U.S. Inflation Isn’t Scary Yet, But It Could Be

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The U.S. Federal Reserve is showing little concern about inflation, even though its preferred measure — the core price index for personal consumption expenditures — has increased 3.1% over the past year, far exceeding the central bank’s longer-term 2% target.

Should people be worried about a wealth-destroying bout of price increases? No, and yes.

Fed officials see the current inflation surge as transitory. For one, low monthly readings from a year ago — when prices dropped amid the onset of the pandemic — are making today’s readings look high by comparison. Also, reopening-related logistical disruptions in areas ranging from appliances to cars are causing temporary price increases, as growing demand chases limited supply.

For the temporary price acceleration to become persistent, three things must happen. First, employers must demand more workers, in a big and sustained way. Second, the increased demand for labor must push up wage inflation to the point where it cannot be absorbed by higher productivity growth or lower profit margins. Third, people’s expectations for future inflation must climb further. Without such an increase in inflation expectations, a tight labor market alone would be insufficient to trigger an upward spiral in which rising wages and prices reinforce one another.   

So where do we stand? Demand for labor has been increasing, but remains below its pre-pandemic level: As Fed officials like to point out, payroll employment is still more than 8 million jobs short of the peak reached in February 2020. Although that measure might overstate the amount of slack in the labor market, it’s probably a better indicator than the 6.1% civilian unemployment rate.

Wage inflation isn’t too troubling, either. Increases have been modest, and the rise in wage inflation has been confined mainly to the past few months. For example, while the employment cost index for private worker wages increased at more than a 4% annualized rate in the first quarter of this year, the year-over-year increase was just 3%.       

Finally, inflation expectations have moved up, but not enough to be alarming. Prices in the Treasury market suggest investors expect inflation to average a bit more than 2% over the five years starting in mid-2026. This is close to what such markets have implied over  the past decade, and means only that the Fed is succeeding in bringing expectations closer to its 2% long-term inflation target. Surveys indicate that household expectations, too, remain within their ranges of the past decade.  

All this strongly suggests that the current sharp rise in inflation will subside over the next year as supply-chain issues get resolved. That said, there’s reason to be concerned that the temporary nature of the spike will also prove to be transitory.

In the longer term, the country still faces the confluence of expansionary fiscal and monetary policy. The Biden administration is pursuing an infrastructure bill and other legislation that will pile on added stimulus. Households have done enough saving during the pandemic to sustain spending long after the fiscal impulse ends. And the Fed has committed to keeping short-term interest rates at zero until the economy has achieved maximum employment and inflation has reached at least 2% and is expected to stay above 2% for some time.

In other words, the Fed — according to its own policies — is likely to act too late to prevent the economy from overheating. So no matter what prices do this year, the risk of higher inflation down the road remains elevated.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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