Threat Inflation


By Ramesh Ponnuru


NR Plus Magazine   June 24, 2021 12:53 PM


Why the 1970s aren’t coming back

Inflation has been rising. That’s not up for debate. How worried we should be about it is.


Americans learned that inflation could be painful in the 1970s. Between 1966 and 1983, the Consumer Price Index (CPI) tripled. In addition to leaving households with less buying power, inflation pulled them into higher tax brackets. It raised taxes on capital, too. And because it was not only high but erratic, it imposed pervasive costs. Firms had less ability to plan for the future, and had to make frequent changes to prices and wages. Inflation zoomed to the top of the public’s list of concerns, too, contributing to the nation’s loss of confidence during that era, its sense that things were out of control. The Federal Reserve eventually put an end to the Great Inflation, but at the cost of two severe recessions with high unemployment.

Conservatives were more hostile to inflation at the time, and have been more alert to the possibility of its return since. They have been expressing concern — and when the Bureau of Labor Statistics reported that consumer prices had risen by 4.2 percent from April 2020 to April 2021, the largest twelve-month increase since 2008, that concern turned into alarm. The May–May number was 5 percent, the largest since 1992.

Republican politicians say that rising inflation is a consequence of President Biden’s free-spending policies, and conservative economists say it’s a reason for the Federal Reserve to hit the brakes. But fear of inflation isn’t confined to the Right. Liberal economists — notably Lawrence Summers, a veteran of the last two Democratic administrations — have expressed similar sentiments.


While a replay of the 1970s is the hawks’ worst-case scenario, the doves tend to dwell instead on more recent history: A decade ago, a lot of conservatives warned about runaway inflation, and it never happened; we should discount what they have to say now. Yet some of those who currently fear inflation were not part of the chorus back then, and in any case people can err and then be right. The truth is that current circumstances are too different from each of those episodes, the 1970s and 2010s, to tell us what we are in for.

Which of those current circumstances matter most is another point of contention. The doves, including most people at the Federal Reserve, say that inflation is “transitory” for two main reasons. The first is that economic conditions a year ago were unusually depressed because of the pandemic and lockdowns, and so both prices and economic activity appear to have jumped a lot. Airline fares and hotel prices have been rising, but are still below their pre-pandemic levels. So while prices rose by 5 percent from May 2020 to May 2021, the average rate from May 2019 to May 2021 was only 2.5 percent. This “base effect” in the statistics will be over by the end of the summer.

The second is that price increases reflect some supply bottlenecks that have accompanied the reopening of the economy but are working themselves out. Lumber prices soared as demand rose faster than sawmills could resume production: Futures prices quadrupled from the start of May 2020 to the start of May 2021. Since then, though, they have been falling steeply. Semiconductor shortages and port congestion have led to price increases, too, but now seem to be easing. When chip prices soar, manufacturers make more.

The hawks place more emphasis on macroeconomic policies that they consider misguided. Deficit spending was already rising before Washington, D.C., devoted additional trillions to fighting the pandemic and relieving its effects. Then the new Democratic government increased it still more, partly because it thought that the previous spending had not done enough to stimulate the economy.

The Federal Reserve has also attempted to provide stimulus, by holding interest rates low and promising to keep them low for a long time. Even before the pandemic, the Fed had started to shift from “inflation targeting” to “average-inflation targeting.” Instead of treating 2 percent annual increases in the Personal Consumption Expenditure (PCE) index as the ideal to reach at all times, it wants to hit that number on average over an extended period. That means that periods of inflation below the target — and we have been below the target for nearly all of the last 13 years — should be matched by periods of inflation above the target. (The Fed hasn’t offered specificity about how far it is looking back to construct its average.)

The hawks look at this spring’s inflation numbers and conclude that all the stimulus from Congress and the Fed has worked too well: It’s stimulating price increases. A particular worry is that public expectations of inflation are rising, too, which can be a self-fulfilling prophecy as workers seek bigger raises and consumers rush to spend money before it loses value. Inflation expectations are measured in a number of ways. Since 1997, when the Treasury began issuing bonds protected against changes in the CPI, a prominent measure has been the difference between the yields on those bonds and the yields on bonds that provide no such protection. The difference is often treated as the market’s implicit prediction of inflation.

