can be hard to tease these things out in real time, but some simple metaphors can help. If we start to see higher prices later in the year, the first thing to ask is: Is this a yo-yo effect; a story of hungry bears emerging from hibernation; the result of excess water sloshing around a bathtub; or a balloon finally being reflated after years of leaking air?
The Yo-Yo Effect
The spring of 2020 was weird in many ways. And that means the economic data in spring 2021 will also be weird in many ways.
The price of many goods and services collapsed between March and May, as much economic activity shut down. In many cases, those prices have recovered to close-to-normal levels, but in the arithmetic of annual inflation, that won’t matter. Even if the basic trend line of the price of those items is reasonably stable, the reported year-over-year inflation will be extraordinarily high.
If, for example, the overall Consumer Price Index rises through May at a rate consistent with 2% annual inflation, it will show a 3.2% year-over-year rise from the depressed May 2020 level. That would be the highest level since 2011 — but would also be misleading, a result of “base effects” rather than the true longer-term trajectory of prices.
For quite a few individual products and services, those numbers will look even more extreme. The price of home natural gas service is on track to be up 5.4%, with airline fares up 16.3%, and the price of women’s dresses up a remarkable 17.9% — all reflecting the deep discounting retailers were forced to do in the spring of 2020.
Those numbers might amount to inflation in a technical sense, but only because of the conventions around using year-over-year data. Dress prices in that model might look as if they are evidence of price inflation, but they would still be 9% below pre-pandemic levels.
These calendar effects don’t matter in any meaningful way, and Fed officials have said as much. (“Inflation may temporarily rise to or above 2% on a 12-month basis in a few months when the low March and April price readings fall out of the 12-month calculation,” Lael Brainard, a Fed governor, said last week, “But it will be important to see sustained improvement to meet our inflation goal.”)
The most important thing to remember about the yo-yo effect on prices: Beware of anyone who might seek to use these numbers to create misleading narratives about the level of inflation in the economy.
The End of Hibernation
Suppose you get a vaccine jab and suddenly feel more comfortable going out to eat, or attending a concert, or taking a long-postponed vacation. Like a bear that has been hibernating through the winter, you will be ravenous for the pleasures long denied.
But if most everyone emerges from hibernation at once? There are only so many restaurant reservations, concert tickets and hotel rooms available; their supply is pretty much fixed in the short run. If anything, the supply is likely to be below pre-pandemic levels because of permanent business failures.
That presents a simple Economics 101 situation: When demand jumps and supply falls, steep price increases can result.
“When suddenly everyone wants to go out again, and there aren’t as many places to go as there used to be, that will make companies more comfortable raising prices, as there is huge demand for limited capacity,” said Kristin Forbes, an economist at the Massachusetts Institute of Technology Sloan School of Management. “That could make prices go up faster than expected, especially as companies try to recoup the cost of dealing with the pandemic.”
This possibility is most obvious in service sectors like restaurants, but could apply to certain goods as well. Suppose all the people who have been working from home for a year in sweatpants need to purchase new work clothes. If retailers and apparel makers haven’t increased supply adequately, they may need to raise prices to avoid shortages. And this form of price inflation can happen through nonobvious ways, such as if a retailer that in normal times routinely offers 20% discounts stops doing so.
This, too, is a classic example of the kind of inflationary surge that central bankers need to mostly ignore — to look through to longer-run trends. The Fed can’t create more hotel rooms or dress shirts any more than it can produce more gasoline when a refinery goes down and causes a spike in energy prices. Prices are how the economy adjusts — allocating a limited supply to those willing to pay and encouraging producers to increase supply.
There is no way of knowing whether, amid a sluggish vaccine rollout and continued economic distress, an emergence from hibernation will take place and whether it will cause this type of spending surge.
But if it does, the price spikes that result will be a sign of the economy healing, not cause for inflationary panic.
The Sloshing Bathtub
Here’s a number that came out Friday you might have missed: JPMorgan Chase said its total deposits were 37% higher in the fourth quarter than a year before, a rise of $582 billion.
It’s a little shocking for what was already the United States’ biggest bank to experience such a vast rise in deposits, but not exactly surprising if you’ve been following the economic data. From March through November, Americans saved $1.56 trillion more than they did in the same period of 2019, reflecting a pullback in spending combined with federal spending that, in the aggregate at least, offset the loss of income from job losses.
And that’s before the $900 billion pandemic aid package Congress passed at the end of 2020, which includes $600 per-person checks to most Americans, and before whatever emerges from President-elect Joe Biden’s plan to spend an additional $1.9 trillion, including a further $1,400 per person.
That is an enormous amount of money sitting in savings, whether in an account at JPMorgan, physical cash or invested in stocks and other investments. So what happens if everybody starts spending at once?
