The economic policy–making community is in the midst of a heated debate that may seem irrelevant and confusing to the general public: what is the real rate of inflation, and is it heading permanently higher? While the topic is dry, its resolution is of critical importance. Depending on the answer, mortgage costs could rise, stock prices could become more volatile, and the U.S. economy’s recent torrid growth could slow significantly. Policymakers, economists, and financial analysts will certainly be watching incoming data closely.
How much has inflation increased?
Let’s start with some facts. Inflation, as measured by the Federal Reserve’s preferred metric, which is called core PCE (this tracks personal consumption expenditures excluding food and energy), was roughly 3.1 percent on a yearly basis through April 2021. The Fed’s publicly announced framework for managing inflation—in which it aims for a 2 percent rate over the long run but can tolerate periods when the rate is slightly higher to offset periods when it is slightly lower—may not make this rate of roughly 3 percent seem extremely problematic. Similarly, surveys indicate that consumers expect inflation to be around 3 percent, a slight increase from the public’s expectation of about 2.5 percent that had prevailed for a long time.
Taking all of this into account, Federal Reserve policymakers have consistently said they will be patient before raising interest rates, and that they see any spikes in inflation above the acceptable range as being purely transitory—the result of temporary bottlenecks as the U.S. economy reopens after the pandemic-induced shutdown.
What is the debate in the United States?
Many economists outside of the Federal Reserve contend that inflation is much higher than these statistics suggest, and that these higher rates are likely to persist longer than the Fed says that they will. While Federal Reserve policymakers seem to believe that inflation will average roughly 2.5 percent this year and decline after that, other economists believe that inflation could rise to 4 percent and perhaps even higher in the next few years. These observers fear that the Fed is “falling behind the curve” and will have to raise rates sharply to keep inflation in check, thereby risking turmoil in financial markets and potentially the broader U.S. economy.
These concerned thinkers present several arguments. First, they argue that the Fed’s measurement tools do not accurately reflect what consumers are purchasing. Their concern is that, as the economy reopens, consumers are ramping up spending on certain goods and services, such as gasoline, leisure travel, and hospitality, where prices are rising more rapidly than in the economy overall. In short, official statistics are understating the inflation that consumers are experiencing. As these price increases are felt, they will push consumers to expect even higher inflation and thus demand higher wages, kicking off a vicious inflation spiral.
Secondly, these economists point to particular markets, such as that for used cars, where price increases have been particularly large. They argue that the factors leading to these outsize price increases, such as supply shortages, will persist, again embedding higher inflationary pressures.
Finally, they argue that the level of government stimulus and the cash available to consumers from savings, government support checks, and increased wages means that demand will drive up prices (i.e., inflation) for years to come.
The bottom line is that there is little consensus about the path of inflation in the United States for the next several years. With such a wide range of potential outcomes, each supported by reasoned analysis, the entire economics profession—including policymakers at the Federal Reserve itself—should be on high alert.
What does this mean for other countries?
If the Federal Reserve is wrong in its view that the current uptick in inflation is transitory, and if its critics are right that the Fed is behind the curve, the rest of the world will not go unscathed. A rapid rise in U.S. interest rates will result in a U.S. dollar that is more attractive relative to other currencies. In turn, other countries, particularly emerging economies, will likely experience a rapid outflow of capital back to U.S. markets as investors seek higher returns. Such capital outflows will likely result in financial market volatility in these countries, with an increased risk of higher interest rates, slower growth, and even recession.
Additionally, for those economies that have issued debt in U.S. dollars, it will become more challenging to pay it back. This is true for both private borrowers as well as official (or government) borrowers. It is not an exaggeration to say that the whole world is watching and wants to know the answer to the question: How much is too much?