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 — at more than 9% — and it may never return to 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.
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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 policy makers can pick an inflation number, maintain it, and all will be well; that Americans will always know what our dollars are worth.
That certainty has a lot of 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 — especially to low earners on tight budgets. The same principle applies to your income. Knowing how much beef and gasoline will cost helps you plan and budget. So less certainty around prices means your income is less valuable. Essentially, the additional risk amounts to a wage cut.
Inflation going forward will not only be higher, but also less stable. And there are reasons for that.
History has given us 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 at the wrong time. High and unpredictable inflation was a feature of much the post-World War II economy. But it seemed economists had figured it out in the 1990s. If we just picked a target, say, a 2% inflation rate, it would become a self-fulfilling prophesy. People could rely on that level of inflation because the Federal Reserve could make it happen, and wages and prices would rise, accordingly.
When I was in graduate school, I was taught that best practice in monetary policy is to target a certain level of inflation, say 2%. But one of my professors from those days, Jean Boivin, now Head of the BlackRock Investment Institute and former Deputy Governor at the Bank of Canada, recently argued that economists may have not have actually solved the inflation problem after all; We may have just been very lucky.
Between more trade and globalization, especially with many goods coming from cheap-labor countries, the global economy had an over-abundance of stuff. More technology made that stuff — and services — 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. It appeared inflation was a problem of the past, something competent technocrats could manage.
Covid-19 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 checks, and paying for it by having the Fed buy the debt incurred from the spending, is inflationary. Add in the 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.
Read the full article here by Allison Schrager, Advisor Perspectives.