From the Great Recession through 2020, this measure of inflation expectations over the next five to ten years was nearly always below 2 percent. When the pandemic hit, expectations plunged toward zero but then recovered as Congress and the Fed took action. As of June 22, the annual inflation rate was projected to be 2.5 percent for the next five years and 2.2 percent for the five after that. Remember, though, that these bonds define inflation in terms of the CPI, which over the last decade has run an average 0.3 percent above the PCE that the Fed targets.

Far from suggesting runaway inflation, those numbers are consistent with a Fed that runs slightly below its average target for the next ten years. The Fed’s bond purchases also affect these yields. When researchers try to correct for this effect, they conclude that inflation expectations are lower still.

These subdued expectations do not erase the basic fact that inflation has been rising. The expectations are consistent with higher than normal inflation this year and next. The Blue Chip forecast is for 3.3 percent CPI inflation for 2021 and 2.5 percent for 2022. That would be the biggest two-year run-up in prices since 2007–08. But it would be way below the inflation rates of the 1970s. It would be a bit below the rates of the early 1990s, too, which were experienced at the time as a blissfully low-inflation period.


For hawks, the question these relatively low inflation expectations raise is why markets aren’t seeing what they’re seeing — especially since they are disproportionately the sort of people who have great confidence in markets. They raise another question for everyone: If the markets have it right, why is all of this monetary and fiscal stimulus having so small an effect on inflation?

This puzzle is not new. The rising deficits of the Reagan years were often held to portend rising inflation, but inflation fell instead. Inflation fell again when deficits rose during the Great Recession. Trump’s first three, pre-pandemic years saw rising deficits again, but inflation stayed at about the same rate. It appears that even as the supply of U.S. debt has grown dramatically, the demand for it has increased even more. Hence the persistent downward trend on Treasury yields since the 1980s. The growth of emerging markets and the aging of the global population have increased the demand for safe, dollar-denominated assets including U.S. Treasuries. These trends continue to put downward pressure on interest rates.

Economists of a monetarist bent are not surprised that the effect of deficits on inflation has been so hard to detect. They place great explanatory weight on the equation of exchange, which says that the supply of money times the velocity with which it changes hands equals the price level times output: MV = PY. (Y stands for the size of the economy, adjusted for inflation.) Deficits by themselves do not increase the money supply or do much to change velocity, and so can’t exert great influence on prices or output either. The effect will be especially muted if economic actors expect the central bank to alter the money supply in such a way as to reach its price-level goals.

That doesn’t mean deficit spending at our current levels is wise. It increases the share of the federal budget that goes to interest payments. It raises the risk that spending will have to be abruptly cut or taxes increased if interest rates rise in the future. It may well direct resources to less productive uses than the private sector would find for them. Our fiscal imprudence could have any number of negative consequences. High inflation just doesn’t seem to be one of them.


Monetary policy, meanwhile, has been less stimulative than it has looked. It’s not low interest rates that are expansionary; it’s interest rates lower than the economy’s equilibrium rate, and those rates have themselves been falling over time as a result of such trends as the aging of the population. The conservatives who predicted skyrocketing inflation a decade ago didn’t take that into account: They looked at low interest rates and assumed they meant easy money. They also missed that while the supply of money had risen, demand for money balances had risen as well (which is another way of saying that velocity had dropped).


The same pattern occurred during the pandemic. The money supply increased and interest rates fell, leading many observers to believe that money had gotten very easy. But velocity fell, too, dampening the expansionary effect. Throw in supply constraints (which bring down Y in the equation) and you end up with slightly higher prices.

These sorts of reassurances do not clinch the case against Great Inflation II. Supply shocks fed that inflation, too. Events in the Middle East caused several spikes in the price of oil. They increased the price level not only directly, but by shifting the public’s expectations of inflation and obscuring how inflationary the Federal Reserve’s policies were. Could something similar happen now, with supply bottlenecks changing economic psychology and the Fed dismissing evidence that it needs to tighten?

There are some hopeful lessons from the 1970s. It took years for inflation to take off. We also now have more and better forward-looking indicators of inflation. (Those Treasury spreads, remember, were unavailable before 1997.) Our political culture is also more inclined to hold the Fed responsible for inflation than it was then: Greedy businessmen and union leaders were popular culprits, along with the sheikhs. And today’s Fed is responsive to concerns about inflation, sometimes even too much so. In President Obama’s second term it raised interest rates even though inflation and inflation expectations were below its target. In mid June, its policy-makers suggested that they would hike interest rates earlier than they had previously said.

