John Maynard Keynes famously said: “When the facts change, I change my mind. What do you do sir?”
One has to hope that now that the inflation facts have changed, U.S. policymakers will not be quite as dismissive as they have been to date as to the real risk that the country could be heading towards an unwelcome period of higher inflation.
One indication that the inflation facts have been changing has been the very much faster than the anticipated pace at which officially measured inflation has been increasing. Over the past year, the consumer price index has risen by 4.2 percent or at approximately double the Federal Reserve’s 2 percent inflation price target. Meanwhile, over the past three months, the Personal Consumption Expenditure Price Index, excluding volatile food and energy prices, increased at an annualized rate of 4.9 percent. This latter measure, which is the Fed’s favorite inflation index, has now been increasing at its fastest pace since 1990.
Other indications of inflationary pressure come from the labor market. The Labor Department recently reported that in the first quarter of this year, the Employment Cost Index increased at its fastest rate in the past 18 years. At the same time, unfilled job openings have spiked to a record 8.1 million jobs, suggesting that the economy is already encountering labor shortages.
Both the Biden Administration and the Federal Reserve have dismissed the recent spike in price and wage inflation as a transitory phenomenon that soon will be reversed once the economy returns to normal. However, this view is not shared by the public.
According to the University of Michigan’s survey of consumer expectations, US households are now expecting 4.6 percent inflation over the next twelve months. At the same time, the financial markets are now expecting inflation over the next ten years to average more than 2 ½ percent, which is meaningfully in excess of the Fed’s inflation target. So much for the Fed’s claim that inflation expectations remain well-anchored.
Unfortunately, there are very good reasons to think that the public will be proved correct in questioning the Fed and the Administration’s assurances that inflation will be well contained. As Larry Summers, President Obama’s former Treasury Secretary keeps emphasizing, the basic economic analysis would indicate that there is a very real risk of higher inflation ahead as a result of the excessive budget and monetary policy stimulus that the economy is receiving. Mr. Summers has characterized these latter policies as the most irresponsible such policies in the past forty years.
A basic reason for fearing that inflation is about to accelerate is that, at a time that the non-partisan Congressional Budget Office estimates that the gap between the current level of US output and its full employment potential is only 3 percent, President Biden has rushed through Congress a $1.9 trillion stimulus package. That package would imply fiscal stimulus for the economy in 2021 amounting to a staggering 13 percent of GDP. Making matters worse, he has done so at a time that the Fed is allowing the broad money supply to grow by 25 percent and at a time that there is a considerable amount of pent-up demand in the economy. As we return to normal, we must expect that a large amount of that pent-up demand will be released thereby adding to inflationary pressure.
It also hardly helps matters that in addition to strong demand pressure, the economy is now also experiencing supply-side problems. Generous unemployment benefits, which extend through September, and school closings seem to be constraining labor supply giving rise to labor shortages. Meanwhile, pandemic-induced disruptions to the global supply chain are causing input shortages, especially of computer chips so crucial in automobile and consumer appliance production.
Past experience teaches us that once inflation takes hold it tends to feed on itself, which makes it more difficult to wring out of the economy than if timely policy action were taken. It also teaches that inflation falls hardest on that part of the population least able to afford it.
All of this makes it difficult to understand why both the Biden Administration and the Federal Reserve appear to be in inflation denial. By not taking measures now to scale back the excessive policy stimulus that the economy is receiving, they appear to be heightening the chances that the economy will have a hard landing next year.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.
