May 24, 2021
Larry Summers has a column in the Washington Post warning about inflationary risks to the economy, due to what he considers an excessively large recovery package from the Biden administration. Summers notes the extraordinarily high rate of inflation in the first quarter and warns us that worse is ahead if corrective measures are not taken soon.
Starting with the inflation that we have seen to date, it is important to remember that this follows the very low rate of inflation we saw in the pandemic. Much of this is just catch up.
The overall Consumer Price Index (CPI) jumped 0.8 percent in April. That sounds scary, but it is up just 3.1 percent since February of 2020, which translates into a 2.6 percent annual rate of growth. The core index, which excludes food and energy prices, is up just 2.5 percent since before the pandemic started, translating into a 2.2 percent annual rate of increase.
We can see a similar story in many of the sectors that were hard hit by the pandemic. Hotel prices jumped 8.8 percent in April, but are still almost 6.0 percent below the level of February 2020. Airfares rose 10.2 percent in April, but are 17.7 percent below their pre-pandemic level.
Everyone knew these big price jumps were coming, so they really should not be cause for panic. We did get an unexpected hit with a 0.5 percent jump in new car prices and an extraordinary 10.0 percent jump in used car prices. (The latter added 0.3 percentage points to the CPI inflation rate for April.)
But these rises were not due to an excessively large stimulus package, they were the result of a shortage of semi-conductors caused by a fire in a plant in Japan. As we are able to produce more semi-conductors later this year, or early in 2022, new car prices will come back down. Used car prices may fall earlier if many people take advantage of high current prices to sell their old cars.
We will have to see how prices move in the months ahead, but Summers is apparently worried that we have to act quickly to stem inflation. He tells us:
“It is possible that the Fed could contain inflationary pressures by raising interest rates without damaging the economy . . . The history here is not encouraging. Every time the Fed has hit the brakes hard enough to slow growth meaningfully, the economy has gone into recession.”
Hmmm, that’s not the history I know. The Fed raised the federal funds rate from 3.0 percent in February of 1994 to 6.0 percent in March of 1995. We didn’t get a recession until March of 2001. It raised rates from 2.0 percent in December of 2004 to 5.25 in July of 2006. We did get a recession a year and a half later at the end of 2007, but this was more obvious due to the collapse of the housing bubble than the Fed’s rate hikes.
More recently, the Fed raised rates from 0.0 in December of 2015 to 2.2 percent in December of 2018. We did get a recession more than a year later, but this seemed to have more to do with the pandemic than the Fed’s rate hikes.
In short, the history doesn’t look quite like Summer’s claims. The Fed has frequently raised rates, with the stated goal and effect of slowing the economy, without bringing on recessions. There is no obvious reason that it can’t do so again if the evidence indicates that inflation is becoming a serious problem.
While we know the data is quirky right now due to pandemic and the bounce back as the economy restarts, as a first approximation, inflation is going to be equal to the rate of wage growth minus the rate of productivity growth. Wage growth has been healthy through the recession, but wages have not risen rapidly enough to give much grounds for concern about inflation.
In the period from February of 2020 to April of this year, the average hourly wage has risen 5.8 percent, which translates into a 5.0 percent annual rate. That sounds fast, but this number is skewed upward by the loss of many low-paying jobs in restaurants and other areas. Taking the average of the last three months (February, March, April) with the prior three months (November, December, January), wages have risen at just a 3.1 percent annual rate.
The Employment Cost Index (ECI) gives us a better measure since it holds the mix of jobs constant and also includes the cost of benefits, such as health care and pensions. This rose 2.6 percent from the first quarter of 2020 to the first quarter of 2021.
In the first quarter of the year, the ECI did rise at a somewhat faster 0.9 percent rate, which translates into a 3.6 percent annual rate of growth. That doesn’t sound too scary since much of this is catch-up following rises of 0.5 percent and 0.7 percent in the prior two quarters.
But to translate this rate of increase in wages into inflation, we need to know that rate of productivity growth. That had averaged just 1.0 percent from the fourth quarter of 2009 to the fourth quarter of 2019. However, in the last four quarters productivity growth has accelerated sharply.
Productivity increased by 4.1 percent from the first quarter of 2020 to the first quarter of 2021. Productivity data are notoriously erratic, but if the economy can sustain just a 2.0 percent rate of productivity growth going forward, that would mean that wages could grow at a 4.0 percent annual rate and still hit the Fed’s inflation target of 2.0 percent.
Our ability to predict productivity growth is not good, but it doesn’t seem implausible that the pandemic has forced businesses to make changes that have led to increases in productivity. So, the idea we could be on a faster productivity path for at least the next several years should not seem far-fetched.
In fact, I recall just reading somewhere about a speed-up in productivity growth. Oh yeah, the first paragraph of Summer’s piece concludes with the sentence: “Wages and productivity growth are increasing.”