The inflation beast is harder to tame than we had assumed
PremiumOur control illusion lies shattered and we may have to live with it
We woke the beast, and now we may have to learn to live with it. After more than 20 years of low, stable inflation, it’s come roaring back in the US—at more than 9%—and it may never return to its pre-pandemic levels. We’ve already lost the benefits of our former economy: low interest rates and pay raises that actually make you richer. Now we also have to manage a new risk in our lives, the beast we thought we had tamed.
The pandemic changed many things, and it’s forced me to give up, reluctantly, my long-held belief that inflation is something we know how to control; that policymakers can pick an inflation figure and hold it steady; that we always know what a dollar is worth. This certainty has value. If you have two different assets with the same average return, but one is more volatile than the other, the risky asset is worth less. The same applies to income. Knowing your expenses helps you plan and budget. So price uncertainty means your income is less valuable. In essence, it’s a wage cut.
Inflation now will not only be higher, but also less stable. We have a long track record of missteps in monetary policy. Central banks cause more inflation by printing too much money, or by cutting interest rates too much. High unpredictable inflation was a feature of much the post-World War II economy. But it seemed economists had figured it out by the 90s. A target of, say, a 2% inflation rate could be a self-fulfilling prophesy, as the US Federal Reserve could make it happen and all wages and prices would rise accordingly.
In graduate school, I was taught that the best practice in monetary policy was to aim for a certain level of inflation, say 2%. But one of my professors from those days, Jean Boivin recently argued that economists may have not have solved the problem after all; we may have just been very lucky. Between more trade and globalization, especially with goods coming from cheap-labour countries, the global economy had an over-abundance of stuff. Technology made stuff even cheaper. Demand went up and down, causing recessions from time to time. But central bankers were pretty good at managing a demand-driven economy, and so inflation stayed low and stable. We knew how to manage it.
Covid shattered that illusion. The world shut down and there was less trade. Supply contracted in a big way for the first time in decades. This sparked inflation all over the world. But inflation is higher in the US because of our policy choices. Economists still don’t have great models to predict inflation, but we do know that sending everyone cheques, and paying for the bill by having the Fed buy the debt incurred, is inflationary. Add shrinking supply, and we have the worst inflation in 40 years. It’s not only high, but it also keeps surprising us. And the uncertainty is almost as bad as the higher prices. The longer inflation is high and unpredictable, the more it gets baked into wages, interest rates and expectations; it seeps into the bones of the economy and it’s very hard to get rid of.
The inflation problem we face is a supply and demand problem. The Fed can only influence demand, but that still gives it the ability to lower inflation. Lower doesn’t mean back to a reliable 2%, though. Even if the Ukraine war ends and China’s economy goes fully back online, supply constraints may remain. Between less globalization, ageing populations and our goals for a greener economy, we may end up with a supply chain that’s less reliable and slower growing. This means less-effective monetary policy going forward.
Even before the pandemic, there were flaws in the idea that the Fed could choose America’s rate of inflation. Inflation was below-target for years, no matter how low the Fed kept rates. Now many economists are speculating that once the Fed gets inflation down to 4% or so, it may give up on tightening further, especially if we are in a recession by then. At that point, we will have years of above-target inflation after all those years below-target. The Fed’s 2% goal will start to feel like a cruel joke, stripped of the credibility it once had. Americans will have to adjust to living with higher inflation and less certainty about what their money is really worth—and that represents a big decline in our welfare.
It also means our monetary policy needs a rethink, starting with less hubris at the US Fed. The central bank can help manage demand and—if it avoids adding to its recent mistakes—make inflation a little less volatile. But between continuing supply issues and less Fed credibility, it will no longer offer the predictability that Americans are used to. We must learn to live with more uncertainty and let go of the comforting illusion that technocrats can manage this big source of risk in our lives. If it’s any consolation, we know now it was always an illusion.
Allison Schrager is a Bloomberg Opinion columnist covering economics and a senior fellow at the Manhattan Institute.
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