On inflation, we should learn from the mistakes of the past

A year ago I warned that “there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflation pressures of a kind we have not seen in a generation.”

At the time, the much-greater optimism of the Biden administration and Federal Reserve were in line with the consensus views. The Survey of Professional Forecasters expected 2% inflation and essentially saw no possibility that core inflation would exceed 4% in 2021. It came in at 4.9%, and the consumer price index was up 7% – with huge consequences for consumer sentiment, President Joe Biden’s approval rating and the sense that the country was on the right track.

Where did the consensus go wrong? What are the implications for judging the current economy? And what must be done now to contain inflation?

The largest errors a year ago came from a deep faith in inertia. After 40 years of almost totally stable inflation, most observers failed to recognize that pursuing fiscal and monetary policy on a transcendent scale to increase demand, at a time when covid-19 was likely to curtail the supply of labor and goods, risked generating a huge overflow of demand. Similarly, after an extended post-financial-crisis period of sluggish growth, they failed to appreciate just how quickly the economy could shift from being demand-constrained to supply-constrained.

It is wrong to blame inflation on the slower-than-expected retreat of covid. Indeed, Jason Furman, chairman of the

Council of Economic Advisers under President Barack Obama, has raised the serious possibility that inflation would have been even higher in 2021 without the delta variant’s negative effect on demand for services.

Now, the consensus view is that inflation will fall below 3% by the end of the year as unemployment continues to decline. Unfortunately, I fear that is likely a repeat of last year’s wishful thinking.

Some elements of the high inflation encountered, such as used car prices, are sure to turn out to have been transitory. Unfortunately, given developments in China and energy-market bottlenecks, other drivers of inflation might get worse before they get better. And housing – one-third of the CPI – has been a transient factor holding down measured inflation, as the CPI’s housing component has increased less than the overall index even as measures of homes prices and rents have risen at rates approaching 20%. Even if all other prices were flat and housing prices stabilized, housing alone will likely be enough to push core CPI above 2% in 2022.

But the key to understanding medium-term fluctuations in inflation is labor costs, which represent more than two-thirds of all costs across the economy. Everyone wants a raise, but periods when wages rise rapidly can also be periods when workers’ purchasing power falls sharply due to inflation – as the experience of this past year illustrates.

Labor costs are rising at close to 5% and accelerated throughout 2021, according to the best available data, which is the Employment Cost Index for private-sector workers after taking out the highly volatile incentive-pay component. This should not be surprising, given the unprecedented ratio of job openings to unemployed workers. Wage growth is likely to keep accelerating. Unless productivity skyrockets or businesses cannot pass on cost increases to customers – all contrary to recent experience or the testimony of business leaders – we now have an underlying inflation rate of 6% or more.

There are many who embrace super-tight labor markets on the grounds that they empower workers, and particularly disadvantaged workers. This benefit is real and significant for as long as it lasts. If a bit of extra inflation were the price of enjoying the worker benefits of red-hot labor markets, it would be a price clearly worth paying.

The rub comes in a principle enshrined in almost all economics textbooks but largely forgotten during the recent decades of price stability. Macroeconomic policies that push demand well past the economy’s capacity, such as those we have pursued over the past year, do not just lead to inflation but rather to increasing inflation – with the inflation rate accelerating for as long as the economy overheated. The painful lesson of the 1960s, 1970s and the 1982 recession is that excessive demand stimulus leads not just to inflation, but to stagflation and ultimately recession, as inflation must eventually be brought under control. Overly easy policies also lead to bubbles in financial markets that ultimately burst with catastrophic consequences for unemployment and poverty.

The past 60 years of economic history record few if any instances of inflation declining substantially without significant slowdown. Policymakers can either learn from that history or repeat it.