The Great Inflation Debate

As the economy heats up, inflation jitters rise.

These days, the most significant disagreement between economists isn’t your age-old tax and spending dinner table debates, at least not directly. Instead, it’s a widely known but hardly intuitive concept that’s existed for the last thirty years as more of an urban legend than a reality: high inflation.

In a macroeconomic sense, inflation occurs when the price of goods and services rise, resulting in a decrease in the value of the currencies we use to purchase them. As the items that we buy become more expensive, the purchasing power of each dollar falls.

The debate around inflation is far from new. Still, it has reignited in recent months as the pandemic produced an economic environment that in many ways starkly contrasts with previous downturns. In a typical recession, endogenous (i.e., internal) shocks cause a short-term strain on credit availability, depressing savings and investment, which triggers a decrease in aggerate demand. When COVID reached US shores in early-2020, the US economy was in full stride with few signs of slowing. The government-mandated shutdown that followed served as an exogenous (i.e., external) shock to what had been a normally functioning economy. With the shutdown came the unattainability of goods and, especially, services, that would otherwise be in high demand. That said, a combination of federal stimulus as a stopgap for lost household income, along with adaptative economic creativity from service providers, have allowed a sizable portion of demand to bounce back quickly, prompting a rebound in GDP during the latter half of the year.

While a total return to pre-COVID normalcy is still more than armlength away, a steady increase in vaccinations and the reopening of pandemic-constrained businesses are buoying prospects for a strong 2021. As of the March WSJ Economic Forecasting Survey, on average, leading economists expect the US economy to grow by 6.0%—higher than any annual increase since 1984. Despite the otherwise great news, the injection of more than $6T of fiscal stimulus, alongside a monetary policy regime committed to holding interest rates low, has raised concerns of increased pressure on prices. Echoing these sentiments, former National Economic Council director Larry Summers recently opined, “I know the bathtub has been too empty,” metaphorizing the steep fall in output that the economy has experienced during the pandemic. “But one has to think about what the capacity of the bathtub is and how much water we’re trying to flow into it.” Summers, who has recently emerged as a bullhorn for inflation concerns, was once a leading proponent for higher government spending to stimulate aggregate demand. His view on the potential unintended consequences of an enormous spending binge may differ from many of his contemporaries. Still, his warnings do not have the mark of an ideologically convenient argument.

The fears aren’t unfounded. In the March release of the Manufacturing Business Outlook Survey, an indexed review of manufacturing activity produced by the Federal Reserve Bank of Philadelphia, 77% of firms reported higher input prices in the past month—pushing its “Prices Paid Index” to its highest level since 1980. Another 35% of firms reported an increase in the price of goods sold, up from 18% in the previous month. While the monthly survey focuses on firms in the Mid-Atlantic region of the US, it is often used as a bellwether forecast for manufacturing activity nationwide, as sector conditions tend to be similar across different regions.

Adding fuel to the fire are signals in the labor market that point to higher demand on the horizon. The four-week average of initial unemployment claims sits at 724k through the week ending April 3rd, within 3k of the lowest total since the pandemic began. The corresponding uptick in job growth and moderate rebound of the civilian labor force during February and March reflects a labor market is entering a Spring thaw. Meanwhile, according to the March release of the University of Michigan’s Survey of Consumers, consumer sentiment during the month climbed to its highest level since March of last year. Taken as a whole, the economy appears to be gearing up for a high-speed joyride— so it’s understandable that some worry it may crash while rounding the curve.

Still, not all are convinced. “We expect that as the economy reopens and hopefully picks up, we will see inflation move up through base effects,” stated Fed Chair Jerome Powell during a press conference on March 4th. “But I do think it’s more likely that what happens in the next year or so is going to amount to prices moving up but not staying up and certainly not staying up to the point where they would move inflation expectations materially above 2%.”

Powell and economists who share his viewpoint note that the US has experienced persistently low inflation for decades. The lack of significant price increases, many believe, is mainly due to tepid investment and consumer demand, and technological advances that have lowered the real costs of starting a business or learning a new skill. Since January of 2000, Core-PCE inflation, a measure of prices for a basket of consumer goods that excludes food and energy prices and is the Federal Reserve’s preferred inflation metric, has averaged 1.7% year-over-year, 30 bps below the Fed’s current 2% target. For perspective, in the 20-year period that ended in December of 1999, core-PCE averaged 3.8% year-over-year. Even if the market fundamentals that have held down inflation for years now start to change, some experts note that because of this long saga of low inflation, the US economy and its consumers are in a unique position to absorb modest increases in prices, shall they occur. A similar school of thought has led the Fed to commit to allowing inflation to run above its 2% target for a short period once it reaches it.

Though the debate is likely far from finished, developments over the next few months should give clues as to which school of thought best aligns with the monetary paradigm in a post-COVID era. Market-based inflations expectations (measured by the spread between TIPS and Treasury Bills) have risen in recent weeks, bolstering Larry Summers and others’ claims. However, whether prices continue to accelerate after the impact of reopening and stimulus fades remains to be seen. For now, back to dinner table debates we go.