Inflation May Have Peaked. Overreacting Brings Major Risks

Whether you are an “average” American, a central banker, a CEO or a parking attendant, inflation is now the primary economic concern for most Americans. A significant portion of Americans believe that inflation is their number one economic concern. This was evident in polling. All economic releases point to higher inflation. This includes the latest government report which showed prices increasing 8.3% annually. News reports about high inflation fuel general concern about rising prices. Increasing gasoline costs and grocery costs, along with increasing interest rates which make it more expensive to mortgages, all add to the confusion.

There is now a broad consensus that inflation is not only too high but that there’s no immediate end in sight. Therefore, the Federal Reserve’s aggressive rhetoric about increasing the rate of short-term inflation more quickly and significantly led to the Bank requesting a 50bps rate rise in May. This is why the Democratic Party panic (and the Republican glee) about the possibility that voters would hold Democrats to account for higher prices during the fall midterms. But a consensus about future outcomes doesn’t mean certainty about future outcomes. Perhaps it is true that there is an increase in inflation. What if, as so often happens, the consensus is wrong? What if those who last year said that inflation was, the words of the chair of the Fed Jerome Powell, “transitory,” were more right than wrong even though they underestimated how long transitory would last? How could it be that the inflation paranoid has been a result of being on constant guard for years?

Larry Summers, former Treasury Secretary and Obama’s economic czar has been the most vocal inflationist of recent years. He warned the size of the federal COVID-19 aid bill in early 2021 combined with very low interest rates would trigger inflation, and he has been loudly critiquing the Fed for being “behind the curve” in its delayed willingness both to raise interest rates and to curtail its policy of buying bonds to bolster the markets. After inflation has been rising for several months, he is doing the rhetorical equivalent of victory laps. He has also been citing others as part of an argument that, for the first-time since the 1970s, the inflation “genie” has been released, which could have unpredictable and possibly destructive consequences.

Until 2021, inflation had been the proverbial dog that didn’t bark, but that only solidified a view especially prevalent in the financial community that when inflation eventually did rear once again, it would do so with a vengeance. This thesis was based on the fact that, despite the absence of inflation for many decades (especially since 2008-2009), the global central banks artificially kept the money price low. The result was that, while the real inflation was not visible in goods like gas, food and furniture, there was a lot of hidden inflation in stocks and homes. What’s more, the efforts of central banks to keep markets liquid was simply delaying the inevitable.

That inevitable arrived in 2021 when the combined effects of a waning pandemic and trillions of dollars in government stimulus in the U.S. and around the world led to an explosion of pent-up consumer demand, which completely deluged global supply chains that weren’t staffed or prepared. For example, the scarcity of chips and glass for cars caused by the Russian invasion, which sent agricultural and commodity prices skyrocketing. We are now in an inflation spiral because the Fed kept interest rates low.

It certainly describes what happened in the previous year. This isn’t the same as saying what the next year will look like. In the most recent report, the 8.3% number got the most attention, because that confirmed the current narrative of “inflation is out of control and the Fed is behind and the government has overspent.” But the month-over-month increases have been plateauing in recent months, except for energy costs which the Fed can’t do much about and has more to do with the disruptions stemming from the embargoes against Russia.

The monthly rate of inflation has been slowing compared to the year-over-2018 pace and is showing signs of stabilizing. Additionally, inflation will be able to begin to show comparisons to the mid-to-late 2021 period, which was when prices started to recover from the pandemic slump. This means that the Fed’s rate hikes will not have any effect on headline inflation, which measures the change in prices year-over-year.

While inflation is an economic fact, it can also be a highly charged term and experience. Every central bank has a mission to combat inflation. The political crises of and the subsequent wars of the 20th century all began with intense periods of price stability. In Weimar Germany, inflation was seen as the main cause for the rise in Nazism. The main problem from 2000 to 2021 was deflation and lower growth. However, in bankers’ and policymakers’ minds the fears of inflation outweighed the difficulties of deflation. With real inflation now in the past generation, dormant concerns have been raised. And fear can grip not only our current sense but also foreboding about what the future holds.

It is not the best way to approach policymaking. Nor is the “I told you so” mantras so prevalent now. It is possible for political opponents to office to use inflation to strike those in power. However, neither fear nor political opportunity nor reputation burning are great foundations to assess where we are at the moment.

This month’s inflation surge is understandable in light of high government spending, pent up demand, disruption to global supply chains caused by politics and the Russian invasion of Ukraine. All of those are indeed “transitory,” even if the length of transitory is longer than a brief few months. However, this is far from the chronic inflation which now calls for draconian central bank action. This goods-and services inflation is a result of higher wages, which has undoubtedly been a positive thing. It would be a travesty if in trying to dampen inflation, policymakers manage to increase unemployment and lower wages in a “we had the burn the village in order to save it” approach. And of course, the deflationary effects of technology haven’t gone away, even as they are currently less potent than the forces above.

At a time when the consensus says fight inflation now at all costs, it’s vital to untangle the web of fear and assumptions about the future that are combining to dictate a draconian policy response that may be unnecessary. Recent years were marked by a global pandemic response that was unprecedented. Maybe we need to wait longer before we presume that we have a good idea of how things will turn out. If we don’t, we may be poised to inflict more harm than necessary to fight a problem that has already peaked.

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