The jump in US annual consumer price inflation to 4.2 per cent reported last week was a shock. But was it a good reason to panic? Not obviously, since special factors can explain it. It was ever thus: when inflation starts to rise, special factors can always explain it. But in truth the big reasons for concern are not what is happening right now, but rather the political forces at work.
Naturally, economic forces shape those political choices. And these forces are currently rather confusing. The unexpectedly big jump in consumer prices followed on an unexpectedly weak employment report: last month, the US added just 266,000 jobs, while the unemployment rate edged up to 6.1 per cent.
The obvious explanation is that this is a recovery from an unprecedented recession, driven not by tightening demand but by shutdown of supply.
Goldman Sachs notes that the proximate causes of that jump lie in travel and related services, where prices are rebounding from depressed levels, and in some goods, where a post-pandemic surge in demand has run into temporary shortages and bottlenecks.
Jason Furman of the Peterson Institute for International Economics notes, too, that employment was still 10m jobs below its pre-pandemic trend in April, even though the job openings rate was higher in February 2021 than in any month since 2001.
Again, this suggests persistent post-pandemic disruption to labour supply. An unprecedented shock inevitably makes the data hard to interpret and performance hard to predict.
This uncertainty applies also to commodity prices. They have jumped upwards. But prices are not that high by historical standards and are well below past peaks.
Meanwhile, the "break-even rate" — the difference between the yield on conventional and inflation-indexed US Treasuries — has risen sharply, though still to only 2.5 per cent over 10 years. This indicates a rise in inflation expectations and concern over the risks of inflation.
Bloomberg's John Authers notes that forecasts by consumers and professional forecasters have also risen, with the former expecting close to 6 per cent inflation and the latter 3 per cent over the next year.
It would be fair to conclude that inflation expectations are moving up. But, at current levels, they will not concern the Federal Reserve all that much, since, as Jerome Powell, Fed chair, said last August, "we will seek to achieve inflation that averages 2 per cent over time.
Therefore, following periods when inflation has been running below 2 per cent, appropriate monetary policy will probably aim to achieve inflation moderately above 2 per cent for some time." Because inflation has fallen short of the goal by a cumulative total of 5 percentage points since 2007, this could justify, say, 3 per cent inflation for five years, before a return to 2 per cent.
So should we keep calm, knowing that short-term performance reflects post-pandemic unpredictability, while rising inflation expectations are just what the Fed ordered? Yes, up to a point. The true concern is deeper and longer term.
First, both monetary and fiscal policy settings are, by historical standards, wildly expansionary, with near-zero interest rates, exceptional monetary growth and huge fiscal deficits, even though the IMF suggests that the US economy will be operating above potential this year.
Second, there is a large overhang of private savings waiting to be spent and surely a great desire to get back to normal life. Maybe, these will not be the "roaring 2020s". But they might be far more economically dynamic than most suppose.
Third, while I understand why the Fed changed its monetary framework, I am unpersuaded it was a good idea. It means driving while looking into the rear-view mirror.
It would surely be better to learn from past experience how the economy works than to try to compensate directly for historic failures. In particular, the new framework creates uncertainty over how the Fed intends to make up for the past shortfalls.
Fourth and most important, politics have changed. One would have to be at least 60 years old to have experienced high inflation and subsequent disinflation as an adult. The government and substantial swaths of the private sector have huge debt liabilities and borrowing plans. Joe Biden's administration is determined to ensure that this recovery does not repeat the disappointment of the previous one.
The stock market is more than generously priced by historical standards, with bubble phenomena everywhere. The doctrines of "modern monetary theory" are highly influential, as well. All this together has strengthened lobbies for cheap money and big fiscal deficits, and weakened ones for prudence.
Given all this, doubts about the Fed are reasonable. We know that it is politically easier to loosen than tighten monetary policy. Right now, the latter is going to be particularly unpopular. Yet if a central bank does not take away the punch bowl before the party gets going, it has to take it away from people who have become addicted to it. That is painful: it takes a Paul Volcker.
Milton Friedman said that "inflation is always and everywhere a monetary phenomenon". This is wrong: inflation is always and everywhere a political phenomenon. The question is whether societies want low inflation. It is reasonable to doubt this today. It is also reasonable to doubt whether the disinflationary forces of the past three decades are now at work so strongly.
It is hard to believe these emergency monetary policies should continue for years, as many at the Fed think. I doubt whether they should continue even now.
Written by: Martin Wolf
© Financial Times