Contribution Is inflation really out of control?
Another Great Inflation unlikely today
By Stephen Lee
Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Mertiz Securities
Inflation has been drifting higher recently, with October's U.S. consumer price inflation (CPI) rate at a whopping 6.2 percent year-on-year ― the highest in three decades. This situation certainly is a dilemma for central banks, as they may have to shift their reaction function to containing inflation, although the economy is still dependent on the course of the virus. So I believe it is useful to diagnose characteristics of today's inflation with historical lessons, so as to gauge its outlook and implications.
What is causing today's inflation?
The origin of today's inflation is natural, as massive fiscal deficits, combined with steep rate cuts and asset purchases, swiftly boosted the nation's aggregate demand. This situation met with short-term, inelastic, aggregate supply, which lifted price levels. We call this kind of inflation “demand-driven,” which often is interpreted as “good” inflation.
The problems have come during the process of economic recovery. Some developing nations in the supply chain suffered a hard time controlling the Delta variant. Lockdowns were imposed and factories were shut down temporarily. Shipments of raw materials and intermediate goods were delayed, creating shortages and resulting in higher prices. Final goods production was also lagging and constrained, due to labor shortages in advanced countries. Less output was combined with higher producer prices, as scarcity in goods, along with wage pressures, were added, and the latter eventually translated into higher consumer price inflation (CPI).
The latter part ― the supply side of the inflation ― lifted the CPI inflation outlook further, while causing the economic growth outlook to be revised down. Some people started to be concerned about another Great Inflation (or a “great stagflation”) coming, worrying about the persistence of such trends.
A closer look at the economic environment of the 1960s-70s
Are we going to experience another Great Inflation? To gauge the likelihood of that, a closer look at the 1960s and 1970s' economic environment seems necessary. Many people tend to think about the two oil shocks that occurred in the 1970s, but they only explain half of the episode. Actually the Great Inflation started in 1965 and lasted until 1982. Therefore, understanding the origin of the Great Inflation is important. This history review relies on a great paper, “Origins of the Great Inflation,” written by professor Alan H. Meltzer in 2005 and published by St. Louis Fed.
Similarities exist between today and those days, as inflation then was also built upon demand and supply. But there are also important differences.
First, the shape of the Philips curve ― showing the adverse correlation between the unemployment rate and inflation ― was steep and convex in the 1960s. This means that, once the unemployment rate dropped below that of the non-accelerating inflation rate of unemployment (NAIRU), wage-driven inflation emerged quickly.
Second, labor productivity growth was slowing in the 1960 and 1970s, meaning that there was a lack of innovation during that period.
Third, the Federal Reserve hesitated to react to the overheating of the labor market or to the rising inflation pressures. Rather, the Fed generally preferred to coordinate with the government in boosting the economy by expanding the monetary base.
Fourth, the influence of labor unions, as well as President Nixon's price controls being lifted by 1974, caused any supply-driven shocks to easily translate into higher wages and core inflation pressures. Additional inflationary pressures from the first and second oil shocks of 1973 and 1978-79 came amidst these environments, resulting in inflation persisting continuously.
How is now different from the 1960-70s?
I would like to point out two things. First, today's Philips curve, even after the COVID-19 crisis, is believed to remain flat. It is because the factors that flattened this curve have never disappeared. Those factors are: 1) productivity growth, 2) lower production costs driven by global outsourcing and 3) lower retail trade costs driven by the greater influence of e-commerce, namely Amazon.
Second, the Federal Reserve's expansion of base money created “monetary inflation” in the 1960-70s on the back of the rising velocity of money. Base money was translated into broad money, and fast circulated within the real economy. Since the mid-1980s, however, the velocity of money has been in a consistently downward trend, implying that most of base and broad money created were staying within the financial market (and creating asset inflation). Although it looks like today's inflation sits above the massive monetary base created by the Fed, this situation does not imply that the two have a causal relationship. I believe that monetary inflation barely exists today.
Future of today's inflation, and implications for the Fed
I believe that supply-driven inflation pressures ― the main cause of recent inflation ― will peak during the first quarter of 2022, based on the following assumptions.
First, inflationary pressures from emerging market-driven global supply disruptions are likely to have peaked out in the third quarter of this year. The effect of the Omicron variant is a risk, but we assume there will be better handling of the virus from these nations going forward.
Second, oil prices are likely to peak during the first half of 2022. We believe oil prices will rise back up, once the effect of Omicron wanes, spurring greater transportation demand. Oil prices are to decline, as increased supply from the U.S. and OPEC gradually meets demand in the first half of next year.
Third, freight costs are to peak in the second half of 2022, as container ship orders translate into deliveries at that time.
Fourth, rising wages from labor shortages in low-wage segments are to peak in months, as employers are to seek capital-intensive production if they feel that labor costs are too much.
Although CPI inflation is to peak out soon, it is expected to stay around 4-5% ―well above the Federal Reserve (Fed)'s target ― at least until the first half of 2022. The Fed will likely accelerate the pace of trimming asset purchases, aiming to end tapering by March of next year. Any policy rate hikes will be also pulled forward. That said, the Fed is likely to consider whether the labor market has accomplished full employment before its first rate hike. With frictional unemployment causing inefficiency in the labor market, which will take quarters to resolve, the first hike will likely take place in September, rather than in June. The Fed will likely stick to gradualism in the longer run once inflation fades out, ending its rate hike cycle below the neutral level.
The writer is the chief economist at Meritz Securities, Seoul.