On the surface, inflation does not seem to be a problem in the American economy. Figure 1 reports Consumer Price Index for the entire U.S. economy, by annual rates reported monthly. The red line at the end of the horizontal axis marks the two-percent inflation target that the Federal Reserve adheres to (though with a much looser approach now than historically). Compared to inflation rates in the 1980s, and even the 1990s, our current rates seem like nothing to worry about:
However, if we look beneath the surface at specific items within the CPI, things look a bit differently. First, the CPI specific for food and beverages, a group of products that is relatively prone to price volatility. Figure 2 accounts for food-price inflation over the past 40 years:
There are five episodes in Figure 2 that inform us about the future of food prices:
- The high inflation rates of the late 1970s and early 1980s were due to a cost-push problem cutting across the economy. Its origin was in part the oil-supply crisis in the wake of the Iranian revolution. It began in January 1978 and lasted for about a year, with increasingly disruptive effects on oil exports from the Middle East. As a result, there was a price shock through the European and North American economies. However, that was not the only reason: the U.S. income tax system punished people who got inflation-compensating wage and salary increases; it was after this episode that Congress linked income taxes to inflation instead of capitalizing on them. The inflation-punishment effect became integrated into wage and salary contracts, contributing to cost-push inflation. Inflation generally peaked at 13.5 percent in 1980, while food prices increased at 8.5-10.5 percent per year for three years.
- This is a traditional high-growth, excess-demand type of inflation. In the late 1980s the Reagan tax reform had revolutionized household finances and put considerably more money into household pockets. It took a while for the economy in general, including the food industry, to catch up and grow its production accordingly. As a result, we saw food-price inflation rates above five percent for about two years, with two tops above six percent.
- This is a period of relative price stability. There are no dramatic shocks to either the supply side or the demand side of the economy. The exception is a brief spike in prices right before the Great Recession.
- Which happens to be the fourth episode of interest. For a short period of time we see food-price deflation. This is due entirely to the deep recession and consumer adjustments to tighter budgets. After a brief spike in prices right as the recession ends, prices return to relative stability, at least measured over time.
- This is the price spike in the 2020 artificial economic shutdown. We have not seen an inflation hike like this one since the cost-push episode four decades ago: all other peaks in food-price inflation since then have been caused by excess demand.
For this very reason, it is wrong to fall for the seeming inflation calm that is visible in Figure 1. As a statistical variable, consumer price inflation remains the same over time, but as an economic phenomenon it changes character over time.
What we have right now is a combination of the cost-push inflation from 40 years ago (though the origin is different) and monetary inflation. This combination is rare – in fact unique to the U.S. economy – and it is explosive in nature.
We can see the unusual inflation situation even more clearly in another product subgroup, namely appliances. The Bureau of Labor Statistics does not report this subgroup any further back than to 1998, but the period gives us enough data to note how two different causes of inflation can look very similar. Behold the A and B episodes in Figure 3:
Episode A is the result of the strong Trump economy, when home construction was growing rapidly and consumer finances had improved markedly after the tax reform. This spike in appliance prices is characteristic for excess demand, or demand-pull, inflation.
By contrast, during episode B unemployment is high due to the artificial economic shutdown. Inflation should have been low, perhaps even replaced by deflation, yet since Congress spend enormous amounts of money on cash handouts to households, the regulatory supply disruption correlated with sustained consumer spending. The result is technically a hybrid between demand-pull and cost-push inflation, but in reality has more cost-push characteristics to it.
Again, the monetization of those cash handouts means that we have set a dangerous form of inflation in motion. It is not yet present in all parts of the economy; as we will discuss in Friday’s economic newsletter, there are sectors where we still see some deflation. However, the the sectorial differences are of less importance than the nature of the inflation we have. What matters is, therefore, that we don’t stare ourselves blind at the numbers, but understand the mechanisms behind them.
When we do, we see forces building up for high inflation, forces that can best be thought of as the lava piling up underneath a volcano before it erupts.