15 March 2021


By Raul Elizalde

This article also appeared on forbes.com

Jerome Powell, the Fed chair, spooked the markets when he said that inflation could be going up. Never mind that he qualified this by saying that it would be due to a “base effect” – that is, prices would be higher this year compared to the very lower levels reached last year, when the economy shut down. Markets wobbled for a day or two as inflation warnings became louder, but dissipated when the CPI release showed a meager 1.3% rise outside of food and gas. The Fed chief is not overly concerned, and neither should you.

Inflation, of the kind that really matters, hasn’t been around in decades. It has actually been coming down in the last few years in the aftermath of the financial debacle of 2008 and more recently the 2020 pandemic. The last inflationary period that caused serious economic trouble was the 1970s. The reasons why inflation was a problem then may be instructive to review, because some observers fear that the U.S. is flirting with sparking that kind of inflation again.

In 1973 and 1974 food prices spiked by close to 35%, due to bad weather in the U.S. and in the rest of the world. As this was taking place, oil-producing countries quadrupled the price of oil between late 1973 and 1974. The final nail in the coffin of price stability was the end of wage-price controls that had been keeping wages artificially low. Once lifted in 1974 by President Nixon, wages snapped back at a time when unions were strong and therefore able to push raises through.

This perfect storm of conditions created the well-known inflation spikes of the 1970s, and it took draconian measures by the then-Fed chief Paul Volcker to wrestle it down. But those were one-off conditions that have little connection to today’s fears that monetary and fiscal policy could unleash anything similar. As the former Fed vice-chairman Alan Blinder put it, “despite the cacophony of complaints about "ruinous" budget deficits and "excessive" monetary growth, the headline-grabbing double-digit inflations of 1974 and 1979-80 were mainly of the special-factor variety.”

The data certainly backs him up, as the price spikes of the time do not seem accompanied by budget deficits or monetary expansion. If they were, inflation would have gone up long ago and yet it has continued to fall.

source: Federal Reserve Bank of San Francisco
While none of those special factors applies to the U.S. today, they did not apply either in the run-up to the 1970s experience. Which is to say that something that we don’t currently foresee could come out of nowhere and trigger a similar situation of rapidly escalating prices.

While, by definition, those “unknown unknowns” are unpredictable, it may be useful to think through some scenarios that could conjure the much-feared specter of inflation. Below are three that come to mind.

1. A rebound in economic activity leads to much higher labor costs. The concern here is that the recovery could spark a price-wage spiral, where the higher wages that businesses would be forced to pay in order to ramp up production will be passed on to consumers, who are also workers and in turn will demand even higher wages to preserve their purchasing power, thus leading to a never-ending escalation of prices.

This hypothetical construct has logical appeal but little chance of happening. Automation, globalization and the systematic weakening of unions have severely impaired the pricing power of labor. Even when businesses complain that they have trouble finding skill workers, the long-term decline in labor participation shows how even an economy where people are exiting the labor force still can experience a steady decline in real salary gains.

2. Serious disruptions to global supply chains force a return to domestic production, causing prices to climb. One of the reasons for the long-term decline of inflation is globalization, i.e. the shipping abroad of a significant number of jobs. The ubiquitous “made in China” stamp or the foreign accents that answer most calls to a service line are just two daily life examples of how businesses have shifted labor abroad where is cheaper and passing some of the savings to customers. Official policy has been fully behind this shift, reasoning that lower prices are desirable (indeed, bringing down prices is enshrined in U.S. law, for instance as a major test for anti-trust injury) and the jobs lost by U.S. workers in industries that could not compete with cheaper labor abroad would eventually be replaced by higher-paying domestic jobs.

This particular application of the “comparative advantage” theory of the global division of labor did not pan out as expected, instead leaving countless people in low-value-added industries that closed scrambling to take even lower-paid jobs, often in areas of the service sector. Much of the political strife in the U.S. of the last few years can be traced to this unintended consequence of globalization.

It also heated up tensions between U.S. and China, threatening supply chains and opening the possibility that some production (and therefore jobs) could return to the U.S. A similar dynamics is taking place in Europe, where there are mounting concerns that control on crucial technologies that support its population are in the hands of U.S. and China. This has prompted calls for “tech sovereignty” and is spurring billions of euros in domestic technology investments. An “onshoring” of jobs could certainly drive up costs, but, on the other hand, the economic growth benefits could be significant.

3. Enormous stimulus packages overheat the economy. Unlike the aftermath of the 2008 crisis, the current coordination of monetary and fiscal policies have resulted in some of the most significant injections of money in U.S. economic history. As we discussed in our previous post, liquidity creation in the U.S. is, unlike after the Financial Crisis, very high and quite likely to spark a very strong economic recovery. Inflation, to the extent that it sometimes responds to a monetary cause when conditions are right, is likely to follow but will not spiral out of control unless there are also special factors to unleash it. A rebound of economic growth is not a sufficient reason for runaway prices. And even if CPI were to double from the current below-2% levels to the high-3% area, it would still lie well within historical averages.

Inflation, as long as it is mild, can be easily handled by the Federal Reserve. One potential problem, however, is that if inflation rises, nominal borrowing rates could go up more than inflation. Depending on how much they climb, this could end the bonanza that corporations enjoyed in the last few years when they have been able to borrow at rates barely above inflation or, at times (like now), below it.

source: Federal Reserve Bank of San Francisco
The beneficiaries of this phenomenon are the ones who depend most on abundant and cheap money to remain viable. Observers have been wrestling with the fact that, as a result, corporate borrowing has surged at the edges of credit-worthiness, fretting that this accumulation of debt makes a credit crisis more likely. But, with the economy also likely to grow strongly in the next couple of years, this worry has receded. And even if real borrowing rates go up, there is a lot of room until they reach even the long-term averages.

The bottom line is that yes, inflation could go up. But without a host of other factors it’s highly unlikely to be as problematic as some fear.

Questions? Talk to us.