Stagnation without inflation
Something funny happened on the way to the Federal Reserve’s latest interest rate hike. On June 15, the Federal Reserve boldly raised its interest rates by 75 basis points, or 0.75 percentage points. It’s a sharp rise for a company that usually tries to move gradually.
Why the rush? Federal Reserve Chairman Jerome Powell has made it clear that he and his colleagues fear that inflation expectations are “slackening,” with some economists arguing that this could lead to “rooting” of inflation. (Loose anchoring, contrast metaphor takes time to call the police!).
Powell said one factor influencing the decision was an improvement in the University of Michigan’s long-term inflation expectations, which he described as “significant.” I and others have cautioned against relying too much on the one-month figures, especially since other measures of expected inflation don’t point in the same direction.
To be fair, Powell acknowledged that this is a prime number that can be revised. Of course, the figure has been revised to a lower level. However, inflation expectations do not appear to be slipping.
Indeed, the big story right now is the sharp drop in market expectations of medium-term inflation. The five-year equilibrium, the interest rate difference between ordinary U.S. government bonds and inflation-protected bonds linked to consumer prices, is an implicit expectation of inflation over the next five years, and has declined by one percentage point since March. The underlying picture is better than this number because investors think we may have a year or so of high inflation before we return to the Fed’s long-term target of a 2% inflation rate. The PCE deflator is slightly lower than the CPI. Earlier this month, a market-based estimate (somewhat in line with others) pegged inflation at 4.4% next year, but only 2.2% over the next five years.
Why are these ratings important? Not because financial markets or consumer surveys are particularly good at forecasting inflation, neither of which predict a rise in inflation in 2021 and 2022, but because most economists believe that expected inflation is an important determinant of actual inflation.
Let’s think of prices that are set a year in advance, like many wage contracts, house rents, and so on. In an economy where everyone expects a 10% pay raise in the next year, even though the supply and demand for workers are roughly balanced, employers tend to offer a 10% increase each time they revise salaries.
Once inflation stabilizes within expectations, it can become self-sustaining. The only way to lower it in the rankings is for a long period of time when demand is less than supply, i.e. stagnation. This is not a hypothetical scenario, but rather what actually existed in the early 1980s, when everyone expected high inflation to continue, and it took years of high unemployment to bring things under control.
Understandably, the Federal Reserve does not want to find itself in this situation again, so it is highly sensitive to any signs that projected inflation is spiraling out of control. Currently, no such symptoms are known. In fact, there is some evidence that the Federal Reserve may be on the verge of making the opposite mistake of what happened last year.
At the time, the Federal Reserve failed to act and did not predict the current rise in inflation. Is he now lagging behind, but in the opposite direction and not seeing an immediate decline in inflation? To be fair, official price figures do not yet show a slowdown in inflation.
Actions that exclude volatile food and energy prices, or extreme price moves that indicate more stable core inflation at 4%, which the Federal Reserve considers unacceptably high. But unofficial numbers, some of which are more recent than official data, indicate that several forces have recently pushed inflation in the opposite direction.
For example, do you remember shipping charges? Going down. Overall, the supply chain problems that caused the price hike turned in the opposite direction. Major retailers have said they have too much excess inventory and are planning to cut prices in an effort to pull items from shelves and warehouses. Why is inflation falling so fast?
Regardless of special factors like the war in Ukraine, many analysts, myself included, attribute rising inflation in the U.S. to government spending and easy money overheating the economy. But despite this warming, the rate at which inflation has increased is surprising.
Historical evidence suggests that the Phillips curve is very flat, or in other words, that the inflation rate is not very sensitive to how hot or cold the economy has been. But that’s not how it looks in 2021 and 2022, leading many economists to conclude that the relationship between jobs and inflation is strengthening as the economy approaches capacity. But if inflation is very sensitive to upside demand, it will also be very sensitive to the downside. With mounting evidence that the economy is weakening too quickly, it is now possible that the economy actually contracted in the second quarter, and it seems reasonable to suggest that inflation will also fall quickly.
However, this is what the markets expect. Now, this progress against inflation, if it happens, will come at a cost. It is clear that growth in the US economy is slowing, and the contraction may be severe enough to be considered a recession, and it will be moderate. Since inflation takes some time to fully reverse its rise, there is a good chance that we will see a short-term economic stagnation with constant inflation, i.e. “stagflation”.
But if I and the markets are right, the “inflation” part of the term won’t last long. Sooner than many think, the Federal Reserve may retreat by trying to exit “recession” territory.
American academic and Nobel laureate in economics.
Published by special arrangement of The New York Times Service.
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