Will the inflation spike be temporary?
A flurry of recent reports highlighting a surge in the price of raw materials, commodities and crops has set off alarm bells in some quarters. Emergence of labor shortages alongside upward wage pressure has provided inflation worriers with further cause for concern. Some are drawing parallels to the inflationary dynamics prevalent in the 1960s and fretting about a potential replay of the “1970s Great Inflation” episode.
The Federal Reserve (the Fed), meanwhile, is betting its hard-earned credibility on the notion that any inflationary surge will prove to be temporary. The Powell Fed has ruled out any sort of monetary tightening in the near-term as officials remain convinced that most price shocks will be transitory. The central bank even appears willing to tolerate above-target inflation rates for a while in order to achieve a full labor market recovery.
A recent speech by Mary Daly, president of the Federal Reserve Bank of San Francisco, clarified the central bank’s policy stance: “We will need to continually reassess what the labor market is capable of and avoid preemptively tightening monetary policy before millions of Americans have an opportunity to benefit. These efforts are critical to support the broad economy and aid the inclusion of historically less advantaged groups, including people of color, those lacking college degrees, and others who face systemic barriers to equitable employment and wages.”
U.S. policymakers are engaged in a historically significant expansion of fiscal policy’s role (aided by accommodative monetary policy) in order to rewire the U.S. economy and reduce economic inequality. Their strategy is influenced to a large extent by the fact that inflation undershot the central bank’s 2 percent target for much of the post-financial crisis period. Even when the unemployment fell to around 3.5 percent just prior to the pandemic shock, inflation remained largely subdued.
It is, however, worth highlighting the crucial differences between the post-financial crisis situation and the current one. First and foremost, both U.S. households and financial institutions have strong and healthy balance sheets at present. In contrast, following the 2007-09 financial crisis, American consumers and banks were burdened by high debt levels and were forced to undergo a lengthy period of deleveraging, which hindered the pace of economic recovery. This time around, fortified by unprecedented levels of fiscal stimulus and aggressive monetary easing, private sector demand is expected to recovery rapidly. Pent-up demand is likely to be unleashed as households, buoyed by record high net worth and excess savings, embark on a spending spree. Early signs of supply-demand mismatches and price spikes suggest that the post-pandemic recovery will be characterized by robust aggregate demand.
A second crucial distinction is in regards to the pace of labor market recovery. Post-financial crisis labor market recovery was painfully slow as it took years for widespread improvements to materialize. This time around, U.S. labor market appears to be healing relatively fast — job openings at U.S. companies are already close to their pre-pandemic levels. In fact, there appears to be far less slack in the labor market than many had predicted, and wage growth is already picking up. While generous unemployment benefits may be a temporary factor hindering labor supply, there are also several pandemic-related developments that may cap U.S. labor force participation. For instance, those able to afford it are taking early retirement in increasing numbers. Meanwhile, many professional women are deciding to reset their work-family balance. Some workers have even decided to abandon stable careers for a more adventurous lifestyle.
A third noteworthy difference between the post-financial crisis period and the current recovery phase is related to developments involving the broad money supply. Fed actions during and after the financial crisis resulted in a massive increase in the monetary base (primarily due to a large increase in bank reserves). But this did not lead to a substantial change in M2 money supply (a sharp decline in the money multiplier was the culprit). Over the past year, however, M2 money supply has grown at an extraordinary clip. A decline in precautionary money demand and a recovery in transactions volume (which should boost the velocity of money) could fuel inflation in light of the astonishing surge in U.S. money supply.
An inflation spike in the near term is widely expected. For April and May, base effects are likely to exaggerate the annualized rate of inflation. Reinvigorated consumers and their changing spending patterns are likely to create further supply-demand mismatches and generate inflationary pressures. Is the expected spike in inflation largely a result of temporary factors associated with the unwinding of disinflationary forces unleashed by the pandemic shock or does it signal a lasting shift in underlying inflation dynamics?
There is considerable uncertainty regarding inflation pressures over the medium term. Whether and when the Fed decides to unwind its extraordinary stimulus measures will be a critical determinant of its credibility and affect its ability to keep inflation expectations well-anchored. Inflation expectations may potentially become unmoored given the Fed’s recent shift to an outcomes-based policy framework. The extent to which employers have to raise wages to encourage workers to rejoin or remain in the workforce will be a key factor affecting inflation. Productivity improvements could, however, offset some of the cost pressures facing firms. In the international context, rising twin-deficits and exploding U.S. public debt levels suggest dollar weakness over the medium run. This, in combination with the expected trend towards near-shoring of global supply chains, is likely to make U.S. imports costlier in the years ahead.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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