The United States has not faced a serious inflation problem since the 1980s. Nonetheless, many pundits worry that highly stimulative monetary and fiscal policies could trigger high inflation. Some even claim that inflation is already much higher than the official data suggest.
For the most part, we don’t have to worry. Aggressive fiscal policy, for better or worse, is unlikely to lead to high inflation. Let’s take a few of these concerns in turn.
There is no perfect measure of inflation, so it is possible that government inflation measures understate the degree to which prices are rising. But there is good reason to be skeptical of claims that inflation has been far higher than the official figures in recent years.
If that were true, it would imply that real GDP growth has been far below official estimates, as any mistake in measuring inflation implies an equal-and-opposite error in measuring real growth. Thus, if inflation in recent years were 4 percent, then the economy during the late 2010s (widely viewed as a boom period) would have experienced almost no growth at all. Given the robust jobs growth we experienced, that seems unlikely.
Complicating matters, there is no objective way of measuring inflation when the quality of products changes. An iPhone is much more expensive than a cell phone from 20 years ago. Does that mean prices have inflated? An iPhone also replaces a still and video camera, flashlight, radio, tape recorder, small TV, calculator, encyclopedia, magnifying glass, watch, alarm clock, wallet, phone book, map, photo album, scanner and many other products.
As a result, our homes are often much less cluttered than they used to be. With such a rapid change in living patterns, it is not even clear which “cost of living” to measure when estimating inflation.
Turning to the bottom-line numbers, the Federal Reserve has settled on a 2 percent “average inflation target” as measured by the government’s PCE index. Because this index runs about 0.3 percent below the more widely known Consumer Price Index (CPI), we should expect the CPI to rise at about 2.3 percent annually going forward. In addition, the Fed’s recent decision to target the average inflation rate over the long run means that they intend to try to make up for the low inflation rate of 2020 with a period of above 2 percent over the next few years.
For all of these reasons, a period of 2.5-to-3 percent CPI inflation in the near future does not mean that inflation is out of control.
Misconceptions also occur when monetary policymakers discount or minimize a temporary surge in the prices of food and energy. Given that these two categories are especially visible to consumers, why do experts focus instead on a “core” inflation rate that excludes them? It is not because the Fed doesn’t care. Rather, it views the core inflation rate, not the more-inclusive headline inflation rate, as the best predictor of future inflation. The prices of both food and energy move around unpredictably, like a random walk.
Some pundits are concerned that highly expansionary monetary and fiscal policies will lead to excessive inflation. Actually, there is little evidence that fiscal policy has much effect on inflation. Budget deficits were modest in the 1960s and 1970s, even as inflation soared to double digits. Deficits became much larger in the 1980s, a time when inflation fell sharply. The Fed can offset any inflationary impact of fiscal deficits by adjusting monetary policy, perhaps through higher interest rates.
In contrast, expansionary monetary policies can indeed cause high inflation, but two factors have recently blunted the usual impact of printing more money. As global interest rates have fallen close to zero, the public and banks have been willing to hold the new money created by quantitative easing programs, rather than spending the extra cash, as they would do during the 1960s and 1970s.
In addition, the Fed now pays interest on bank reserves. When the economy recovers and interest rates begin to rise, the Fed intends to raise the interest rate paid on bank reserves, which will encourage banks to continue holding larger-than-normal levels of cash on their balance sheets. This restrains lending and holds down inflation.
Eventually, we’ll have a new generation of policymakers with no memory of the Great Inflation of 1966-81. Government officials will begin to (wrongly) assume that inflation cannot occur in a modern economy, due to factors such as globalization and technology. That is when we should begin to worry about inflation. But not yet.
Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy with the Mercatus Center at George Mason University and a professor emeritus at Bentley University.