I wrote this essay.
Do you disagree that inflation is likely to remain elevated over the next eighteen months, as GDT leads me to predict? If so, what theory do you prefer? The theory that high inflation is transitory? A theory that the Fed will step in and keep inflation at low levels? The theory that I here associate with Modern Monetary Theory, that inflation will only rise when there is hardly any unemployment? A theory that we will have another recession in the months ahead, due to COVID or some other factor?
UPDATE: John Cochrane writes,
The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%.
He makes the same point that I would, namely:
Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.
Read the whole thing.
My view is that the rising inflation environment as experienced in the 1960s boom is unlikely because:
(1) The economy is much more flexible than it was then. Labour shortages coming out of the pandemic can be ameliorated by implementing already-invented labour saving devices especially in retail. If marginal labour demand is in retail or health care (as seems likely), firms can push delivery of those services onto the customer to a significant degree (self checkouts, early discharge from hospitals, on-demand nursing). All of this will blunt low-skill worker’s bargaining power.
(2) Central banks did learn something from the 1970s. It may not be politically popular, but I doubt Jerome Powell wants to be remembered as a failure like Arthur Burns was. If underlying inflation pressures get stronger, I think the Fed will have the guts to withdraw enough liquidity to push rates higher. This is aided by the fact that we are a much older society now than in 1970. Unemployment is bad for the young, inflation is bad for the old so on a relative basis we should be more attuned to it.
(3) The inflation we’ve seen so far looks transitory. Its driven by huge jumps in isolated categories for the most part and inflation expectations look reasonably anchored. Inflation will not become self-reinforcing and require central bank action until Joe Policeman or Jill Schoolteacher asks for a 5% raise as a COLA. We aren’t seeing it.
With respect to 2), inflation is bad for older Americans, but rising interest rates will hurt their bond portfolios and stock portfolios at the same time.
“I’ll note here that my largest portfolio holding is inflation-indexed bonds.”
Aren’t you worried they will lie about the CPI? OER in particular just seems off.
The Zumper August 24, 2021 rent report data show rents are actually lower than a year ago in some major cities even after increasing in recent months: SF, Seattle, Chicago, Philly, Baltimore, LA, Newark, Minneapolis, Houston, Fort Worth. I’m not making this up and you can search for it yourself. Presumably this is not OER but something more “real”.
What about willingness to pay higher rent? Renters own less of the equity and real estate market so they didn’t benefit as much from asset price increases. Unemployment is higher than the pre-pandemic level so again less willingness to pay.
In some jurisdictions there are rent freezes. For example, Washington, D.C. rent is frozen until the end of 2021. These renters don’t have to be willing to pay more until then.
Perhaps the 15% rent increases that are happening in some places are simply because the marginal renter is eager and that the marginal renter might deviate less from the median renter once the ones eager to move have already moved.
The report you mention, despite high profile cases like nyc and sf, says that one bedroom rents are up 9.2% and two bedrooms 11% nationally.
It also doesn’t tackle suburban rents or single family residences, which of course are the housing stock that has seen the biggest increases during the pandemic.
So according to private sector research, rents are up ~10% over the past year.
The CPI value for rent is, to the contrary, up 2%.
https://fred.stlouisfed.org/series/CUUR0000SEHA#0
That’s a fairly large discrepancy.
Not to mention that owner’s equivalent rent should be house prices. The idea that the price level is better measured by including a made up price that no one pays, rather than the largest expense most people make is absurd.
If you replace the CPI rent with the Zumper value, and OER with the FHFA index, we’re already at 1970s inflation levels.
The Zumper data appear to be median rents which is a subject worth reporting on. If people move from SF to a city that has rents closer to the national median, such as Sacramento, then there will be an increase in the national median rent paid. Mean rents are also worth reporting on but it didn’t happen in that Zumper blog article.
To clarify: I imagine an eagerness to move ranking. The most eager make the move and because they are eager they have higher willingness to pay. The right margin renter (highest in eagerness) drives up the rents in a place like Sacramento. After the most eager to move have moved, the propensity to move of even the most highly ranked is less than it was before until the next pandemic or pressure. The moves drive the change in rents more than revaluation of the benefits. A rational person might say avoidance of more crowded places has become a new benefit but people usually think of benefits as being positives more than avoidance of negatives.
I conjecture that it’s not just government debt, but government spending as a fraction of GDP vs resource limits that matters. I guess you could say that “crowding out” of resource use will sometimes be inflationary, regardless of how government finances it.
Example: Fed Govt takes 10% of GDP, and decides that 10% of GDP shall be spent on roads. People who supply roads will know there’s a large pot of money, money that cannot go elsewhere. While they may compete with each other, they’re not competing with trains and busses (on the whole.) What’s more if the elements of the economy that can supply roads is fully comitted at 7% of GDP, that extra 3% will just cause inflation.
