Why you need to keep cool if inflation starts to heat up

Do you remember the great inflation scare of 2010-2011? It’s an episode worth revisiting, because there’s a good chance that we’ll see a replay over the next year or so.

After the 2008 financial crisis plunged America into a deep recession, both the new Obama administration and the Federal Reserve tried to stimulate the economy, spending hundreds of billions on a variety of programs while buying trillions in bonds. There is now consensus among economists that these efforts were helpful but also inadequate (as some of us argued at the time).

On the right, however, it’s an article of faith that activist government is bad, even in a crisis. So there were many warnings that these efforts to rescue the economy would cause runaway inflation. By mid-2010 there was a palpable sense of frustration among conservatives that inflation had failed to materialize.

Then came a few months when inflation seemed to be rising after all. Consumer price inflation reached almost 4%, and the average price of commodities like oil and soybeans rose almost 40% in a year. Soon Republicans were haranguing Ben Bernanke, the Fed chairman, suggesting his efforts might

“debase the currency.”

But the Fed stayed its course, arguing correctly that rising prices were a blip, not a harbinger of ’70s-style stagflation. Inflation soon subsided, and it has stayed low ever since.

Now here we go again. The $1.9 trillion American Rescue Plan will, without question, deliver a lot of economic stimulus. Just about everyone, from private forecasters to the

Fed, expects an economic boom, with the U.S. economy growing at rates not seen since the 1980s. There will almost surely be a rise in inflation, too.

And rising inflation will, in turn, lead once again to talk about a return to stagflation. So here’s how to keep your cool when inflation headlines get heated. The key is to understand is that there are really two kinds of inflation.

The prices of some goods, like oil and soybeans, fluctuate all the time, changing day by day or even minute by minute in response to changes in supply and demand. Many other prices, however — including the price of labor — change less frequently. Most workers’ wages are adjusted once a year.

Stagflation, it turns out, mainly involves “sticky” prices.

Imagine an economy in which everyone expects inflation to be high for the foreseeable future. In such an economy, a company setting its prices for the next year will do so taking into account the likelihood that everyone else’s prices will be going up over time.

Reflecting this expectation, companies will mark prices up relative to what they would have been if they didn’t expect future inflation — which feeds the inflation they fear.

Short-term fluctuations in volatile prices, however, tell us little about whether stagflation is a risk. That’s why Fed policy generally ignores the headline inflation rate and focuses on a measure that excludes food and energy prices.

So what’s going to happen in the months ahead? We’ll probably see a number of transitory price increases. The question will be whether these price increases are a 2010-2011type blip or something more dangerous. If they aren’t — and my bet is that they won’ be — the lesson of 2010-2011 will remain: Don’t panic.

Now as then there are people eager to denounce government attempts to help the economy. And it’s certainly possible that the American Rescue Plan will turn out to have been too much of a good thing. But don’t let the usual suspects seize on a few months’ inflation data as evidence of looming disaster.

Paul Krugman writes for The New York Times.