The Fed Is Right Not To Jump The Gun On Inflation
There are at least five reasons to doubt that the U.S. economy has already hit its inflationary speed limit, writes Paul Sheard.
The drumbeat of concerns that high inflation lies ahead if the U.S. Federal Reserve doesn’t do something about it soon keeps getting louder, spurred by a jump in the CPI in April and signs of labor shortages. Such concerns are overdone and premature, and reflect some fundamental misunderstandings about inflation and monetary policy.
Reflecting the modern academic, policy and political consensus, the Fed uses its monetary policy tools to try to keep the economy at full employment with consumer price inflation running around 2% annually. PCE (Personal Consumption Expenditures) inflation has averaged 1.5% year-on-year over the past ten years, which means the Fed has undershot its inflation target by an average of 0.5% per year for a decade.
The Covid-19 pandemic dealt the U.S. (and much of the global) economy its sharpest negative blow in recorded history. In Q2 of last year, real GDP fell by 9.0% in non-annualized terms and the unemployment rate shot up from 3.5% to 14.8% in two months. Unprecedented monetary and fiscal policy was called for and was delivered. It has worked: real GDP has rebounded by 10.3% in just three quarters and the unemployment rate is down to 6.1%.
For high inflation to break out, two things need to happen: first, the economy has to get back to full employment and start to overheat; and second, in the face of that, the Fed must fail to tighten monetary policy sufficiently to keep inflation in check. The first is unlikely to be imminent and the second is unlikely to happen at all.
Five Reasons Inflation Doesn’t Scare
Despite the jump in CPI inflation in April and signs of labor shortages, there are at least five reasons to doubt that the U.S. economy has already hit its inflationary speed limit.
One, the base effects associated with the Covid-19 economic collapse in the first half of last year are making inflation readings look worse than they really are.
Two, there is still a lot of “slack” in the labor market: the wider (U6) unemployment/underemployment measure stands at 10.4%, way above its pre-Covid trough of 6.8%, a rate which did not seem to be giving rise to inflationary pressure. The labor force participation rate for high school graduates without a college degree aged 25 years and over fell a whopping 4.3 percentage points and has regained just a quarter of that lost ground.
Three, labor shortages and product market bottlenecks seem to be limited and in specific areas rather than being endemic to the whole economy. To a degree, these likely reflect timing and transient effects as the economy gets going again in earnest. Job openings have shot up, but that likely reflects more a return of consumer demand than a lack of labor supply. To the extent that they do not, this is “running the economy hot” in action.
Four, the powerful secular disinflationary forces that were at work pre-Covid, associated with digitalization and the advance of the information economy, have not gone away, and in fact have been amplified by the pandemic. The (AI) “machines” are still coming.
Five, the stimulus that is on its way is not quite the inflationary avalanche it seems to be. Most of the pandemic-related fiscal expenditure has taken the form of compensatory income transfers, not direct spending on GDP. The Biden administration’s still-to-be-passed American Jobs Plan and American Families Plan with price tags of $2 trillion and $1.8 trillion, respectively, are ambit claims, whose associated spending is set to be made over eight to ten years. As for the Fed, it gets full marks for increasing the size of its balance sheet by 82% since Covid hit, but 72% of that expansion has come from buying treasuries (95% including government-guaranteed mortgage-backed securities), which just changes the profile of government debt in the public’s hands. Not quite the inflationary monster many fear it to be.
Let’s say the economy starts to overheat and inflation threatens to break out on the upside. Coming out of such dire times, this would be welcome and would dovetail with the Fed’s “average inflation targeting” framework adopted in August of last year. Now the Fed wants inflation to run a bit about 2% for a while to make up for past inflation misses.
Inflation being a self-fulfilling phenomenon, sustained high inflation – the very thing the Fed is paid to prevent – can happen only if the Fed allows the public’s inflation expectations to rise and start to drive inflation outcomes. For this to happen the public would have to lose its confidence that the Fed will implement the necessary monetary tightening to keep inflation at its target when it must.
There is an irony here.
Those who are most convinced that high inflation is on the way point to the Fed’s no-holds-barred “money printing” and willingness to work hand in glove with the fiscal authorities as harbingers. But they should take comfort from that. The more aggressive and willing the Fed is to do “whatever it takes” when confronted with downside risks to inflation (and employment), the more credible its commitment to do likewise to keep inflation in check when that becomes the proximate threat.
Paul Sheard is a research fellow at Harvard Kennedy School. He was formerly vice chairman of S&P Global and prior to that chief economist at S&P, Nomura Securities, and Lehman Brothers.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.