In my first blog post, I claimed hyperinflation was not a threat. While I maintain that hyperinflation is not a feasible near-term risk to Americans, I must concede that inflation is likely to get a bit out of control in the next few years and the FED will have to cause a recession to bring it under control. In this post I will explain:
A quick refresher on economic theory for inflation.
Why inflation data shows I’m wrong.
Why employment and jobs data shows I’m wrong.
Why inflationary expectations show I’m wrong.
Why we can expect a FED-driven recession.
Why you probably aren’t experiencing as much inflation as those crazy people on Fox News.
1. A quick Refresher on economic Theory
The theory behind inflation is that it is determined by two factors: a trend component of inflation and a supply/demand component of inflation.
First, I’ll explain the trend component:
Imagine you are someone whose job is to set prices. You could be an employer, a factory-owner, a union negotiator or a restaurant owner, for example. If you expect more inflation in the future or if prices really went up a lot since the last time you set prices you will tend to set higher prices now.
For instance, if the last time a union agreed to a contract was 10 years ago and they agreed to 1.5% annual pay raises, but inflation was actually 3% on average for the pat 10 years and they expect it to go to 5% for the next 10 years, you can bet they won’t agree to 1.5% annual raises unless they have a really weak bargaining position.
Similarly, a restaurant or factory owner might think they can get away with higher prices if their competitors already hiked their prices and are likely to continue to in the future. Overall economists largely conceive of the trend in inflation in terms of expectations, but some also think in terms of catch-up inflation. Basically, the scholarly opinion is that a 1 log-% a year increase in expectations and previous inflation leads to a 1 log-% a year increase in current inflation.
Now, I’ll explain the supply/demand component of inflation.
When demand outstrips supply, this is increases inflation. When supply outstrips demand this decreases inflation.
Imagine it is easy for a company to find new workers. If a union goes on strike the company could easily hire new workers. In this case wages would likely be low relative to trend inflation. This is because the supply of workers companies are looking for exceeds the demand for workers. Similarly, if there's a shortage of workers that the company can hire, this could cause wages to grow higher relative to the trend component of inflation.
Likewise if a restaurant finds itself unable to attract many customers and a factory finds it’s warehouse full it likely will raise wages at a rate lower than trend inflation. Meanwhile, if the opposite is the case (the restaurant has more customers than it can serve most nights and the factory cannot keep up with orders) the owners who run these institutions will hike prices at a high rate relative to past increases and expected inflation.
An important implication of this model is that if demand overshoots supply for too long, inflation will outpace the trend level for too long (inflation will overshoot expectation and price increases will more than catch up for earlier price increases). This, in turn, can cause the trend component of inflation to increase too (expectations and past inflation will rise because demand outstripped supply for too long). If we want to keep trend inflation stable over time, we need to keep the non-trend supply/demand component of inflation at 0 on average.
2: Why inflation data shows I’m wrong.
In my first blog post, the strength of my argument really stemmed from the fact that the good measures of inflation were not flashing any warning signs. That is no longer true. The good indicators now tell us that inflation is rising.
By good measures of inflation I mean stable measures of inflation that do not swing greatly from month to month and year to year. Normally the news only tells people about bad measures of inflation, like Headline CPI inflation. Headline CPI inflation looks at the “Consumer Price Index” and gives the weighted average change of all its components. I argued that good measures of inflation like Median CPI inflation showed there was nothing to worry about. Median CPI looks at the “Consumer Price Index” (CPI) and reports the weighted median change in prices in the index. Median CPI is better than headline CPI because if the price of one thing goes up a lot all of a sudden for a reason not related to underlying trends in prices, this will not affect the median as significantly as it affects an average. When one looks at the average measure of inflation, one places too much weight on prices which are extremely volatile. The charts below drive this point home. The Median inflation line is always more stable than the Headline line.
At the time I wrote my blog post, there wasn’t evidence of high inflation from good measures of inflation. But now, both bad and good measures of inflation tell us we have a problem.
Below is a chart of monthly Median CPI Inflation from the data point Dec 2018-Jan 2019 all the way to the most recently released data point of Aug 2021-Sep 2021. It shows some evidence of lower inflation during the year of 2020. However, after Biden’s inauguration there has been a definite upturn in inflation. Other good measures of inflation like Median PCE and the Sticky-Price CPI are similarly showing upturns in monthly figures. This hasn’t necessarily led to a sharp jump in annual figures yet, but it looks like it will.
I will also admit that in my original blog post I predicted that headline CPI inflation readings should drop down in a few months. In particular I guessed June or July. In reality, this did sort of happen but a few months after I predicted.
3. Why employment and jobs data shows I’m wrong.
Unemployment is at normal levels. We tend to think that when unemployment is at normal levels inflation should be stable. The reason we associate normal unemployment with stable inflation is we normally think of high unemployment as being synonymous with recessions which are synonymous with not enough demand to meet supply. Similarly, we assume low unemployment is associated with an economic boom and too much demand for supply to meet. Therefore, normal unemployment should mean a stable economy and supply and demand meeting each other.
However what we are currently experiencing is unfamiliar and has a supply-driven component to it. It is hard to understand unemployment’s relationship to supply and demand using conventional thinking.
