The Case for Inflation

Colloquially, inflation is generally ignored and misunderstood as a topic for stuffy economists. As consumers, we rarely notice the couple-cent increase in the price of our groceries, but this time we might. Inflation is easily, and albeit boringly, defined as being the change in the price level of an economy. The basic laws of supply and demand govern inflation; as the economy is flooded with cash, the value of that cash decreases. While inflation most obviously leads to price increases, in the United States, it’s even more economically fatal than other countries. The United States Dollar (USD) serves as the world’s primary currency (Federal Reserve Bank, 70) and as such, its value is intrinsically important to the global economy. As the rate of inflation increases, the value of the USD decreases, thereby putting the entirety of the world economy in flux. 

Inflation has tended to fluctuate dramatically in the United States. As can be expected, it drops dramatically during a recession and has a steep increase in the economic rebound (FRED). In recent economic history, recorded since 1960, the highest peak of inflation was in 1980 where it was around 13.5%. Since 2012, the Fed has transparently held 2% as its target inflation rate (Board of Governors, FRB). While there have been times, such as 2015, where inflation has been dramatically lower than the Fed’s target rate, 0.12%, the Fed has generally tended to be successful. The Fed’s dual mandate system, established by Congress, dictates that two of the bank’s main objectives must be to maintain both low and stable inflation rates (~2%) as well as low and stable unemployment rates. Which mandate takes precedent depends on the economic conditions at the time. 

The Fed’s current policy of purchasing treasuries through the creation of dollars and maintaining low interest rates coupled with the recently passed stimulus project are “stoking inflation fears” (Davies 2021). These expansionary monetary policies make it abundantly clear that Jerome Powell’s current focus is the high level of unemployment (Thorbecke 2021). Powell has repeatedly emphasized that the Fed will continue its easy-money policies until there are more tangible threats of high levels of inflation and the presence of a strong labor market. (Powell 2021). While inflation is most commonly referred to as the increase in prices, there’s a major difference between a consistent price increase over several consecutive years versus a one-time increase following a recession. Jerome Powell is confident that the combination of the Fed’s continuance of expansionary policies while maintaining a long term target rate of 2% will allow the economy to grow in the short- and medium term while ensuring inflationary stability in the long-run.

Inflation is inherently driven by expectations. Jerome Powell is relying on consumers’ and investors’ trust in the Fed to ensure a stable inflation rate. Theoretically, the Fed’s actions should be increasing inflation. However, the market’s faith in the Fed is holding prices relatively stable (Schneider 2021). Powell has indicated that he anticipates a one-time “pop” in inflation, but a return to normalcy afterwards (Schneider 2021). While the eventual spike in rates has the potential to undermine the public’s confidence in the bank, Powell’s anticipation and warning to investors indicates the bank’s commitment to transparency: this will ultimately ensure the market’s long term faith in the bank. This increase in prices will most likely be driven by a sharp increase in demand once public health conditions improve and unemployment decreases. 

Policymakers, economists, investors, and consumers are in a rare but general consensus: unemployment is a larger concern than inflation. While this consensus is unlikely to last, it still provides major bilateral support for the Fed’s policies of keeping rates low. For Powell to combat inflation, which we have yet to see, the Fed would have to sacrifice employment which quite frankly the economy is not ready to do. Based on Powell’s statements, it is clear that significant tightening of the money supply is unlikely to occur before 2023 (Winck 2021). Since the 80s and 90s, the Fed has proven itself competent in holding rates at steady levels; however, this may be the Fed’s greatest test yet (Schneider 2021).

