When it comes to high inflation economists are largely divided into three camps, which have made no sense on the radar screen for more than a decade. The first camp seems to have both Powell and Yellen, any increase in inflation being considered primarily temporary, if there are any consequent spillovers. Second is that it can be a long-term phenomenon, the broad and dangerous consequences of which are temporary and reversible. Third is the fear that high inflation will prove to be a more durable and consequent problem with multifaceted domestic and international influences.
All three camps agree that, statistically, the US is experiencing a noticeable pickup at the measured inflation rate. This is due to the “base effects” – an unusually small number in the past; In this case in particular, the readings that followed the Kovid-related lockdown a year ago were particularly depressing.
For them to be necessarily statistical anomalies, high inflation rates must have minimal consequences in the short term and not more than in the long run. The first camp loses interest in the inflation debate; It did not pose any challenge to the Biden administration’s financial plans or to the Fed’s ultra-expansionist policies.
The other two camps hope that the base effects will soon expand through what is called demand-pull inflation in the old inflation literature. Here, the increase in both private and public demand outweighs the ability to respond towards supply, putting upward pressure on prices. Already, there are early signs of supply disruptions and high transport costs, most of which appeared before the blockade of the Suez Canal last week, which now makes supply chains more meaningful and, once again, highlights their lack of resilience.
The combination of base effects and demand-pull will keep the inflation rate above the Federal Reserve’s 2% target for a few months after a few years of undershoots. The third camp hopes that the possibility or emergence of such an outcome will change inflationary expectations and related behaviors, adding an “cost-push” element to the inflation dynamic.
In order to protect their profits from high input costs and to be brave through low internal and external competition, companies opt for advance price increases. Meanwhile, wage editors are trying to defend themselves, reminiscent of “true wage resistance” a few decades ago.
In the context of the third camp, the possibility of a self-feeding dynamic that keeps inflation high and rising poses major risks for the country’s long-term economic and social well-being. There is a risk that the Biden administration’s drive to redesign the economy, which is the main driver in shifting financial intervention from relief to recovery, will be delayed. This increases the regressive impact of inflation on American society, which, by pushing an unequal burden on the less fortunate sectors, is already exacerbating the inequality trifeta of income, wealth and opportunities. All this is happening ahead of the 2022 midterm elections.
Meanwhile, the Fed is battling criticism over a defamation policy framework revision that has shifted its importance from preemptive action based on inflation forecasts to reactive based on results. In this scenario, the Fed will probably have to hit the brakes, yet less than full and less inclusive recovery. All of this is bad not only for America but also for the global economy and markets.
Only in the third scenario are there no accidents. Second, more benign due to market reaction. As economists and the Fed see rising inflation through the long lens, markets will be able to live longer on what Bloomberg’s Jonathan Ferro labels as “the moment” – that is, short-term response by taking bond yields faster and taking risks. To destabilize stocks and other risk assets that have benefited greatly from the widespread market confidence in maintaining adequate and able reversible liquidity injections. Excessive and in some cases, irresponsible risk taking can lead to negative financial spillovers.
European Central Bank officials have already complained of “unnecessarily tightening” the euro-zone financial situation as US bond yields remain high, contributing to a slow expanding cycle of interest rate hikes by central banks in emerging economies.
In predicting all of this, I will conclude with confidence that the US will experience rising inflation over the next few months due to base effects and demand-pull. With balance, the next stage of significant cost-push effects is certainly not in my baseline, enough of a meaningful threat that requires close and frequent monitoring. With that comes high market volatility and the possibility of further heated congressional talks on economic and social well-being in the political arena, making it difficult to quickly cross the next financial packages despite their importance for a permanent U.S. recovery.
Mohammed A. L-Arian Bloomberg Opinion columnist. He is president of Queen’s College, Cambridge; Chief Financial Adviser at Pimco’s parent company Allianz SE, where he served as CEO and co-CIO; And Grammarcy Fund Management Chair. His books include ‘The Only Game in Town’ and ‘When Markets Collide.’