Notwithstanding these indicators, it is too early to say whether inflation has been contained. Nevertheless, the current price surge has taught us two vital lessons.
Firstly, economists’ standard models – particularly the dominant one, which assumes the economy is constantly in equilibrium – were rendered virtually useless. Secondly, those who declared firmly that it would take five years of misery to drain the system of inflation have already been debunked. Inflation has dropped drastically, with the seasonally adjusted CPI for December 2022 being only 1% higher than that for June.
There is clear evidence that the primary source of inflation was pandemic-related supply shocks and fluctuations in demand pattern, not excess aggregate demand or any additional demand created by epidemic spending. Anyone who believed in the market economy recognized that the supply difficulties would be handled someday, but no one knew when.
After all, we’ve never seen an economic shutdown caused by a pandemic followed by a speedy reopening. That is why models based on previous experience were rendered obsolete. Nonetheless, we can expect that resolving supply constraints would be disinflationary, even though this would not necessarily counterbalance the earlier inflationary process instantly or completely, due to markets’ proclivity to respond higher more quickly than downward.
Policymakers are still weighing the risks of doing too little versus doing too much. The risks of rising interest rates are obvious: a fragile global economy might be pushed into recession, sparking new debt crises as many deeply indebted emerging and developing economies confront a triple whammy of a strong dollar, decreased export income, and higher interest rates. This would be a disgrace. After already causing unnecessary deaths by refusing to share intellectual property for COVID-19 vaccinations, the United States has intentionally adopted a policy that will certainly sink the world’s most vulnerable economy. This is hardly a winning tactic for a government that has declared war on China.
Worse, it is unclear whether this strategy has any advantages. Raising borrowing rates, in fact, may do more harm than good by making it more expensive for businesses to invest in solutions to current supply shortages. The US Federal Reserve’s tightening monetary policy has already slowed house building, despite the fact that increased supply is precisely what is required to reduce one of the most significant causes of inflation: housing costs.
Furthermore, many price-setters in the housing sector may now pass on increasing business costs to renters. Furthermore, in retail and other industries more broadly, higher interest rates can actually drive price increases by inducing businesses to write down the future worth of lost customers relative to the benefits of higher prices today.
To be sure, a prolonged recession would keep inflation in check. But why would we do that? Fed Chairman Jerome Powell and his colleagues appear to enjoy cheering on the economy’s demise. Meanwhile, their commercial banking colleagues are making out like bandits now that the Fed is paying 4.4% interest on more than $3 trillion in bank reserve accounts, earning a tidy annual return of more than $130 billion.
Not only is inflation declining, but wages are rising at a slower rate than prices (indicating no spiral), and expectations remain stable. The five-year forward anticipation rate is just above 2%, which is scarcely unanchored.
Some worry that we will not return to the 2% target inflation rate quickly enough. But keep in mind that number was generated at random. It has no economic significance, and there is no evidence that it would be harmful to the economy if inflation ranged between, say, 2% and 4%. In fact, given the need for structural changes in the economy and price rigidities, a slightly higher inflation target has a lot to recommend it.
Others will also argue that inflation has remained subdued precisely because central banks have demonstrated such resolve to combat it.
One would think that modern economic analysis would go further than Woofie did. A comprehensive examination of what is happening and where prices have fallen confirms the structuralist thesis that inflation was primarily caused by supply-side disruptions and adjustments in demand patterns. As these difficulties are rectified, inflation is expected to continue to fall.
Yes, it is too early to predict when inflation will be entirely contained. And no one knows what new surprises are in store for us. But I’m still betting on “Team Temporary.” Those who argue that inflation will be substantially healed on its own (and that the process can be accelerated by policies to reduce supply restrictions) have a much better case than those who advocate measures with evident high and long-term costs but relatively dubious benefits.
