America's economics writers seem to want to work themselves into an incautious panic about inflation
I know, I know, I just said I wouldn’t write about inflation again for a while, but the discussion that’s unfolding online is driving me nuts. It seems to me that there’s a real lack of perspective and, often, a real disconnect between what people are arguing and what we think we know about how the economy works. A few points.
First, we don’t want to isolate ourselves in a bubble and convince ourselves that inflation isn’t out there having a painful effect on household budgets, but at the same time we need to keep things in an appropriate context. So for example, gasoline has gotten more expensive over the past year, and quite a bit more expensive than it was early in the pandemic, and high gas prices are a thing that people notice and don’t like. But gas prices are by no means at absurdly or historically high levels. Nationally, gas is at about $3.4 a gallon. In the early 2010s, that was just what the gas price was over a period of years, and immediately prior to the financial crisis gas jumped over $4 per gallon. In real terms, current gas prices are substantially below the levels of the early 2010s and mid 2000s.
Relatedly, people need to be careful in arguing both that soaring wages are about to set off a wage-price spiral and that high energy costs are a big inflationary problem. Rising energy prices work something like a tax increase: they are contractionary. If expensive gas and electricity are squeezing disposable income, then people will need to cut back on other spending; and indeed, one of the conclusions that holds across the literature on the economic effects of energy shocks is that durable goods consumption tends to fall as a consequence. So while rising energy costs contribute directly to higher inflation during the period in which energy costs are going up, they also contribute to weaker demand, which is likely to reduce inflationary pressure over the medium-term. And meanwhile, the direct effect of energy on inflation ebbs as energy prices plateau, and goes into reverse when prices fall.
But even without energy costs squeezing budgets, how likely is a wage-price spiral to emerge anyway? This is an area where a lot of inflation worriers are implicitly making pretty radical arguments about structural change across the economy without showing their work. Just to remind people, two short years ago it seemed clear that workers were in a very difficult position in terms of their bargaining power, and had been so for several decades. This seemed clear in several different ways. In March of 2020, Larry Summers co-authored a paper with Anna Stansbury which examined a number of significant features of the pre-pandemic economy—high profits, a falling labor share of national income, and low interest rates and inflation even in the context of very low rates of unemployment—and concluded that “the decline in worker power has been the major structural change responsible for these economic phenomena”.
This seemed very plausible and correct! People seem to want to argue now that tight labor markets alone are enough to fundamentally upend the prevailing labor-market power balance because low unemployment is translating into pay increases for low-wage workers which will further goose demand and keep labor markets tight. But we have very recent experience which suggests that things are not likely to work this way. In 2019, the unemployment rate fell to 3.5% at a time when both the labor-force participation rate and the employment-population rate were much higher than they are now. And despite this, wage growth levelled off and the economy lost momentum—enough so that the Fed felt the need to cut interest rates. You can go back to the late 1990s, for that matter, to a time when unemployment was low and productivity was growing strongly, and yet wage growth did not accelerate ever upward.
Have things changed dramatically since then? It is certainly true that there are a lot of job openings per unemployed worker, and it’s very nice that several major retailers have begun paying wages substantially above the federal minimum. But if labor market tightness alone failed to generate sustained acceleration in wages before the pandemic, why should the story be different now? Demographic change? If you look at other rich economies with older populations than ours, you’ll generally find places with inflation that is persistently below ours. Unionization? As someone who feels that it would be good for workers to wield more bargaining power than they have in the recent past, I find the labor activism of the past year to be encouraging, while also recognizing that it doesn’t amount to very much on the whole. We are nowhere close to returning to the structures of the 1970s.
Does it seem reasonable that a company like Amazon will continue to hire at its recent clip, and continue to offer year-on-year pay rises like those it has recently announced into the indefinite future, even as the technologies to automate processes in its logistics hubs get ever better? Do you think your pay is likely to rise at 8% or more per year (we’ll grant you a 2% annual increase in your productivity, plus a 6% rate of inflation) over the next decade? How probable is it really that lots of jobless American workers are going to remain on the sidelines indefinitely, even as the flow of stimulus turns off and rising food and energy prices eat into their savings? If you’re going to either completely rewrite the economic history of the past few decades or suggest that a radical shift in labor markets has occurred, you need to do a bit more than link to an employment cost index which shows growth returning to the rates of the 2000s after a very long period of depressed increases.
About that long period of depressed increases. I know that the internet has given us all the memory spans of goldfish, but it was only a very short time ago that economics writers universally recognized the asymmetry in the costs of weak demand relative to inflation. The cumulative economic costs of weak growth in the aftermath of the global financial crisis ran, very conservatively, to about $4trn or so, or more than $12,000 for every man, woman and child in America. Estimates of the welfare costs of inflation are much, much smaller. I mean come on, are you all really up in arms about the efficiency costs associated with uneven adjustment of relative prices? For a decade the American economy suffered from depressed investment, from diminished earnings prospects among the young workers who entered a slack labor market, from the compounding costs of doing less with the talent and resources available to us than we could have done. There is simply no equating the welfare effects of current inflation and those of weak demand, and you should dismiss any argument which suggests that there is.
More narrowly, the American economy has grown faster over the past year than it would have in the presence of a smaller stimulus; comparison with other rich economies makes that clear. Given the large asymmetry in the costs of weak growth relative to high inflation, one has to assume, in a manner I think difficult to justify, that less stimulus would have generated a lot less inflation and only a little less growth if one wishes to argue that a smaller stimulus would have left Americans better off.
