Streetwise Professor

I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks. Feckless progressive Democrat presidents. (Though Carter, while an idiot, was at least compos mentis, which is more than can be said of Señor Senile Joe Biden.) Crime. (I’m betting on a comeback of the Charles Bronson revenge and Clint Eastwood Dirty Harry genres.) All in all, the 70s sucked, and I am not nostalgically hoping for a reprise–I’m dreading it actually.

One of the things that sucked worst was inflation. The 1970s were the inflation decade (although it peaked in 1980-1981). In recent months, the price level measured by the CPI, PPI, and GDP deflator has been up substantially. CPI, for example, is up about 4.5 percent on a year-on-year basis. This has raised concerns about a return of 70s-style inflation. Are these concerns justified?

The jury is out, but there is reason for concern.

First, it is important to distinguish between one time changes in the price level and inflation. Inflation is a long term upward trend in the price level, rather than a single stair-step jump in the price level.

The impact of the pandemic (or, more accurately, the draconian policy response to the pandemic) has created the conditions for a one-time step up in the price level. The economic recovery from the pandemic is a positive aggregate demand shock. Moreover, it has occurred against the backdrop of constrained supply conditions that resulted from the pandemic. Upward shifts in supply and demand lead to a higher price level, ceteris paribus.

One would think that these are effectively one-time shocks–hopefully the pandemic is a one-time thing, and therefore the recovery from it is too. Furthermore, supply conditions should ease. (We are already seeing that in some sectors, such as lumber, though not in others, such as semiconductors. Policy, namely paying people not to work in some states, may impede the easing of supply conditions). Thus, one would expect that this is one time, and at least partially transitory, jump in the price level rather than inflation qua inflation.

That said, there are reasons for concern. Most notably, the fiscal diarrhea in the US, and the willingness of the Fed to finance (i.e., monetize) that spending is freighted with inflationary potential.

In the post-Financial Crisis era, the Fed mitigated the inflationary impact of QE and other expansive monetary policies by paying interest on reserves. So the inflationary threat that I worried about in 2009 (and asked Ben Bernanke about) never materialized. But that’s no reason for complacency. We dodged a bullet once, but that doesn’t mean we will always do so. Massive deficit spending accommodated by the monetary authority is highly likely to result in inflation, sooner or later. (I am inclined to favor Thomas Sargent’s fiscal theory of the price level.).

Part of the reason that inflation didn’t occur post-2008 was that money velocity plunged. Part of this was due to the Fed paying interest on reserves, which led banks to hold them (lend them to the Fed in effect) rather than lend them to private individuals and firms. But expectations, and the self-fulfilling nature thereof with respect to inflation, likely played a role too. In the gloomy aftermath of 2008 people expected low inflation (or even deflation), which made them more willing to hold rather than spend money balances–which results in low inflation, thereby validating the expectations and perpetuating the equilibrium.

But expectations are fickle things, and as a result there can be multiple equilibria. Fed board members have strenuously argued that the recent spurt in prices is a one-time stair step phenomenon, not the harbinger of inflation. But if the spurt results in an upward shift in inflationary expectations by the hoi polloi, people will be less willing to hold money balances at the existing price level, so they will try to reduce (i.e., spend) them, which leads to inflation–thereby validating the expectations.

Thus, it’s not so much what the Fed believe that matters. It’s about what you and me and other individuals and firms believe. Combine a negative fiscal picture with a surge in prices and it’s quite possible that inflation expectations soon will no longer be “anchored” at low levels, but will surge to higher levels, which would result in inflation no longer being anchored at low levels.

So although I think that the recent surge in the price level is of the one-time variety, that doesn’t mean everyone will think the same way. And if everyone doesn’t think the same way we may see a 70s rerun. The dire fiscal picture contributes to such worries.

When the subject of inflation comes up, as Dr. Commodities I’m often asked whether commodities are a good hedge. Intuitively it makes sense that they should be, but historically, they have not been. Commodity prices are much more volatile than the price level, and not that highly correlated. That is, relative prices move around a lot even when the price level trends upwards.

I think that availability bias is a big reason why people focus on commodity prices–they are readily observable, on a second-by-second basis, because they are actively traded on liquid markets. Other goods and services, not so much. But just because we can see them easily doesn’t mean that they are reliable beacons for the price level overall, or changes therein.

This brings to mind why we should really fear a return of 70s-style inflation (or worse, heaven forfend).

When sitting in (the great) Sherwin Rosen’s Econ 302 course at Chicago on a cold morning in February, 1982, I was startled when Sherwin’s normal rather droning delivery was interrupted by him shouting and pounding his right fist into his left palm: “And that’s the problem with inflation. IT FUCKS UP RELATIVE PRICES!!!!”

Some prices are stickier than others, meaning that inflation pressures can impact some goods and services more and sooner than others–thereby causing changes in relative prices.

This is a bad thing–and why Sherwin dropped the F-bomb about it–because relative prices guide resource allocation. If you fuck up relative prices, as inflation does, you interfere with resource allocation, leading to lower incomes and growth. Inflation has adverse real consequences.

So we should definitely fear an acid flashback to 70s inflation. And although I do not believe the recent surge in prices is a harbinger thereof, I think that there is a material risk that we may all experience such a flashback–even if you didn’t grow up in the 70s.