Many of those today who are concerned about rising inflation in the United States are likely to disagree, but the US Federal Reserve (Fed) should be rewarded with an Olympic lap. Just look back and see what the Fed has accomplished in the last two years.
By this time of year in 2020, the covid-19 pandemic had caused a gigantic drop in employment of 14% as large sectors of the economy were forced to close. And while employment rebounded as activity began to reopen, it still remained 7% below its pre-pandemic level.
Recovering that remaining 7% was always going to be difficult, because it required a new division of labor. During the disappointing, anemic and unsatisfying recovery from the Great Recession a decade ago, the rebuilding of the fabric of the labor market occurred at a pace that pushed employment up just 1.3 percentage points a year. As demand was weak and grew very slowly during that period, it was hard to figure out which business models would be profitable and where labor would actually be needed.
This time, the reconstruction happened at much faster pace. Employment increased by 5% in just one year, because the Fed and the Administration of US President Joe Biden did not take their foot off the accelerator too quickly, as their predecessors had done in the early 2010s. we should see today’s economy as a huge political victory—perhaps the biggest I’ve ever seen in America. Fed Chairman Jerome Powell and his colleagues should be very proud.
Higher inflation, as a side effect and as a consequence of the robust recovery, was inevitable and therefore not something to lament. When you quickly rejoin freeway traffic at full speed you are going to leave tire marks on the asphalt. The question now is what will happen next. The bond market seems to think that this wave of inflation will pass, and that price stability will return in the medium term. The market currently anticipates that in the next five to 10 years inflation will average 2.2% per year.
It is always possible that the market is wrong. But, in this case, I believe in your opinion. One can trust the bond market not because it is a good forecaster (it is not), but because of what it tells us about expectations. If current US inflation doesn’t dissipate quickly, it will be because people didn’t expect it to. Fortunately, as Joseph E. Gagnon of the Peterson Institute for International Economics points out, the people whose expectations matter here are essentially the same people who bet on the bond market.
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From a broader historical perspective, there were six episodes of US inflation above 5% in the 20th century. One occurred during World War I, but this inflation turned into substantial deflation and a deep and short recession, due to what Milton Friedman later determined to have been an excessive increase in interest rates (from 3.75 % to 7%) by the Fed. Another episode occurred during World War II, when inflation was tempered with price controls. The next two occurred after World War II and after the Korean War, when inflation turned out to be transitory and passed rapidly without substantial monetary adjustment. And the last two came to define the decade of the seventies. The final episode ended up being checked by a deep recession after huge interest rate hikes by Fed Chairman Paul Volcker.
Regardless of whether they realize it or not, all those who present arguments about the probable course of inflation today are not based on theoretical principles, but on arbitrary historical analogies. Some, like the shrewd Olivier Blanchard, who was my teacher, see the seventies as the best analogy. But while this may be correct, his argument is weak. The 1974 bout of inflation followed a previous inflation episode that had changed expectations. In 1973, people thought that the rate of inflation, absent a recession, would stay around what it had been the year before—if not a little higher. By contrast, I don’t see any evidence today to suggest that US inflation expectations have become unanchored.
Likewise, employment in the United States remains 7.3 million below its pre-Covid trend. In a recent paper, Lawrence H. Summers (another shrewd former teacher of mine) and Alex Domash attribute a 2.7 million job shortage to structural factors such as an aging population and immigration restrictions. But there are still 4.6 million people who have dropped out of the workforce, but may be tempted to return by a strong enough economy. This potential pool of labor reduces my fear of an inflationary wage spiral, which happens when employers try to hire more workers than are available.
In addition to spiraling wages and prices, the other two frequently blamed culprits for non-transient inflation are bottlenecks in supply chains and self-fulfilling expectations. In all three, the only potentially serious risk is that we may not be able to resolve key disruptions in supply chains.
That brings us to the bad news. Supply chain risks may have become more acute now that Russia’s war against Ukraine has sent oil and grain prices into an upward spiral, as they did in the early 1970s. Thanks to Russian President Vladimir Putin, the 1970s may turn out to be the correct analogy after all.
J. Bradford DeLong He is a former Deputy Assistant Secretary of the US Treasury, Professor of Economics at the University of California, Berkeley, and a Fellow at the National Bureau of Economic Research.
© Project Syndicate 1995–2022
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