When does transitory inflation become sustained?

on May27
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AT NEARLY 43 years old, the median American worker has never in her career experienced an annual rate of “core” inflation, which excludes volatile food and energy prices, above 3%. That will soon change. Core consumer prices in America rose by 0.9% month-on-month in April, the highest jump since 1982, practically guaranteeing that the annual rate will exceed 3% in the near future. Some economists sense the first stirrings of an outbreak of sustained high inflation, like that which afflicted many countries in the 1970s. But prevailing theories of inflation suggest that, for now at least, this threat remains remote.

The Great Inflation, as the episode in the 1970s is often called, led to radical revisions in macroeconomic thinking. Until then Keynesian economists believed that a permanently lower rate of unemployment could be achieved by accepting higher inflation. Critics of this view, like Milton Friedman and Robert Lucas of the University of Chicago, thought differently. In the long run, they argued, the unemployment rate was determined by an economy’s structural features. A government using easy money to push joblessness below this “natural” level would fail. Instead, inflation would accelerate as people learned to expect faster price growth.

The Great Inflation lent credibility to the critics. But Friedman’s monetarism—the view that inflation in the long run was determined by growth in the money supply—also proved inadequate. Central banks that tried to target money growth found its relationship with inflation to be unstable. They have since been guided by a hybrid “New Keynesian” framework, where inflation is determined by three main factors: the effects of supply shocks; the extent to which the economy is operating above or below capacity; and people’s expectations of inflation. The debates around the probable trajectory of inflation today hinge on these variables.

Start first with supply shocks. The current inflation spike is clearly rooted in disruptions relating to the messy process of reopening. Supply shocks featured prominently in the Great Inflation as well, which might suggest that a short-term problem can quickly become entrenched. But a closer examination of that episode provides some reassurance. Work by Alan Blinder of Princeton University and Jeremy Rudd of the Federal Reserve suggests that the Great Inflation in fact reflected two distinct phenomena: a persistent problem of too much demand, overlaid by short bursts of supply-side pressures. Shocks to food and energy markets led to dramatic spikes in inflation in the 1970s. But Messrs Blinder and Rudd point out that inflation quickly dropped when these shocks abated. Headline inflation in America rose by nine percentage points from 1972 to 1974, but by 1976 had fallen by seven percentage points. That suggests that supply pressures today should ease when disruptions are resolved.

An economy that is operating beyond its capacity could perhaps create more enduring inflation problems. Here again history is instructive. Inflation had been creeping up in America well before the 1970s, rising from less than 2% in the early 1960s to nearly 6% later in the decade. That was the result of a policy error: the Fed consistently let demand exceed productive capacity. Why it did so remains the subject of debate. It may have failed to grasp that productivity growth was slowing, thereby overestimating the economy’s potential. Or it may have been reluctant to incur the social or political costs of inducing unemployment to rein in inflation. It took the grim determination of Paul Volcker, who became the Fed’s chairman in 1979, to expunge this inflationary inertia.

Some economists worry that today’s stimulus-powered growth could lead to a repeat of the errors of the past. Employment in America remains nearly 8m short of its pre-pandemic level, pointing to plenty of spare capacity. But even the Fed reckons that this might quickly be hoovered up, with unemployment falling below its long-run rate by the end of 2022. Yet though the disappearance of slack could add to inflation pressures, it may not do so by very much: shifts in unemployment seem to have had smaller effects on inflation in recent decades. In fact, research by Jonathon Hazell of Princeton University, Juan Herreño of Columbia University and Emi Nakamura and Jon Steinsson of the University of California, Berkeley, suggests that this phenomenon may not be new. They find that the relationship between unemployment and inflation has been fairly weak across American states since at least the late 1970s. The drop in inflation that occurred on Volcker’s watch owed less to high unemployment, they argue, than to a profound shift in the public’s inflation expectations.

What to expect when you’re not expecting

Expectations are the trickiest piece of the inflation equation. Measurement is one problem. A survey by the University of Michigan suggests that consumers expect average annual inflation of 3.1% over the next five years; market-based measures imply a rate of about 2.6% over the same period, before falling to about 2.2% over the subsequent five years. That is above the Fed’s 2% target but still well short of a 1970s-style rerun. Perhaps punters are less worried about price pressures. Or perhaps they trust in the Fed’s commitment to price stability. Mr Hazell and his co-authors posit that inflation expectations dropped dramatically in the early 1980s because the public perceived a “regime shift” at the Fed. A repeat of the Great Inflation, then, might require another big change to central banks’ frameworks, and time for the public to perceive it.

Is such an about-face imminent? The Fed recently amended its approach, and says it will accept periods of above-target inflation to offset past undershooting. Whether this represents a “regime shift” is another question. The Fed still promises inflation of just 2% on average. It has not dropped its commitment to keep control over prices, nor does the public believe it has. Middle-aged Americans may get a taste of modestly high inflation this year. But they are hardly returning to the economy of their parents.

This article appeared in the Finance & economics section of the print edition under the headline “Hot stuff”

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