Inflation Hawks on the Path Toward an Inflation War

January 13, 2022

The continuous drumbeat of inflation is louder than ever after the release of December’s data for the Consumer Price Index. This means it’s worth bringing a bit of sanity to the discussion.

First, as fans of reality like to point out, the jump in inflation over the last year is largely a worldwide phenomenon, not something that can be attributed to bad policies in the United States. Our year-over-year (December 2020 to December 2021) inflation figure was 7.0 percent, which is definitely high. But the figure for the U.K. was 4.6 percent, for Canada 4.7 percent, for Germany 5.2 percent, and for Spain 5.5 percent. (These are all inflation numbers from November 2020 to November 2021, since December data are not yet available.)  

The jumps in inflation in these countries cannot be blamed on the American Recovery Act (ARA) that Biden pushed through Congress back in February or Federal Reserve Board policy. Obviously, the US inflation rate is higher than in these other countries, but the point is that we would have seen a substantial jump in inflation even if Biden has not moved aggressively to restart the economy.

As a result of the ARA, we are the only country to have a level of output above the pre-pandemic level. The unemployment rate is down to a level rarely seen in the last half-century. And, workers at the lower tiers in the labor market have unprecedented freedom to leave jobs they don’t like and to look for better opportunities.

But the inflation data reported in December is definitely a cause for concern. There are a few points worth making here. First, the 0.5 percent inflation rate reported for the month of December itself is somewhat lower than the 0.9 percent rate for October and the 0.8 percent rate reported for November. The monthly data are always erratic, but still, this is going in the right direction.

Also, much of the inflation is not any mystery. We continue to see the supply chain crisis, aggravated by the shortage of semi-conductors, which has impeded car production. New car prices rose 1.0 percent in December and are up 11.8 percent over the last year. Used car prices rose 3.5 percent and have risen an incredible 37.3 percent over the last year. Together, these components accounted for almost 1.5 percentage points of the inflation we have seen over the last year.

The major auto manufacturers are getting around the chip shortage and ramping up production. Since the cost of producing cars has not hugely risen, we can expect most of the rise in new and used car prices to be reversed in the not distant future.

There is a similar story in the other components where supply chain issues have pushed up prices. Apparel prices, which have been trending downward for decades, rose 5.8 percent over the last year. The index for household supplies and furnishings, which includes everything from linen to major appliances, rose 7.4 percent over the last year.

This index has also been flat or moving downward in the decade prior to the pandemic. For this reason, it is likely that most of these price increases will also be reversed.

The big question that no one has a good answer to is, when will the supply chain problems be resolved? While I don’t have a good answer to this, the seasonal timing of purchases may provide some relief. The holiday season is peak demand for a wide variety of goods. The normal falloff in January and February sales is close to 20 percent. Our seasonal adjustments (correctly) hide this falloff, but the smaller flow of goods in these months should allow for shippers to catch up to some extent.

The spread of the omicron variant, which is preventing many people from working (in addition to filling hospitals), is a big factor going in the wrong direction. But there is some evidence that it is peaking in the Eastern part of the country, and we may be through this wave before too long.

One promising sign was a sharp drop in the inflation rate shown in the Producer Price Index Final Demand Index. (This is the last stage for goods and services before they reach retailers.) The overall index rose just 0.2 percent in December, while the goods index actually fell by 0.4 percent, driven by drops in food and energy prices.

The monthly data are highly erratic, so it would be foolish to make too much of the December report, but it is a promising sign. More importantly, there are good reasons to believe that much of the inflation that we have seen in the last year will be reversed in the months ahead, even if there is no easy way to predict the timing.

For what it’s worth, the financial markets seem to agree with this assessment. The interest rate on 10-year Treasury bonds is just over 1.7 percent. This is not consistent with an expectation that inflation will remain near 7.0 percent. The breakeven inflation rate between normal Treasury bonds and inflation-indexed bonds is less than 2.5 percent. Financial markets can be wrong (see stock and housing bubbles), but at the moment they don’t seem concerned about runaway inflation.

It would be incredibly irresponsible for the Fed to slam on the brakes, and throw millions of people out of work, to head off inflation associated with a clogged supply chain. We can unclog the supply chain by getting people to stop buying things, in the same way that we can cure cancer by draining a patient of blood. Neither is an especially effective way to accomplish the goal.


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