By: Dr. M. Ray Perryman
Published in syndication December 08, 2021
Inflation by some measures is at 30-year highs, hitting many families hard. It's complicated, but there are basically two things happening. Let's take a closer look.
First, the massive (but largely necessary) deficit spending to minimize fallout from COVID-19 inevitably puts upward pressure on future prices. That piece is permanent and will likely engender somewhat higher inflation than had the pandemic never happened. The Federal Reserve recognized this phenomenon and changed its inflation target from a 2% maximum rate to a 2% average rate (thus allowing greater flexibility). Yields on long-term government bonds, where the only real risk is loss of purchasing power, are quite modest, suggesting that markets expect overall inflation to be manageable over time.
The second factor, which is currently getting all of the attention, is transitory. As people get out and about again (many with extra cash from various stimulus programs), they are ready to spend. Simultaneously, the massive global supply chain has experienced widespread difficulties getting reignited. The simple, traditional explanation of inflation is "too much money chasing too few goods." Both sides of that equation have been in overdrive. However, consumers will revert to more normal behavior in the near future, and production and distribution will be restored.
We are beginning to see pressures easing, but with inflation remaining high, it is becoming increasingly probable that the Fed will ramp up its tapering (which basically means buying fewer bonds and putting less money in circulation) in the coming months (assuming virus variants don't further threaten the recovery). The Fed's dual mandate is maximum employment and low inflation, and recent trends are indicating it's time to pull back a bit. Historically, most of the attention has focused on price stability, but the past two years have been anything but normal.
Interest rates will likely rise modestly as the Fed pushes forward. However, I don't see any major increases for the foreseeable future. Given the magnitude of recent monetary expansion, there's ample room for deceleration without notable market disruptions. While some observers are comparing this period to the double-digit inflation of the late 1970s and early 1980s, it is not remotely similar. Then, inflation was essentially institutionalized (many will recall that savings accounts paid 5.25% annually). Nothing even close to that is happening now. The Fed broke that cycle decades ago, and none of the core elements are still around (the model from my dissertation was used to monitor this process, so I was pulled in early).
It's difficult because COVID-19 has the potential to change the dynamics rapidly, as we saw with the initial reaction to the emergence of the Omicron variant. Short-term price rises are unavoidable, but it is not a permanent condition. Stay safe!