On inflation, it’s past time for team ‘transitory’ to stand down

November 16th, 2021

There is a wise apocryphal saying often attributed to John Maynard Keynes: “When the facts change, I change my mind. What do you do?” After years of advocating more expansionary fiscal and monetary policy, I altered my view this past winter, and I believe the Biden administration and the Federal Reserve need to further adjust their thinking on inflation today.

Fed Chair Jerome H. Powell’s Jackson Hole speech in late August provided a clear, comprehensive and authoritative statement, enumerated in five pillars, of the widespread team “transitory” view of inflation that prevailed at that time and shaped policy thinking at the central bank and in the administration.

Today, all five pillars are wobbly at best.

First, there was a claim that price increases were confined to a few sectors. No longer. In October, prices for commodity goods outside of food and energy rose at more than a 12 percent annual rate. Various Federal Reserve system indexes that exclude sectors with extreme price movements are now at record highs.

Second, Powell suggested that high inflation in key sectors, such as used cars and durable goods more broadly, was coming under control and would start falling again. In October, used-car prices accelerated to more than a 30 percent annual inflation rate, new cars to a 17 percent rate and household furnishings by an annualized rate of just above 10 percent.

Third, the speech pointed out that there was “little evidence of wage increases that might threaten excessive inflation.” This claim is untenable today with vacancy and quit rates at record highs, workers who switch jobs in sectors ranging from fast food to investment banking getting double-digit pay increases, and ominous Employment Cost Index increases.

Fourth, the speech argued that inflation expectations remained anchored. When Powell spoke, market inflation expectations for the term of the next Federal Reserve chair were around 2.5 percent. Now they are about 3.1 percent, up half a percentage point in the past month alone. And consumer sentiment is at a 10-year low due to inflation fears.

Fifth, Powell emphasized global deflationary trends. In the same week the United States learned of the fastest annual inflation rate in 30 years, JapanChina and Germany all reported their highest inflation in more than a decade. And the price of oil, the most important global determinant of inflation, is very high and not expected by forward markets to decline rapidly.

Further considerations reinforce concerns about inflation. Meme stocks, retail option buying, crypto market developments, credit spreads and some start-up valuations suggest significant froth in some markets. Housing prices and rents are both up 15 to 20 percent in the past year. These movements are far from fully reflected in the shelter component of the consumer price index, which represents one-third of the CPI, implying substantial pressures to come.

What now?

First, let’s not compound errors that have already been made with far too much fiscal stimulus and overly easy monetary policy by rejecting Build Back Better. The legislation would spend less over 10 years than was spent on stimulus in 2021. Because that spending is offset by revenue increases and because it includes measures such as child care that will increase the economy’s capacity, Build Back Better will have only a negligible impact on inflation. It will of course be imperative to ensure that various temporary measures, such as the child tax credit, will not be extended without new revenues to pay for them.

Second, the administration is making a series of Fed appointments in coming weeks. The president’s choices need to recognize, as Powell has started to do in recent remarks, that the major current challenge for the central bank is containing inflation. If price stability is lost and inflation accelerates, sooner or later the consequence will be a severe recession that will hit the poor and middle class hardest and undo recent employment gains.

Third, Powell and his colleagues have rightly emphasized the need for close economic monitoring and attentiveness to inflation risks. Now the Fed should signal that the primary risk is overheating and accelerate tapering of its asset purchases. Given the house-price boom, mortgage-related purchases should stop immediately. Because of inflation, real interest rates are lower, as money is easier than a year ago. The Fed should signal that this is unacceptable and will be reversed.

Fourth, the administration should signal that a concern about inflation will inform its policies generally. Measures already taken to reduce port bottlenecks may have limited effect but are a clear positive step. Buying inexpensively should take priority over buying American. Tariff reduction is the most important supply-side policy the administration could undertake to combat inflation. Raising fossil fuel supplies, by relaxing regulations and deploying the Strategic Petroleum Reserve, are crucial. And financial regulators need to step up and be attentive to the pockets of speculative excess that are increasingly evident in financial markets.

Excessive inflation and a sense that it was not being controlled helped elect Richard Nixon and Ronald Reagan, and risks bringing Donald Trump back to power. While an overheating economy is a relatively good problem to have compared to a pandemic or a financial crisis, it will metastasize and threaten prosperity and public trust unless clearly acknowledged and addressed.