Inflation is becoming a real problem for the U.S. economy, and – just as I have predicted – so long as Congress maintains its reckless fiscal policy, inflation will set roots, dig in and entrench itself. This will affect us all, and – contrary to what some pundits suggest – not for the better.
As measures of inflation hit a 30-year high, the Biden White House is abandoning its happy talk that inflation would be a short-term side effect of the economic recovery from COVID-19 restrictions. White House economic adviser Jared Bernstein told Fox Business that inflation will endure longer than the Biden administration had been saying. His current call is that annual inflation will end at about 4 percent this year and drop to 2.3 percent at some point in 2022. However, even Bernstein said there is no clear idea when in 2022 that might happen.
According to the CPI-U, the consumer price index that covers all consumer goods, the September annual inflation rate of 5.4 percent is the highest in 31 years. Back then, the U.S. economy was at the end of the Reagan growth period and the inflation we saw back then was so-called demand-pull inflation.
The 5.4-percent rate is based on raw CPI data, in other words not even seasonally adjusted. I try to avoid seasonal adjustments and other statistical trickeries, which are often aimed at smoothing trends to make them either look better or give a more purified long-term view of the economy. However, such technical adjustments of raw data always distance the statistical consumer from reality; rather than making things look good from an optical or analytical viewpoint, I prefer to remain as close to reality as we can get. That way I can guarantee accuracy to the highest possible degree in my analysis.
However, there are more important metrics for inflation than a simple year-to-year calculation. The first of those metrics is the year-to-date rise in prices. While the calendar year itself is only a technical construct to give us a measurement of time, in actuality it carries high symbolic value in the political and economic public discourse. For example, the year-to-year comparisons that have appeared in media are ultimately based on calendar year, even when they run the comparisons month to month.
Therefore, in order to track where inflation is heading this year, let us go back to the start of the year and see just how much prices – measured again as CPI-U – have increased thus far through 2021. Figure 1 compares this year to 2019, which was the last year of the Trump economy and the last year before the artificial economic shutdown. So far this year, consumer prices have increased by almost 4.9 percent; by this time in 2019 they had gone up by just two percent:
The scary part about the consumer price trend is that it shows inflation both being resilient and rising. We have five months in a row now with 5 percent or more annual inflation; by this time in 2019 we had seen only one month where inflation exceeded two percent (April). Furthermore, we have underlying inflation pressure from producer prices: in 1990, again the last year with sustained 5+ percent inflation, consumer prices rose at a pace 1.5 times producer prices; this year so far, producer prices have outpaced consumer prices by 3.8 to 1.
What does this tell us? that we have strong inflationary pressure from producer prices that has not yet worked its way into consumer prices. It is, in fact, the strongest such pressure in any non-recession year since at least 1980. Therefore, it is highly likely that we will see sustained inflation for a number of months going forward. Which, by the way, is why the Federal Reserve is now signaling a change of tone on inflation: after having talked about it as transitory for the better part of this year, they are now ready to admit that inflation is here to stay for some time.
Some people think this is good. One of them is economist Karl W Smith, formerly with the Tax Foundation, now a Bloomberg columnist. His latest contribution is an argument that higher inflation is a really good idea:
Analysts are concerned that the rise in inflation may be persistent because they see hints of a broader, gentler rise in prices across a range of goods — and, crucially, in the wages of the workers who produce those products. This increase in both wages and prices can lead to the dreaded wage-price spiral.
Not necessarily. There are a number of conditions that have to be met before that spiral gets moving. Most of the research that suggests the existence of this spiral is based on European economies with highly centralized, union-contract based wage negotiations. That does not mean the spiral does not exist in the U.S. economy, but it is far from as obviously a threat here as it is in, e.g., the Scandinavian countries. In fact, our decentralized wage setting structure allows for labor productivity to play a bigger role in mitigating the spiral than in unionized economies. The more productivity affects wages, the smaller the transmission from wage hikes to price hikes.
That does not mean inflation is not a threat to household finances. Inflation caused by bad fiscal and monetary policy lives its own life in the economy, a point that Smith seems to overlook when he says that because inflation
is shared by both households and businesses, the pain is muted. Indeed, a higher rate of inflation, and correspondingly higher wage growth, could be a net positive for the economy.
Nonsense. No inflation is “shared” by businesses. All inflation eventually trickles down to workers. One of the most sure-footed ways this happens is through the long-term effects of the very higher inflation rates that Smith advocates.
Sustained high inflation means more long-term uncertainty in business activities, especially investments. If inflation sustains at a high rate, it has a more upsetting effect on relative prices than if inflation is low. Bluntly: unless all prices rise at the same high pace, a high inflation rate creates larger “gaps” between prices throughout the operations of a business; every such gap injects uncertainty into business planning; the bigger compounded uncertainty is, the less inclined the business is to invest in the future of the business.
A decline in capital formation – even relative in the form of a slowed-down pace of investments – has a negative effect on labor productivity. This in turn weakens the actual support for wage hikes. If inflation stays high as productivity gains weaken, there will inevitably be a price to pay for workers in the form of declining real wages.
Or significantly higher unemployment. Or both.
Smith also makes the argument that higher inflation weakens the cost of debt:
A permanent increase in inflation from 2% (its average over the last decade) to 4% would cause interest rates to rise by roughly 2% as well, as lenders sought to protect themselves from rising prices. Economists describe this as a rise in nominal rates, because the net return from lending — the real interest rate after accounting for inflation — remains the same.
Smith is relying on the Keynes effect on real balances, and he has a point. However, it hinges on a balanced response in interest rates to higher inflation. Most prominently, Smith’s argument presupposes that the Federal Reserve does not roll back its monetary expansion as inflation rises. He might even be assuming that the sustained higher inflation is driven by a continuation of the Fed’s currently highly accommodative monetary policy.
The problem here is that to sustain inflation at the rates we already have, by means of expansionary monetary policy, is to play with inflationary fire. There is no more dangerous form of inflation than that which is driven by monetary expansion – it is not to be confused with supply-side inflation, which is what we saw 40 years ago. Furthermore, the monetary expansion becomes even more dangerous when it is directly linked to fiscal policy:
- When the purpose of that monetary expansion is to fund a government deficit, and
- When that deficit is used to pay for entitlements that are to a large degree inflation indexed,
you have an inflationary death spiral going in the economy.
I am not saying that Karl Smith actually proposes monetary expansion to drive U.S. inflation, but he also does not refute the idea. But where else would he get the sustained, higher inflation he wants? As a rare voice for higher inflation, he might want to clarify the macroeconomic context of his pro-inflation argument, because it is a safe bet that he will soon have others on his side. There are a lot of Democrat politicians and pundits out there who would love to find a way to defeat the inflation argument against more deficit spending.
Inflation is a reality in the U.S. economy. It cannot ge higher without causing long-term harm; it is already at a level where it can change economic behavior for the worse.
At the core of the inflation problem we have the Democrats’ desire to spend endless amounts of money by means of monetized deficits. This makes it particularly difficult to fight to keep inflation out of the economy, yet precisely because of the grave dangers associated with ongoing monetized budget deficits, we absolutely need to continue that fight.