Inflation Is Here. The Big Debate Is, Will It Stay?
(Bloomberg) -- The U.S. Federal Reserve and investors in the bond market have traditionally been seen as hard-eyed cops on the inflation beat, ready to spring into action when prices rise. But this year, as inflation surged to a level not seen in more than a decade, both have remained surprisingly serene. Plenty of other people, however, are worried.
1. How did inflation get going?
In March 2020, the lockdowns in response to the coronavirus pandemic triggered the steepest U.S. economic downturn on record. Then in early 2021, mass vaccinations and trillions of dollars in stimulus from the federal government led to a pickup in consumer spending. Supply chains, on the other hand, took longer to rev up. Semiconductor production, for example, slumped during the 2020 lockdowns, and then couldn’t be ramped up fast enough when demand for cars and electronics returned, leading the prices of new and used autos to rise at a record pace. Prices for airfares and hotel stays also jumped. Companies found themselves short of workers as they reopened, leading some to offer bonuses or boost wages and subsequently raise prices for consumers.
2. Where’s the disagreement?
The question is whether the inflation seen so far in 2021 is transitory. That is, whether those factors pushing prices up persist or prove temporary as supply chain constraints are resolved, more Americans return to the workforce and demand for travel normalizes. There’s not a clear answer from the data so far: While prices in some categories -- like used cars -- have started to come off the boil, those in other categories have begun picking up in recent months. The concern among those who think inflation pressures are more than a blip is that they persist long enough to become self-perpetuating, as happened in the U.S. and elsewhere in the 1970s, when expectations of inflation fed what was known as a wage-price spiral.
3. What does the Fed think?
The Fed is firmly in the transitory camp. In July, Fed Chair Jerome Powell said that current price pressures represent temporary shocks associated with the reopening of the economy. Lumber prices, for example, spiked when demand for new homes returned and have since normalized. “Our expectation is that these high inflation readings that we’re seeing now will start to abate,” Powell said in June. “And it’ll be like the lumber experience, and like we expect the used-car experience to be.” He has acknowledged that annual inflation figures running above the bank’s 2% target bring heightened uncertainty. “We don’t know when they’ll go away,” he said of recent price hikes. “We also don’t know whether there are other things that will come forward and take their place.” But he added that what the Fed isn’t seeing is “broad inflation pressures showing up in a lot of categories.” Powell and other Fed officials are also seeking to avoid repeating past mistakes.
4. What mistakes?
Choking off an economic recovery through misplaced inflation fears. Before the pandemic, the Fed spent a decade trying to pull inflation up to 2% after it fell steeply as a result of the 2008 financial crisis. It began raising interest rates as the economy began to grow even though inflation remained tame, but had to reverse course in 2019. The Fed has a dual mandate of achieving both price stability and maximum employment, and Powell has repeatedly noted that nearly 6 million Americans remain out of work compared with pre-pandemic levels. The Fed’s official position is that it won’t begin winding down the stimulus it’s giving the economy through massive purchases of bonds until it sees “substantial further progress” in the labor market.
5. What are investors thinking about inflation?
Judging by what they’re willing to pay in the U.S. Treasury market, they’re not worried. So-called breakeven rates -- the amount of extra yield investors demand to offset expected inflation -- surged briefly in May but moderated to levels consistent with inflation matching the Fed’s 2% target. The “five-year five-year forward” breakeven rate, which measures expectations for the compensation needed to offset inflation for the period between five and 10 years ahead, is below the five-year rate, which suggests investors see inflation moderating over time. And models maintained by Fed economists that attempt to extract investor expectations for inflation from breakeven rates also indicate a decline over the last few months.
6. Who is worried about inflation?
Most Wall Street economists, as well as those in the White House, are on Powell’s side. But some big names aren’t -- especially those who experienced the rapid inflation of the 1970s. Former Treasury Secretary Larry Summers, who served in the last two Democratic administrations, has repeatedly predicted that the current combination of monetary and fiscal stimulus, coming on top of the reopening of the economy, will spark considerable pressure for price increases.
7. Who else?
Republicans in Congress, meanwhile, have seized on the inflation surge to rally support ahead of the 2022 midterm elections and portray the administration’s plans for trillions of dollars more in spending as “reckless.” President Joe Biden’s administration hopes to pass a $3.5 trillion package of social spending and tax increases on the heels of the $550 billion infrastructure plan passed by the Senate on Aug. 10.
8. What has this meant for workers and consumers?
Thus far, consumers are paying up, as companies that are having to pay more for their inputs have largely been able to pass those costs on to their customers. Many people added to their savings during the pandemic -- and were highly motivated spenders after being cut off from many pleasures. But the longer-term outlook for spending may depend on whether inflation-adjusted wages increase as much as prices. A recent study by the Peterson Institute for International Economics found that compared with December 2019, workers in most U.S. industries are seeing any wage increases being more than offset by inflation.
9. What’s at stake?
If inflation proves persistent -- meaning outsize price increases continue into next year and beyond -- Fed officials will have to reevaluate their assessment of how soon to raise interest rates and pull back monthly bond buying. But at the same time, the Fed has to keep risks to its outlook in mind. The spreading delta variant has jolted investors who worry it could threaten the economic recovery. “As long as Covid is running loose out there, as long as there is time and space for the development of new strains, no one is finally safe,” Powell said following the July Federal Open Market Committee meeting.
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