The costs of inflation would be different this time, too. President Reagan signed a law tying income-tax brackets to inflation, so people no longer pay taxes on illusory raises. (Taxes on capital still apply, however, to inflationary gains.) Other costs would depend on the nature of the inflation.

When adverse supply shocks cause inflation, it’s essentially all cost. A productivity slowdown — whether caused by pandemics, geopolitics, or weather — will reduce real incomes regardless of the Fed’s response. If it tightens money to keep the supply shock from raising prices, the effect will typically be to reduce incomes further.

In theory, inflation caused by monetary policy could have more benign effects. To the extent that the inflation is steady and predictable, the economy should be able to adjust so that the relationship between different prices — such as the ratio of your wage to your grocery bill — stays the same. (Leaving aside the tax issues, which can be changed by Congress.) Loan rates, too, can incorporate expected inflation. But the inflation of the 1970s did not, of course, proceed nearly so smoothly.


For much of the last decade, some economists have had the opposite worry from the one prevailing today: They have fretted that inflation has been persistently below the 2 percent target. It is not a concern shared by the public. But undershooting the target makes the long-run price level less predictable and the central bank less credible. A higher inflation rate would also raise interest rates, giving the Fed more room to cut them in a recession. That last consideration has led some economists to think that the Fed should not only do more to hit its target but raise it, too, so that it aims for 4 percent a year.

The hawks have gotten some important things right. Inflation has risen. Changes in monetary and, to a lesser extent, fiscal policy have contributed to that rise. Letting inflation and inflation expectations rise too far would be harmful. But we have good reasons for thinking that the monthly CPI numbers are already peaking. In that case, by fall the current scare could seem, well, inflated.

Housing Boom to Continue

First Trust Economics - April 12, 2021

Housing prices have soared in the past year. The national Case-Shiller index is up 11.2% in the past twelve months, the largest gain since 2005-06. The FHFA index is up 12.0% in the past twelve months, the largest on record (going back to 1991).

Given these gains, some are wondering whether housing is back in a 2000s-type bubble. But a deep dive into the data suggests we are not.

To assess home prices we use the market value of all owneroccupied homes calculated by the Federal Reserve. We then compare that to the “imputed” rent calculated by the Commerce Department for the GDP report. (Imputed rent means what people would pay to rent their homes if they rented them from someone else.) In the past 40 years, home values have typically been 16.4 times annual rent. At the peak of the bubble in 2005, they were 21.4 times annual rent, or 33% above normal. Now, home prices are 17.8 times annual rent, about 11% above normal.

We also compare home prices to the Fed’s measure of replacement cost. In the past 40 years, home prices have typically been 1.59 times replacement cost. In 2005, they peaked at 1.94 times replacement cost, a premium of 22.5%. Now homes are selling for 1.63 times replacement cost, only 2.5% above normal, which is minimal.

Does this mean housing is at risk? We don’t think so. The recent price surge is based on fundamentals and the housing market should continue to boom.

The primary problem is a lack of homes. Based on population growth and scrappage (voluntary knockdowns, fires, floods, hurricanes, tornadoes…etc.), we would normally expect housing starts of 1.5 million per year. But in the past twenty years (March 2001 through February 2021), builders have only started 1.256 million per year. Builders haven’t started more than 1.5 million homes in a calendar year since 2006.

No wonder the inventory of homes for sale is so low! Single-family existing home inventories are at rock bottom levels, with only 870,000 for sale in February. To put this in perspective, the lowest inventory for any February on record from 1982 through 2016 was 1.55 million. Meanwhile, there are only 40,000 completed new homes for sale, versus 77,000 a year ago and an average of 87,000 in the past twenty years.

Two other factors are likely at work. One issue is that there’s a moratorium on evictions, so some tenants are paying less in rent than they normally would, which is temporarily holding down rental values versus home prices (therefore elevating the price-to-rent ratio). This is also holding down the housing component of the Consumer Price Index, which is calculated using rents, not home prices.

Another factor is that people have moved away from places where renting is popular to places where home ownership is popular. If you leave New York City or San Francisco for Nashville or Boise, there’s a good chance you went from renting to owning. This helps boost home prices as well.

Yes, home prices are up and, yes, they look somewhat expensive relative to normal, but this is more about the unprecedented events of the past decade, not some problem with the market. With the Fed so easy, and the stock of housing constrained, prices will continue to rise. The housing boom will continue.