While the vast majority of the market is in agreement with Washington’s inflationary analysis, some analysts and reporters are more hesitant in the Fed’s policy to continue to prioritize unemployment fears. Given the data coming out of Washington, downward pressure on wages and a modest increase in the Consumer Price Index (CPI), it appears that any fears of a disproportionate increase in the CPI are unwarranted (Jakab 2021). However, the bond market and quicker than anticipated economic recovery indicate otherwise. The continuous climb in bond yields, associated with higher rates of expected inflation, indicates that the bond market anticipates an imminent spike in inflation; whether this spike is a permanent shift in the inflation curve or an outlier is dependent on the Fed’s ability to exercise its monetary tools. In addition, an additional 916,000 jobs were added to the market in March, approximately 241,000 more than what was anticipated (Jakab 2021). This steeper than expected recovery does little to calm inflationary fears and instead leads investors to question the prioritization of the labor market.

Inflation’s greatest impact on the market is uncertainty. While investors can rely on the bank to keep rates low until 2023, long term policy is uncertain. Although it is clear that there will be at least a one-time increase in prices, it’s unclear as to what long-term effect that policy may have on consumers. As the economy continues to get back on track, it remains to be seen whether the Fed will engage in a gradual increase of rates or if it will rely on a one time jump of the rate. An important phenomenon to underscore is the Federal Reserve Bank’s steadfast ability to control the effects of inflation for the past three decades. The past year has been accompanied by abundantly high levels of uncertainty that will undoubtedly plague the market for the next few quarters. However, so long as investors remain confident in the Fed’s ability to control the effects of economic stimulus and expansionary monetary policy, inflation is unlikely to pose a major threat to the market. Once consumers and firms begin to doubt the bank’s ability to maintain low and stable inflation while prioritizing unemployment, the precarious balance necessitated for the market may shatter.

Sources

Bank, Federal Reserve. 2016. “Section 4 - Function: Promoting Financial System Stability.” The Federal Reserve System : Purposes and Functions, 2016: 54–71. https://doi.org/10.17016/0199-9729.10.

Board of Governors of the Federal Reserve System. Accessed April 9, 2021. http://www.federalreserve.gov/faqs/economy_14400.htm.

Davies, Paul J., and Caitlin Ostroff. 2021. “Why Covid-19 Aid, Inflation Fears Hold the Key to the Dollar's Future.” The Wall Street Journal. Dow Jones & Company, March 18, 2021. http://www.wsj.com/articles/why-covid-19-aid-inflation-fears-hold-the-key-to-the-dollars-future-11616059289.

“Inflation, Consumer Prices for the United States.” FRED, March 3, 2020. https://fred.stlouisfed.org/series/FPCPITOTLZGUSA.

Jakab, Spencer. 2021. “Jobs Report Might Shift Thinking on Inflation and Yields.” The Wall Street Journal. Dow Jones & Company, April 2, 2021. https://www.wsj.com/articles/jobs-report-might-shift-thinking-on-inflation-and-yields-11617377445. 

Powell, Jerome. 2021 “Powell Says Fed Plans to Keep Inflation Anchored at 2%.” Interview by Nick Timiraos. WSJ Jobs Summit, WSJ, March 4, 2021. Audio, 0:27. https://www.wsj.com/video/powell-says-fed-plans-to-keep-inflation-anchored-at-2/0584A2DF-9104-44AF-9F7F-C93EC338DE1A.html 

Schneider, Howard. 2021. “Analysis: Fed Hopes for Inflation Psych-out, Stable Expectations, as Prices Rise.” Reuters. Thomson Reuters, March 22, 2021. http://www.reuters.com/article/us-usa-fed-expectations-analysis-idUSKBN2BE16B.

Thorbecke, Catherine. 2021. “Unemployment Rate Falls to 6% in March, Employers Add 916,000 Jobs.” ABC News, April 2, 2021. https://abcnews.go.com/Business/unemployment-rate-falls-march-employers-add-916000-jobs/story?id=76788420.

Winck, Ben. 2021. “US GDP Will Return to Pre-Pandemic Highs by the End of March, Morgan Stanley Says.” Business Insider, March 9, 2021. http://www.businessinsider.com/economic-outlook-us-gdp-growth-inflation-unemployment-forecasts-morgan-stanley-2021-3#:~:text=The%20US%20economy%20will%20grow,rate%20from%20before%20the%20crisis.