High inflation will likely be with us for a while, which means I’ll be writing a lot of posts like this. So, for the sake of variety, after this morning’s inflation news, I’ll try to put as optimistic spin on it as possible. Just keep in mind that today’s news is objectively very, very bad. The Consumer Price Index (CPI) increased by 1.2 percent during March, which annualizes to 8.5 percent inflation. This up sharply from February’s 0.8 percent month-over-month increase and 7.9 percent annualized rate. The Fed’s target inflation rate is 2 percent.
A small part of the CPI increase is due to the Kremlin’s invasion of Ukraine and the related energy supply shock. As I recently explained, supply shocks are not inflation. When the administration points to Putin to deflect blame from itself, it won’t be entirely wrong, but it will be exaggerating.
For one, energy is only 7.5 percent of the basket of goods that CPI tracks, or less than 1/12th, not nearly enough to push inflation as high as it is now by itself.
Second, while, the Putin oil shock is severe enough to show up in the CPI, that doesn’t make it inflation. It is extremely difficult to tease out how much of a good’s price rise is due to monetary inflation that affects all goods and how much is due to a supply shock that affects just one good (and its downstream uses). The CPI is not up to the task, which is one reason why the Fed no longer uses it.
One way to compensate for this is to use the Core CPI instead of the regular CPI index. This is identical to the standard CPI, but excludes food and energy, which have frequent inflation-unrelated supply shocks. This currently reads an annualized 6.5 percent. The Atlanta Fed also calculates a Sticky Price CPI based on a similar philosophy. Its most recent reading is 4.3 percent.
These are both better than the standard CPI’s 8.5 percent inflation rate, and likely more accurate, since they exclude supply-shock-prone goods. But the target inflation rate is 2 percent, and inflation is still at multi-decade highs by any measure.
The second piece of (kind of) good news is that the Fed can get inflation back to its target 2 percent level very quickly. Congress and President Biden have not been helping with their multi-trillion-dollar deficit spending spree, which will likely add a percentage point or so to the inflation rate for as long as the next decade. But that’s only one percentage point out of eight.
Most of the rest is on the Fed, which has been creating new money at a frantic pace in an attempt to stimulate the economy during the COVID-19 pandemic. This was not the right thing to do, since the economy was otherwise healthy, but this mistake is fixable. All the Fed has to do now is to slow money supply growth so that it matches growth in real economic output. It has the authority and the tools to do so.
That does not mean reducing the money supply in absolute terms. The money supply should still grow, which is an underappreciated point right now among inflation hawks. The money supply needs to grow at the same pace as the rest of the economy, but not slower than real growth, which would cause deflation. And not faster, which is what is causing today’s inflation, but as close a match as possible.
The Fed is able to quickly grow the money supply by buying large amounts of government bonds. It pays for these with new money it creates, which then spreads throughout the economy. The Fed can counteract this just as quickly by doing the opposite—selling government bonds. It can then retire from circulation the currency it receives from bond buyers.
The Fed seems to know this, and ended its multi-trillion-dollar COVID-stimulus bond buying program last month. It is also hiking the federal funds rate. This has smaller inflationary effects than the bond buying program’s direct money creation, but the federal funds rate has important psychological effects on the public’s inflation expectations. Many supply chain and investment decisions cover months and even years. Companies set their prices today in part based on what they expect inflation to look like over those periods. If the Fed credibly commits to getting its monetary house in order, companies will set their prices accordingly.
Expectations aren’t as important as the actual money supply, but they still matter for getting inflation back to Earth. Higher interest rates can play a positive role, despite their lack of oomph on attacking inflation directly. The Fed has indicated that it will continually raise the federal funds rate for at least most of this year.
While it will take a few months for those changes to work their way through the economy, they bode well going forward, especially if the Fed ramps up its changes to the degree it should.
There is some reason for guarded optimism, if you look hard enough. On one hand, anything could happen with Russia and Ukraine, the Fed is being far too timid, and Congress and President Biden show no indication of reining in deficit spending. But on the positive side, supply shocks are not inflation, no matter what the CPI says. The Fed has finally started to do the right thing. These things take time to percolate through the economy, so inflation will likely remain at or near 40-year highs for a while, but we may be at or near the worst of it.
As Eric Idle sings in the crucifixion scene at the end of The Life of Brian, always look on the bright side of life.