It’s entirely possible that, as people become more confident in the economy, all that money starts sloshing around, with demand for goods and services outstripping the supply of them.
If you have thousands of extra dollars in savings and are increasingly sure that you won’t be losing your job, why not buy a new car or renovate the kitchen?
There’s an important distinction between this potential broad-based surge of demand and the pent-up demand effects on certain industries of Americans coming out of hibernation. It wouldn’t be limited to a handful of industries, but rather could push up the prices of nearly everything.
This would be less like what happens when an oil refinery goes offline and more like what happened in the 1960s, when a combination of high domestic and wartime spending pushed the economy to its productive limits. That created a very tight job market and remarkable income growth for Americans, but by the end of the decade inflation was rising and would become a major problem in the 1970s.
That makes the potential post-pandemic surge of demand a tricky situation for the Fed and other economic policymakers. In a lot of ways, a broad surge of demand that fuels a boom in economic activity is exactly what the nation has needed — not just since the pandemic struck, but since the Great Recession 13 years ago.
After all, if Americans start spending their accumulated savings en masse, companies will need to rush to satiate that demand by building more factories and stores and hiring more workers, creating a boom on the supply side of the economy as well, and higher incomes that come with it.
“My hope is that we would see a broad-based reflation of the economy, to restore the dollar size of the economy to the trend path it was on before the pandemic, which implies higher inflation temporarily and higher incomes,” said David Beckworth, a senior fellow at the Mercatus Center at George Mason University.
The Fed will have to decide whether what’s happening is a desirable and long-awaited heating up of the economy, or something that’s likely to spill out into sustained inflation, such as if consumers and businesses begin to think prices will keep rising indefinitely and act accordingly. In that situation, the Fed might see a need to raise interest rates sooner than it now expects, trying to stop that cycle but at the cost of cutting off a long-awaited boom.
Beckworth hopes the Fed won’t unnecessarily slow the economy just because prices have finally surged. “It’s hard to break old habits,” he said. “And it’s not just the Fed. They’ll get intense pressure from Congress and people in the markets if inflation starts to rise.”
Jerome H. Powell, the Fed chair, has said he does not believe a 1970s-style inflationary cycle is likely. Inflation is a process where prices “go up year upon year upon year upon year,” he said at a December news conference. “Given the inflation dynamics we’ve had over the last several decades, just a single price-level increase has not resulted in ongoing price-level increases.”
But when a bathtub is filled to the very top, it doesn’t take much sloshing for it to spill out on the floor.
The Great Reflation
Over the last three decades or so, the world economy began to work differently. Inflation, interest rates and growth have fallen persistently in nearly all advanced nations.
Not many people predicted this, and economists have spent years wrapping their heads around the reasons. They include demographic shifts, the entry of billions more workers into the economy and a worldwide glut of savings.
But nothing says the pattern of the last few decades must continue into the next few. And while experts’ track record of forecasting these big global shifts is poor, you can’t rule out that another such shift is underway.
The basic story would go like this: Inflation has been pushed downward over the last generation in significant part because of a rapidly rising supply of labor. China’s integration into the global economy, the rise of information technology that allowed Western companies to tap labor in India and many other countries, the economic integration of the former Soviet bloc with Western Europe — all these things diminished the bargaining power of workers, holding down wage inflation.
But now the tides could be reversing. Wages are rising rapidly in China as its economy becomes more advanced, and its demographic outlook is bleak because of the lagged effects of its one-child policy. There is no country close to China’s size on the verge of integrating into the world economy. And the demographics in advanced nations suggest slow growth or a shrinking workforce over the coming years.
So there’s a real possibility that in the 2020s and beyond, the world’s crisis will be too few workers rather than too many — which, all else equal, would mean more upward pressure on wages, as British economist Charles Goodhart argues.
Other forces to watch: The pandemic, the rise of nationalism, and the breakdown of relations between the United States and China could cause de-globalization, which would tend to be inflationary. The United States and some other countries may now be engaging in deficit spending on a scale that ends an era of inadequate demand.
Any combination of these forces would imply a worldwide reflation of sorts, with prices once again rising and central banks forced to worry about inflation that is too high rather than too low.
The hard part is figuring out whether it’s happening and, if so, what the policy response should be. After all, it took decades for an understanding of structurally low inflation and interest rates to become part of the consensus view of policy elites. Arguably, it’s only really taken hold in the last couple of years.
If this great reflation happens, it will probably be the most important economic story of the 2020s. But if the past is a guide, it will take time to know whether the decade started with a benign yo-yo, a surge of activity after a long hibernation, the soggy results of an over-full tub, or a lasting change in how the world economy works.
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