Contributed by Dr. Thomas D. Simpson, Executive in Residence at the UNCW Cameron School of Business. Dr. Simpson joined the Department of Economics & Finance after his retirement from the Board of Governors of the Federal Reserve System in Washington, DC.

Written for Wilmington Business Journal – Link.

According to public opinion polls, after a forty-year hiatus, inflation has returned as the top concern facing our nation.   The chart below shows the most widely known measure of inflation—the Consumer Price Index (CPI).  The blue line shows headline CPI inflation, and the red line shows headline inflation after removing volatile food and energy prices—so-called core inflation.  Headline inflation rose to 8.5 percent over the twelve months ending in March, the highest in forty years.  Not surprisingly, this increase was paced by energy prices, as you observed from filling up your car.  Even after removing food and energy prices, core prices rose 6.5 percent, also the highest in forty years.  It is noteworthy that forty years ago the country was enduring the worst recession of the postwar period (to that time)—which was the cost that had to be paid to bring inflation under control.

The term inflation refers to a sustained increase in the average price of the goods and services that we buy.  There are two primary indexes that measure consumer prices, the CPI (mentioned above) and the Personal Consumption Expenditures (PCE) index.  The PCE index is favored by the Federal Reserve (Fed) and many analysts because it is thought to be a more accurate measure of the change in the cost of living.  The Fed has set a target for the PCE index of 2 percent, and that target has been seriously breached over the past year.

Inflation is caused by too much aggregate demand in relation to aggregate supply.  Our current bout of inflation can be traced to the COVID shock in early 2020.  At the onset of the lockdown, both demand and supply plunged, total output collapsed, and many prices fell.  Once conditions began to stabilize, demand snapped back more sharply than supply.  The rebound in demand was aided by a dramatic shift in Fed monetary policy—that took short-term interest rates down to near zero—and that was supplemented by massive purchases of Treasury and other securities, and by an unprecedented surge in federal spending (exceeding $5 trillion) aimed at COVID relief.  With demand outstripping supply, business inventories were drawn down—shelves became bare—and prices began to turn up.  Some of the restraints on supply have come from supply chain disruptions—notably of microchips—and a reluctance of workers to return to the workforce because of the pandemic.  The continued substantial excess of demand over supply has led to faster inflation. 

Previous experience has shown that once inflation has persisted this long, it gains a momentum that is hard to break.  Businesses transition from viewing price changes as indicators of movements in relative scarcity to indicators of broader-based inflation, and these businesses change their pricing strategy to raise their prices frequently to protect against anticipated losses of the purchasing power of their dollar receipts.  Similarly, workers seek increases in compensation that cover the loss of purchasing power that they face.  For most workers, their compensation will in time adjust upward to the higher rate of inflation, but those in lower-income brackets typically lag behind.  Similarly, prices of real estate and stocks will rise in line with underlying inflation after a period of adjustment to higher underlying inflation. 

The task of bringing inflation under control falls on the Fed as it has in the past.  The Fed will need to raise short-term interest rates a good bit before we see inflation on a distinct downward trajectory.  To some degree, inflation relief will come from an easing of supply-chain disruptions and a return of idled workers to the labor force.  But those factors will not be nearly enough.  Interest rates will need to rise above the underlying rate of inflation to curb demand by enough to stop inflation momentum.  The burden of these rate increases will fall heavily on the housing and other interest-sensitive sectors.  As often in the past, this tightening of monetary policy may well push our economy into recession.  The longer the Fed acts cautiously in limiting necessary increases in interest rates, the greater the odds of a painful recession.  

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