The mere fact that unemployment is higher than where it was before the epidemic does not mean that it is easier for companies to hire new workers. Just because there are more people looking for work does not mean there are more people looking for the type of work available. If someone was a senior-level worker with a high-paying job that no longer exists, he or she may retire before accepting a minimum wage junior-level post. Furthermore, workers and employers may now have differing preferences over virtual or in-person work, whether the worker should be vaccinated and how careful the employer should be about preventing infections. Essentially, the disruption caused by any significant economic downturn on top of all the confusing post-covid social questions is creating friction in the job market that is stopping unemployed people from matching with employers. As long as it is harder for employers to find employees, supply in the job market is weak relative to demand.
This is provable given data which shows that there is a higher level of open job positions than there was before. For instance the chart below shows that the level of job openings relative to the employed population has shot up recently.
The amount of open positions relative to the unemployed population, plotted below, has not increased quite as dramatically but it is still at an all time high for this century so far (at least since July).
Furthermore, employees are quitting their jobs at unprecedented rates. This indicates they likely think they can get another job. This is further evidence that increased friction in the job market is keeping some workers from matching with employers but ensuring that other employees feel confident enough to quit their current jobs and look for new ones. Plotted below is the annualized, seasonally-adjusted rate at which current workers are quitting their jobs.
Furthermore, while unemployment is higher than it was right before the pandemic under any sort of conventional measure, it is declining rapidly and may by next year’s end be lower than prior to the pandemic under some measures.
Overall the job market data shows that the supply/demand component of inflation is going to be very strong. This is especially the case because developments in the job market tend to impact inflation with a lag.
4. Why inflationary expectations show I’m wrong.
Inflationary expectations are increasing. This along with the current high levels of inflation we are experiencing indicate that the trend component of inflation is drifting upwards which means that demand exceeding supply is destabilizing inflation in the long term. The plot below shows expected inflation from Q1 2017 to Q3 2021.
5. Why we can expect a FED-driven recession.
In the late 1970s, inflation was rather high. This was due to about a decade of demand exceeding supply. Inflation kept exceeding expectations and expectations had been rising. A big part of this was a desire among politicians to continue a war in Vietnam without cutting domestic spending or raising taxes or raising interest rates. Furthermore, it seems that the rate of unemployment (using the traditional measure you hear about on the news) which was consistent with stable inflation had gone up during the 60s. This may have had something to do with a dramatic growth in labor force participation driven by higher female participation and the baby boomers entering working age.
Eventually the government got expected inflation and inflation down. This happened because in the late 70s the FED decided to stop printing out so much money to buy government debt. In an ideal world the FED could have announced this decision, and expectations would have fallen immediately bringing inflation under control. However, expectations did not fall immediately.
Instead, what happened was that the FED stopped the rate of money growth by raising interest rates. When the FED allowed short-term interest rates to rise they needed to print out less money to keep the rates at their new target levels. This eventually rippled through the financial system and caused interest rates on everything including home loans and credit cards to skyrocket. This caused a giant recession in 1980. Unemployment stayed high for several years. But at the same time, inflation was undershooting expectations and inflation was falling.
The period of high interest rate policies at the FED is known as the “Volcker Shock” after the FED chairman Paul Volcker at the time. What the “Volcker Shock” reveals is that when embedded inflation gets too high simply choosing to print less money and bring inflation down is harder than it sounds. Jimmy Carter lost his reelection in a landslide because voters couldn’t understand how an economy could have both double digit inflation and unemployment at the same time.
When this is all over, the FED will want inflation to be at 2% according to the PCE (“Personal Consumption Expenditure”) price index (this means CPI inflation will be a bit lower than 2%). If we all expect it to be at 4% they will have to prove to us that we are wrong. They’ll do that by raising interest rates and causing a recession.
However, expected inflation isn’t really at 4% (expect according to consumer surveys and some market data over a very short time frame). So we haven’t reached that point yet. But an increase in interest rates will take at least 1 year for its full impact on unemployment to be felt and higher unemployment also acts with a lag on inflation, so arguably the FED has already lost it’s chance to head off expectations before they rise significantly above the FED’s target.
6. Why you probably aren’t experiencing as much inflation as other people
Different states responded to Coronavirus differently. The more Republican-leaning states took a hands-off approach, whereas the Democratic-leaning states enforced rules which hampered their economies in order to stop the spread of the virus. Furthermore, the more Democratic states tended to be more densely populated and therefore experienced more of an economic impact than Republican states even ignoring policy differences. It seems that the hands-on approach reduced overall demand. Democratic states have higher unemployment and lower inflation (calculated using GDP and Real GDP data) than Republicans.
The plot below shows a correlation between the margin of Joe Biden’s victory in the popular vote for every state in 2020 (% voting Biden - % voting Trump) and the unemployment rate as of September 2021.
The following chart shows the negative association between inflation (log-% change in the GDP deflator by state) and Biden’s marginal election victory.
So if you are reading this blog you probably are not living in a state with exceptionally high inflation. Therefore you, like me, likely scoffed initially at Republican scaremongering about inflation. However we were out of touch. We were living in a world where a global pandemic wreaked havoc on the economy leading to weak demand and necessitating fiscal stimulus in order to prevent deflation. However, for many people, everything has been essentially normal recently, except liberals decided to close down all the sports and give everyone cash for one and a half years. If one were to examine recent government policy in the absence of the virus (or at least a response to it), it would not be unreasonable to anticipate hyperinflation.