No Immediate Miracles
No Immediate Miracles
Inflation probably isn't going away this year
Thank you to everyone who subscribed this week! The recent surge in inflation isn’t unprecedented, but it is unlike anything we’ve seen for a long time. The unusual events that brought inflation on—the pandemic and the invasion of Ukraine—are not behind us. There probably isn’t much anyone can do in the short term to bring prices back down rapidly.
In October 1974, in the wake of the 1973 oil crisis, inflation was nearly 12% in the US. Shortly after taking office, President Gerald Ford gave a speech to Congress calling on Americans to mobilize to fight inflation. He asked Americans to take steps like to fight food and energy costs by planting their own vegetable gardens and carpooling. Americans who signed a pledge to “enlist as an Inflation Fighter” got a free red-and-white WIN button—which stood for “Whip Inflation Now.” People ridiculed Ford’s campaign by turning the buttons upside down so that they read “NIM”. They joked that it stood for “Nonstop Inflation Merry-go-round” or “No Immediate Miracles.”
Ford’s efforts to fight inflation didn’t work as well as he would have liked. Inflation did come down for a while, but it remained above 5% throughout the Carter administration and into the Reagan administration. It eventually peaked again—after another oil crisis—at an even higher level. It didn’t finally go below 5% until 1982, after the Federal Reserve had raised interest rates to a staggering 19%.
Inflation is now higher in the US than at any time since 1982. The Consumer Price Index (CPI)—the most commonly cited measure of inflation—was 7.9% higher in February than it was in February 2021. For more than a decade before then, consumer price inflation had averaged a relatively imperceptible 1.7% a year. The problem of inflation seemed like it might be behind us. But the recent extraordinary surge in inflation should probably not be that surprising, since extraordinary things have been happening in global markets over the last couple years. The supply of things to buy fell sharply as the pandemic affected production and transportation, while the demand for things to buy rose dramatically as rising wages, low interest rates, and pandemic stimulus checks gave Americans money to spend. Prices rose because we had more money to spend on fewer things.
Prices really began to rise in the US in early 2021, after Congress approved a new set of stimulus measures. Inflation was already running high before Russia’s invasion of Ukraine, but Russia’s invasion—which still hasn’t really shown up in the data—will add to the problem by driving up the price of crucial inputs to the global economy, including wheat, fertilizers, nickel, and oil. Even with wages rising in the US, inflation this high means that many of us can afford to buy less. In some cases, it will mean that people can’t afford to buy food, heat their homes, or get gas to commute to work. Around the world, high inflation will cause governments to fall.
In his State of the Union Address, President Biden said that his top priority is “getting prices under control”. He called for long-term measures to improve American productivity and competitiveness, so we can reduce inflation without lowering wages. But in the short term he probably can’t do much more than President Ford could. While some economists argued initially that this inflation would be transitory—that when the surge in demand for goods subsided and things like semiconductor production returned to normal, prices would return to normal too—that position has become harder to defend. When we locked down in response to the pandemic, some businesses and factories had to shut down for good. Rebuilding the supply of goods will take more time. Meanwhile, rapidly growing wages and the new extension of student loan relief—whatever you otherwise think of the policy—are increasing the amount of money Americans have to spend.
If sanctions on Russia were substantially lifted, oil prices could drop significantly. But because Putin is likely to remain in power and because it will take time to negotiate any agreement in Ukraine, sanctions will probably not be lifted soon. Even if sanctions are lifted, energy prices are likely to stay high as western countries seek to transition away from dependence on Russian fossil fuels. In the long run, reducing our energy consumption should make us less vulnerable to future energy shocks, but that will take time.
The Federal Reserve does have some leverage to reduce inflation relatively soon. By raising interest rates, the Fed makes borrowing more expensive and reduces demand by encouraging people to save rather than spend their money. Higher rates could have a big impact on housing markets by driving up the cost of mortgages, potentially lowering the price of homes and reducing the amount of money homeowners have to spend. But while the Fed has recently taken steps to reduce the money supply, the Federal Funds rate is still only slightly more than 0%. It’s certainly well below the rate you would expect to slow the economy. As Jason Furman recently told Ezra Klein, what the Fed is doing is more like pulling back on the accelerator than it is like tapping on the brakes. As long as interest rates are lower than the inflation rate—as long, in other words, as what it costs to borrow money is less than what it would cost you just to hold on to it—raising interest rates isn’t likely to reduce what we spend much. My guess is that years of low inflation have given people confidence the Fed can get inflation under control eventually—which is what will ultimately determine how long inflation will last—but the more time it takes the more confidence in the Fed will wane.
If we look at the Personal Consumption Expenditures (PCE) price index, which tends to be slightly lower than CPI, prices increased 6.0% in 2021. The last time—and the only time since the dollar went off the gold standard—PCE inflation went over 5.0% year-over-year, inflation kept increasing and stayed over 5.0% for more than 9 years. In the 50 years since the dollar stopped being pegged to gold, there have been 35 months when year-over-year PCE inflation was within a half point of 6.0%. On only one of those occasions—when the long run of high inflation was finally over—was the inflation rate more than 2 percentage points lower a year later. More than half the time it was actually higher.
The Federal Open Market Committee’s March Summary of Economic Projections projects headline PCE inflation to be 4.3% in 2022. That seems low to me, since it would require PCE inflation to go back to growing at pre-2021 rates starting soon, even though food and energy expenditures, which are included in headline PCE, seem likely to remain high. The February 2022 Survey of Professional Forecasters projects PCE inflation to be just 3.1% in 2022, which—am I missing something?—seems like it would require an almost unprecedented drop in the inflation rate. The inflation rate has dropped that quickly only when it was already much higher or during financial crises.
I expect inflation to remain high throughout the spring at least, with low unemployment keeping wages and labor costs high. I think there’s a good chance inflation will moderate later in the year as rising interest rates have some effect on the housing market and as supply catches up with demand in some areas. I also expect the impact of sanctions to moderate, which should help reduce the inflation rate. But, ultimately, engineering a “soft landing” will require finesse, and I’m afraid that even though the US economy is booming now there’s a good chance of a recession next year when higher interest rates begin to kick in. In the longer run, I expect the same factors that kept inflation low over the last decade to eventually keep it low again. But I don’t think inflation is likely to fall much in 2022.
My Forecast
50% chance PCE inflation will be over 4.7% in the US in 2022
11% chance PCE inflation will be under 4.0% in the US in 2022
Congratulations to my fantastic college classmate Ketanji Brown Jackson on her appointment to the Supreme Court! I highly recommend this interview with Jason Furman on the impact of the war in Ukraine on the economy on the Plain English podcast. While you’re listening to podcasts, I also recommend the interview Scott Eastman and I did with superforecaster James Bosworth on Latin American politics (as well as his great Substack Latin America Risk Report). If you enjoyed this post, please support my work by sharing it with your friends and colleagues!