Ok, fine, but it’s the Fed’s job to maintain inflation around 2% and it isn’t doing it. Shouldn’t monetary policy be tightened right now? So, a very important thing to note is that the transitory versus permanent question isn’t simply about who is arguing what on Twitter. If a meaningful component of current inflation is transitory and is likely to peter out or reverse itself over the next 18 months or so, then monetary tightening now may end up being procyclical rather than countercyclical. That is, the Fed may end up placing downward pressure on inflation at a time when inflation is already falling, which is not what you want if you’re trying not to exacerbate the volatility of inflation and definitely not what you want if there’s a risk of substantially weakening or ending the recovery.
Now, it is certainly the case that the Fed has underestimated the magnitude of the inflationary impulse it’s dealing with, but that doesn’t mean it has misunderstood the trajectory of that impulse. And there are still very good reasons to expect inflation to decelerate in 2022. One is that by next year vaccines and treatments are likely to mean that Covid waves are no longer economically disruptive. Another is that labor force participation is likely to rise. But beyond that, an easing of various supply constraints may not merely mean that inflationary forces level off but rather that they become profoundly disinflationary. Firms have been ordering things flat out for fear of not having what they need, even as production capacity increases. Here, take this for instance:
Given this dynamic, even a small slackening of demand could quickly translate into a situation in which firms find themselves with large inventories, and in which production is more than adequate to satisfy the market. Where energy is concerned, fossil-fuel supply will respond more slowly to higher prices, given a reluctance to invest in new production. But there will be some supply response, and there will be some demand destruction, and the end of winter will bring additional price relief—especially if temperatures prove milder than expected.
None of this should be taken for granted. It should, however, be taken into consideration. Look, a 6% rate of inflation is high, and we’re likely to see still higher rates in the next couple of months. But there is a very big difference between a one-off 7% increase in the price level and 7% inflation year in and year out over a long period. That the world might experience a pretty big one-off increase in the price level as a consequence of the pandemic makes all sorts of sense, given that Covid caused massive production disruptions while governments provided lots of income support. That it should result in a sustained high rate of inflation is far less clear.
And while a one-off jump in the price level isn’t a lot of fun to go through, it may well prove very useful. For one thing, very rapid growth in nominal GDP this year means that America’s debt burden scarcely rose despite the government’s having run a massive deficit. But more importantly, the jump in the price level provides an opportunity to reset inflation expectations and the long-run level of nominal interest rates at a healthier level. It would be much better for the American economy over the long run if short-term interest rates were on average above 1%. The Fed’s new framework might be sufficient to allow that to happen, but we won’t get there if the Fed overreacts to the increase in the price level, tightens into decelerating inflation, and is subsequently forced to cut interest rates to prevent a recession.
What if those disinflationary pressures never really materialize? Then the Fed can tighten in a measured way until inflation eases. But there is no need to rush this. It’s important to think about the global context here. Even if America has somehow turned its economy on its head as a consequence of stimulus spending, such that labor is much more powerful than in the past and investment is substantially higher, the natural rate of interest across the global economy probably hasn’t moved very much. So as American interest rates rise, money is going to flow toward the American economy and the dollar is going to surge. A rising dollar will depress import prices, and also facilitate a flow of demand from America to the rest of the world. Indeed, we are already seeing a sustained rise in the dollar despite the fact that the Fed has barely begun tightening. We are not in a world in which the Fed has to smash the economy over the head and create a crushing recession to start cooling things down. The global financial system is just a very different place from what it was in the early 1980s.
This matters when it comes to the Fed’s asset purchases, as well. People are arguing that as far as central bank balance sheets go it is the stock rather than the flow that matters—which would mean that monetary policy continues to get easier even as the pace of asset purchases shrinks—and so asset purchases need to be halted immediately. But while one can find papers that support this view, one can also find papers which suggest that other channels, in particular the effect on expectations, are what really matter. In general, the literature on QE is unsatisfyingly inconclusive, and anyone who’s telling you that we have a clear idea how it works is selling you something you shouldn’t be buying.
What we can say with some confidence is that America is a monetary hegemon, and that what happens with American monetary policy has big effects on the rest of the world. Furthermore, those effects can and do wash back over the American economy. Now, over the past two years, a lot of emerging markets have taken on a lot of debt. Many are already struggling to deal with the effects of a stronger dollar on their currencies. There has, furthermore, been quite a lot of dollar borrowing among emerging-market firms in recent years, no small amount of which occurred in China. China is already struggling with serious troubles in its property markets, which account for a hefty chunk of Chinese growth, and both firms and households are facing the prospect of significant deleveraging in the months and years ahead.
Monetary tightening in America is going to mean straitened financial conditions across much of the world, and it is going to be more than some emerging markets can handle. To suggest that the Fed should introduce into this environment a major monetary shock, as a sudden end to asset purchases would be, is in my view the height of irresponsibility, even from the narrowest of perspectives in which only what happens in America matters. The Fed doesn’t need to introduce that kind of shock to get inflation under control, and it would be strongly advised to ignore the voices recommending this course of action.
All of which is to say that, yes, things are difficult in some important ways and are likely to remain difficult over the next year, but matters could also be far worse, and the quickest way to turn things from difficult to far worse is to lose one’s sense of perspective. The Fed should continue to taper its asset purchases as planned, and if inflation continues to surprise to the upside then it should adjust its guidance about future interest rate increases (as it may do anyway when it releases new economic projections in December). It is absolutely fine to worry about inflation and to have a debate about what the right response ought to be. But it seems to me that some of what presents itself as sober commentary about the state of the economy in fact represents a counsel of panic, which is the last thing we need right now.
Should outsiders tell China what it is doing wrong ? For example funding local government through property sales. Not only is real estate made bubbly, but there is no brake on spending, no feedback.
The bigger question is, as always, do we offer help to a geopolitical rival.