Where do we go with inflation?

Inflation is a concern on the minds of many right now. Let’s get it out of the way right now, this is both a simpler problem than some make it out to be, and simultaneously more complicated. There are not necessarily easy answers to address this issue and certainly not immediate answers. Headlines right now talk about the highest inflation measures in 40 years. Fair enough, but what if we look just beyond this headline grabbing, and purely artificial time horizon?

Just beyond that 40 year window is a period of significantly higher inflation. (I calculated this as the YOY percent change in the CPI.) What do we take away from this then? We are coming off a very long period of lower, stable inflation. That period was preceded by much higher inflation levels. Are we seeing a return to the situation of the 1970s? It seems unlikely, and at the very least the Federal Reserve knows what worked in the past to address that kind of problem.

The 40 year time frame is artificial and worse, in this situation, leaves out a time period that bears similarities to what we see currently. The 1970s inflation had an external driver, the oil price shock from the embargo. Covid, the associated policies and adjustments, and the economic fallout of all of the above are, in many ways, a similar exogenous event. There is one major difference though, we have been here before.

We saw this type of inflation, and we addressed it with high interest rates. Now the Volcker deflation is hardly a scientific exercise (not a surprise that inflation comes down when you push rates near 20%) but did generate policy credibility for the Federal Reserve as an inflation fighter. We can see that the Fed Funds Rate (a key policy rate) has been incredibly low for the last decade, a significant difference compared with the earlier high inflation period.

The Fed kept rates too low for too long and then an exogenous event occurred (let’s not act like the Fed should have predicted pandemic) with associated supply-side and demand side issues. Let us not forget there was a significant fiscal response at the same time that contributes here as well.

Let’s talk big picture though. The simple fact is that monetary and fiscal policy did not get themselves figured out after the Great Recession and the financial crisis in 2008. The current fiscal policy is either a regime of “borrow and spend” or “tax and spend” with no real consideration of consequences. Monetary policy kept an accommodative stance for too long, in large part I suspect because Powell was afraid to cross former President Trump whose approach to monetary policy resembled an individual that speculated in real estate and had a history of bankruptcy (go figure). These issues notwithstanding it is also clear that the Fed can raise rates without necessarily creating significant restrictions on economic activity given its current position. It can, and should, start some degree of normalization.

Inflation is a big issue and nothing I write should be interpreted as trivializing the situation facing those on fixed or lower incomes. The biggest problem with inflation, in my opinion, is the adjustment to relative benchmarks. Inflation is not a uniform force and it impacts the prices for different goods in different ways. Consumers need to learn the new relative prices, how many gallons of milk equal a half pound of bacon, and so on. Over time consumer substitute and preferences change, so some of these factors will not be fixed either.

We should expect continued adjustment and continued hiccups, especially on the supply side as geopolitical and business/industry supply chain situations search for resolutions.

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