But I think this is only material above a certain level (which I don’t claim to have a theory for) and that level will change with how tight or loose a particular market is, resource allocation issues, and so forth.
Put another way, at some level, even with 100% direct funding, compelled spending (mostly government) will be inflationary.
There is an inflation swap market. That would be a good way to actually bet on inflation. The only problem is that like all swap markets, it’s for institutions, not individuals.
I am less optimistic that inflation is transitory.
I’ve spent the past 8 months leading various projects to increase wages for front line employees (hourly warehouse) by as much as 35%. We still dont see turnover and application rates stabilizing. As a Fortune 500 we have deep pockets but Fortune 100s can go deeper.
Other factors – many hourly employees have child care needs. Government schools can fill that need at 1st grade. But for the 1st six years you need day care. With regulations (and frankly daycare provider sanity) requiring some ratio of child to adult of 10 or 15 to 1 this means they need help – but most day cares are Fortune 1,000,000 companies. So they need to radically increase wages too.
This doesnt even get into direct costs.
Basically we will see this ripple out until businesses cut their losses and agree to deliver lower services.
Automation is a pain in the ass to implement – and as long as chips remain in short supply and labor to implement the tech is wrapped up in a talent war it wont be a panacea.
Things will get better as manufacturers throttle capacity – but this will drive inflation.
August data are now available. There was an update the morning of September 14. Both price level plots, core CPI and full CPI, appear to be “bending” so inflation appears to be moderating.
You might be right that there is a 70% probability of greater than or equal to 3% inflation in 2022 but the August data seems to weaken the support for that idea.
You annualized a 4 month inflation rate to get 8.7%. I can annualized a one month rate of core CPI reported in August to get 1.1%. Why does this even matter? It seems to me that 1 year changes are probably more useful. Since a year ago the pandemic was still a new situation there is a “base effect”. This means 2 year changes might be more useful in this special case. Using core CPI the August to August levels are 264.151 and 279.338 which is a 2.8% CAGR over 2 years. This is above the Fed’s intention (or maybe not) despite the negative inflation rate when the pandemic started but not as significant as the 8.7% rate you cited.
Great essay! Mr. Kling explains basic economics very clearly. Some contrary points.
1) There seems to be a growing Eurodollar shortage, esp. in China. That country desperately needs dollars to buy food and fuel. The result may be that the dollar will appreciate considerably against other currencies, esp. EM. The result will be declining commodity prices, along with much cheaper imports.
2) The economy isn’t doing all that well right now. The labor shortage is a bit of a myth because companies can’t raise wages enough to grow the labor force. The reason they can’t do that is consumer resistance. Mr. Kling rightly points out that real estate and cars have gone up dramatically in price. It’s important to mention that sales volumes have shrunk commensurately.
3) Uncontrolled immigration through our southern border will depress low-end wages.
4) There are structural changes in the economy that will reduce the need for labor, reducing both wages and prices.
5) Just because Congress allocates money doesn’t mean the money will get spent. As I understand it, about half the Covid relief funds are as yet unspent. The so-called renters’ assistance to end the eviction moratorium is so far only 20% spent. The moral of the story is that it’s really hard for the gov’t to increase the money supply. If there are strings attached (which when talking about the gov’t, there always are) people simply won’t accept money they don’t need. For example, given record low birthrates it’s unlikely that the gov’t will substantially grow our childcare infrastructure. The Biden administration seems spectacularly incompetent, so they are esp. unlikely to successfully spend the money.
6) The gov’t is flush with cash, and also has a record tax haul. Accordingly they are not now issuing debt. Since banks (domestic and foreign) need T-bills for collateral, the cost of T-bills is going up. This is causing the current low interest rates. Given the debt limit, it seems unlikely that the gov’t will be issuing many bills/bonds in the near future. Foreigners in particular need collateral, and there will be a big market for US debt. I don’t see interest rates rising anytime soon.
7) To the extent federal largesse is flowing to the 1%, then yes, asset prices will appreciate. Mr. Kling predicts that the money will eventually be spent. But for the 1% that “eventually” is likely two or three generations hence. In other words, it’s not an immediate inflation threat.
OK–I confess. I’ve been listening to Jeff Snider recently. But these are the reasons why I think deflation is more likely than inflation–and why I’m long on TLT. I’m probably wrong on a lot of this–maybe even all of it. I’d appreciate some feedback. Thanks.
Okay, here is your feedback. You sound wrong on several items. Buy some subscriptions or read some high reputation sources and you’ll self-correct.
–“The theory that I here associate with Modern Monetary Theory, that inflation will only rise when there is hardly any unemployment?”–
I think MMT has a little more nuance here. I think MMT would acknowledge that people can be unemployed due to skill/geographic mismatch.
Great post!
Love it!