The end of ‘the end of inflation’

Inflation can no longer be dismissed as only a concern of the past

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Jul 09, 2021

Sections Economics

Concerns about inflation began to look much more prescient when the price index for personal consumption expenditures this past April was up 3.6 percent year over year, the biggest such jump since 2008. Core PCE (the same index, but without food or energy prices factored in) for the month rose 3.1 percent, a leap the likes of which we haven’t seen since the early 1990s. Fed officials have assured us this spurt of inflation is temporary. 

Whether it really is temporary or the beginning of a more persistent rise, the surge clearly already means one thing: the end of “the end of inflation.” 

For 25 years, inflation has seemed stuck on a downward trend. Those of us who worry about inflation seemed like end-of-the-world sign holders who couldn’t leave the 1970s behind. It’s hard to buck the trend. A famous economist advised me to give up studying inflation—inflation is 2 percent, he said, that’s all you need to know. 

Well, apparently not. Inflation can happen, and there is an economics of inflation. Right now it’s pretty obvious where inflation is coming from—supply constraints both natural and artificial, coupled with rampant demand. 

Nobody is really sure where inflation will go. A June poll of economists conducted by Chicago Booth’s Initiative on Global Markets provides a good indication of how wide sensible consensus is on the issue: 26 percent of the economists agreed that “the current combination of US fiscal and monetary policy poses a serious risk of prolonged higher inflation,” 23 percent disagreed, and 40 percent said the answer was uncertain. 

Maybe these are just temporary shocks, supply bottlenecks, a one-time price-level rise from stimulus. Or maybe it is the beginning of the 1970s again, when exactly the same excuses were offered. 

I’ll summarize my bottom line in thinking about this issue. 

1) The dynamics of inflation are roughly: 

inflation = expected inflation + inflation pressure (*)

If people expect higher inflation next year, sellers will be quicker to raise prices, and buyers will be quicker to pay higher prices. The right measure of inflation pressure is more contentious. Traditional metrics such as the unemployment rate or the GDP gap have been pretty terrible measures. For fundamental pressures, take your pick of too-low interest rates set by the Fed, too much money, or too much debt and deficit. Whichever it is, if expected inflation remains “anchored,” inflation comes back quickly once the pressure is off. If expected inflation rises, we’re in trouble. 

The Fed seems to think that anchored expectations come from soothing speeches about how anchored expectations are. At worst, it may say it has “the tools” to contain inflation should it break out, but it seldom says just what those tools are. 

If anyone could tell you for sure that we will have inflation next year, we would already have inflation today.

I believe that expectations come from expected actions, not speeches—and better, from robust institutional rules and commitments that force necessary but unpleasant actions when needed. At least, people must believe that the Fed is willing to repeat 1980—dramatically high interest rates, causing a deep recession, if that’s what it takes. 

And raising interest rates will be much harder now than it was in 1980 for a number of reasons: 

  • The debt-to-GDP ratio is 100 percent, rather than 25 percent, so higher interest rates will immediately hurt the budget.
  • Huge reserves mean the Fed will be seen to pay a windfall to big banks to not lend out money.
  • The too-big-to-fail banks will all lose a bundle if interest rates rise. 
  • The Fed’s current emphasis on inequality will also restrain it, as a recession will hurt the most vulnerable the most. 

2) In today’s economy, in the end, inflation comes when people do not believe the government will repay debt. Beyond changing interest rates, the Fed only changes the composition of government debt—reserves versus Treasurys—but not the amount of debt. Whether we hold Treasurys via the world’s largest money market fund (that’s what the Fed is) or directly really does not matter. 

Inflation does not come from debt alone, but from debt relative to a credible plan and expectation that debt will be repaid. Expected inflation is anchored by the belief that if inflation gets out of control, our government will promptly put its fiscal as well as monetary house in order. Moreover, since our government has tragically borrowed short term, inflation comes when people believe that other people will lose this faith. 

Putting the fiscal house in order is not hard as a matter of economics—it requires a straightforward progrowth reform of the tax code and entitlements. But our government has kicked that can down the road for nearly 40 years, and absolutely nobody wants to do it. It may have to come during or after the crisis, which will be much harder. 

None of these thoughts are useful as a short-term forecast, which I do not offer. Both fiscal- and monetary-policy expectations can switch quickly. I can offer, then, a summary of the forces at work, but those forces only emphasize how hard forecasting must be. If anyone could tell you for sure that we will have inflation next year, we would already have inflation today. The logic of (*) is like the logic of a bank run or a stock market crash. That nobody can predict inflation well is proof of the theory. 

This spurt may pass, and expected inflation, reflecting faith in the ultimate sanity of US fiscal and monetary policy, remain anchored. Or this spurt may lead to a quick undermining of that faith. 

But at least the question is alive again, and a matter of useful economic analysis and debate. This is for sure: the end of “the end of inflation” is at hand.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.