BackFaster inflation is coming. How bad will it be?
The potential consequences of higher prices fall largely into three camps: transitory, irritating or troubling.
PremiumAn economic debate that has been heating up for a few weeks in markets and the academic world made a notable appearance in Congress last week when lawmakers questioned Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen about inflation. This is understandable given that the answers about the scale, scope and duration of a possible surge in inflation have implications that go well beyond economic well-being and the country’s borders.
Economists are mostly split into three camps when it comes to higher inflation, which has not been on the radar screen in any meaningful sense for more than a decade. The first camp, which seems to include both Powell and Yellen, considers any surge in inflation as primarily transitory with few if any consequential spillovers. The second thinks it could be a longer-lasting phenomenon whose potentially wider and more risky consequences would, nevertheless, be temporary and reversible. The third one fears that higher inflation could prove to be a more durable and consequential problem with multifaceted domestic and international effects.
All three camps agree that, statistically, the US will experience a notable pickup in the measured inflation rate. This is due to “base effects"— comparison with an abnormally low number in a previous period; in this case specifically, the readings that followed the Covid-related lockdown a year ago were particularly stunted.
Should they remain essentially statistical anomalies, the higher inflation rates should have minimal consequences in the short term and none over the longer one. This is where the first camp loses interest in the inflation debate; it doesn’t see it posing any challenges either to the Biden administration’s fiscal plans or the Fed’s continued pursuit of ultra-expansionary policies.
The two other camps think that the base effects will be amplified soon by what, in the old inflation literature, was known as demand-pull inflation. Here, a boom in both private and public demand outpaces the ability of the supply side to respond, putting upward pressure on prices. Already, there are initial signs of supply bottlenecks and higher transportation costs, most of which appeared before last week’s blockage in the Suez Canal, which is now disturbing supply chains more meaningfully and, once again, highlighting their lack of resilience.
The combination of base effects and demand-pull would likely keep the inflation rate above the Federal Reserve’s 2% target for a few months after years of undershoots. The third camp thinks that either the prospect or emergence of such an outcome would, in turn, alter inflationary expectations and related behaviors, adding a “cost-push" element to the inflationary dynamic. This would be supported by structural changes in the production and labor landscapes, including intensified corporate concentration, deglobalization, disrupted movement of people and more skill mismatches.
Seeking to protect their profits from higher input costs and emboldened by lower internal and external competition, companies would opt for preemptive price increases. Meanwhile, wage earners would also seek to protect themselves, reminiscent of the “real wage resistance" of a few decades ago.
The third camp’s scenario, with its possibility of a self-feeding dynamic that would keep inflation high and rising, would pose bigger risks for the country’s longer-term economic and social well-being. The Biden administration’s drive to reshape the economy, a main driver in the transition of fiscal intervention from relief to recovery, would risk being delayed if not derailed. This would add to inflation’s regressive influence on American society which, by imposing a disproportionate burden on the less fortunate segments, would worsen an already concerning inequality trifecta of income, wealth and opportunity. And all this would be taking place in the run-up to the 2022 midterm elections.
Meanwhile, the Fed would find itself fighting criticism of a discredited policy framework revision that naively shifted its emphasis too far away from preemptive measures based on inflation forecasts to reactive ones based on outcomes. In this scenario, the Fed would probably feel compelled to hit the brakes hard, risking what would still be a less than full and sufficiently inclusive recovery. All of that would be bad not just for the U.S. but also for the global economy and markets.
The third scenario is not the only one posing risks. Even the second, more benign one does because of possible market reaction. While economists and the Fed would view a spike in inflation through a longer lens, markets might well end up living more in what Bloomberg’s Jonathan Ferro labels “the moment" — that is, reacting in the short term by rapidly taking bond yields higher and risking to destabilize stocks and other risk assets that have benefited enormously from the widespread market confidence in continuing ample and predictable liquidity injections. Coming at a time of excessive and, in some cases, irresponsible risk-taking, this could have adverse economic spillovers.
Such effects would be felt well beyond the U.S. Already, European Central Bank officials have complained about the “undue tightening" of euro-zone financial conditions because of higher U.S. bond yields. This has also contributed to a slowly widening cycle of interest rate increases by central banks in emerging economies.
In assessing all this, I end up with rather high conviction that the US will experience rising inflation in the next few months because of base effects and demand-pull. While, on balance, a subsequent phase of significant cost-push effects is not strictly in my baseline, it is enough of a meaningful threat to require close and frequent monitoring. With that comes the risk of higher market volatility and, on the political front, the prospects of more heated congressional deliberations on economic and social well-being that could make subsequent fiscal packages harder to pass quickly notwithstanding their importance for a lasting U.S. recovery.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include 'The Only Game in Town' and 'When Markets Collide.'
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