South Winston Salem News

Davidson College recently issued the following announcement.

Vikram Kumar, professor of economics, tells his students that inflation is an “unwanted guest who shows up and doesn’t want to leave.”

And during the upcoming holidays, that unwanted guest is not only overstaying its welcome, it’s dominating the conversation. Inflation is hitting levels not seen since the 1970s. Prices in October 2021 are 6.2 percent higher than they were in 2020–with food and energy leading the surge. 

For the first time in decades, inflation is exceeding acceptable levels.

“We have really not had a significant case of inflation since the early 1990s,” Kumar said. “We have had more than a generation of Americans who have grown up with little inflation.”

And now, with inflation surging, the question is: How long will this go on? 

“Public figures have been trying to shape expectations by saying that the inflation we are seeing is transitory,” Kumar said. “But at some point, when does transitory become non-transitory?

“I think there's a divergence between the Fed and public perceptions.”

Kumar is an expert on international trade and finance, macroeconomic theory and history of economic thought. We caught up with him to talk about this unwelcome visitor and how we can be rid of it safely and quickly.

How are you feeling about the recent inflation numbers?

Not good. There seem to be some warning signs we should be paying attention to.

One of the things about inflation of course is that, if it's expected, it's not a huge issue; though if it is high, it can hurt seniors and lenders. But it’s really important to contain inflation expectations, and we’re starting to see signs that there is a general sense that inflation is on the uptick and is not coming down very soon.

What are you seeing that we should be concerned about?

One is the break-even inflation rate, which is based on differences between the treasury yields and the treasury inflation-protected securities. It's basically a market-based indicator of inflation expectations. And that number predicted that inflation for five years out on average would be about three percent, which is higher than the average inflation target of two percent.

Then, the Federal Reserve Bank of New York recently conducted a survey of inflation expectations that showed inflation expectations high and trending up. You can also see it in rising gold prices. Gold is an inflation hedge, so when it starts to rise it may mean more people are buying it to protect against inflation.

The real problem is that once people build those expectations into their thinking, it begins to push on wages and costs. Higher prices get passed on to consumers and wages need to rise to pay for the higher costs creating a wage-price spiral.

What’s causing the surge in prices?

At its root, it's an imbalance of supply and demand where the overall demand exceeds overall supply. Or you can say that there's too much money chasing too few goods. 

But in the context of our economy, there are a number of factors.

COVID-19 created some shocks on the supply side. You’ve probably read about the semiconductor and microchip shortage that is causing a number of shortages where supply cannot meet demand. That’s an example of how the pandemic interrupted the supply side of our economic system.

At the same time, commodity prices like oil and gas have gone up. 

But the biggest surprise is that the labor force has had a very tepid recovery from the pandemic. We don’t know exactly why it’s happening yet. It’s possible this is a natural evolution of the market. The labor force participation rate has actually been dropping for the last 20 years. 

But we just do not have sufficient data yet to explain exactly why this is happening. 

Those all weigh on the supply side. Has the demand side changed as well?

Yes, we are in the midst of a highly expansionary mix of monetary and fiscal policies. The extent of stimulus that is in the economy is quite unprecedented in peacetime. 

The 2008 financial crisis and the great recession established new baselines of how far policy can go in terms of government stimulus. And I think the Federal Reserve was trying to move away from that degree of support to the economy right when the pandemic hit and upturned all plans for sustaining an economy during a shutdown.

What can the Fed do to control inflation?

The Federal Reserve has a dual mandate of maximum employment and price stability. And starting in 2012, the Fed's interpretation of price stability was a two percent inflation rate. Then in August 2020, it changed its targeting policy to be more flexible. It's going to target an average of two percent over an undefined period. 

I think that the message that the Fed is sending out has become a little muddled. It’s something that I think the Fed would be wise to revisit.

Once inflation takes root, it's very costly to uproot it. Because to undo it, you have to take the economy through a recessionary phase. That's the orthodoxy. So I think we should not be sanguine about the current state of affairs. I'm not hearing the degree of concern that I’d like to.

In the context of inflation, prevention is definitely better than the cure.

How might the proposed infrastructure and Build Back Better bills impact inflation? We hear a lot about that affecting political support for the bills.

I think the infrastructure bill will contribute very modestly to demand in the short run and so it would have a pretty small impact on inflation. Most of its impact will be over the long run since it takes a long time to build infrastructure. There’s also going to be a beneficial effect because if it's implemented prudently, it should increase capacity for the economy.

The Build Back Better bill is more complicated.

It sounds like it will increase demand pressure because spending is front-loaded relative to tax receipts. And I don't think taxes will reduce consumption much because if they are mainly paid by the very rich, the rich will pay their taxes out of savings; they won't decrease their consumption.

So, as it stands now–and it’s almost certain to change–the Build Back Better bill would add to inflation.

Original source can be found here.