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Two big things to understand about inflation

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Treasury Secretary Janet Yellen caused some consternation last week when she raised the possibility that "interest rates will have to rise somewhat to make sure our economy doesn't overheat." Stock markets fell, and Yellen clarified her remarks by saying that she was neither forecasting nor recommending an interest rate hike.

But the issue isn't going away. More voices are starting to publicly warn of rising inflation. Warren Buffett recently called the economy "red hot" and said he's seeing higher prices. Some wealth managers are starting to tell clients inflation is on the way. Some economists, like Larry Summers and Bloomberg columnist Mohamed El-Erian, are giving the same warning.

Skeptics will note that past inflation scares have been false alarms. In 2010, a number of economists and financiers sent an open letter to then-Federal Reserve Chair Ben Bernanke, warning that quantitative easing policies would lead to higher inflation. The Fed ignored the letter and pressed ahead with QE, and inflation never materialized. Why should this time be different?

One difference is that in 2010, there was little sign that so-called core inflation — which strips out volatile food and energy prices — was rising. But in March of this year, core CPI and core PCE inflation (two alternative measures of price changes) both showed increases of over 4%. These are well above the levels we've become used to in recent years — and indeed, in recent decades.

One month, of course, is just one month. It remains to be seen if March's levels were a temporary spike or the start of a new long-term trend; in fact, it will be several months before we really know. It's perfectly OK for inflation to occasionally exceed the Fed's target of 2% — that target is not supposed to be a ceiling.

But in any case, given the number of people who are now talking about rapid price rises, it makes sense to think about why and how that might become a problem. And even more importantly, it's time to start coming up with a contingency plan for what to do if the dreaded inflation monster does awaken from the slumber it's been in since the 1980s.

In fact, these are both very difficult things to ponder because of the uncertainties, complexities and multitude of decision-makers involved. There are two key concepts to understand here: regime shift, and fiscal dominance.

Regime Shift

Economists often think about inflation as obeying some kind of Phillips curve. A Phillips curve is a relationship between employment and inflation — when lots of people have jobs, they spend a lot, and they charge higher wages, and then prices go up. There are a lot of fancy variations on this theme, but that's the basic idea. The Phillips curve is where the idea of "running the economy hot" comes from — it implies that if you raise demand with government stimulus or monetary policy, you'll get a concomitant increase in prices.

Inflation isn't as much of a worry if prices rise smoothly with demand because as soon as policymakers see that prices have begun to exceed their appointed bounds, the Fed can just bump up interest rates, or Congress cuts deficits a bit, and balance will be restored.

Unfortunately, the economy probably doesn't work that way. In a recent paper, macroeconomists Jonathon Hazell, Juan Herreño, Emi Nakamura and Jón Steinsson look at the history of price increases using detailed new data and conclude that the Phillips curve is pretty flat — in other words, changes in demand, including demand driven by government policy, typically don't shift inflation that much.

But big changes in inflation still do happen, and policy can cause them! The most important was when Fed Chair Paul Volcker raised interest rates in the early 1980s, crushing inflation at the expense of two deep recessions.

Hazell et al. explain this as a regime shift — not a change in policy, but a change in the way that policy gets made. In other words, Volcker's big interest rate hikes convinced the whole country that the Fed would simply not accept continued high inflation. At first people didn't quite believe things had changed, but when Volcker stuck to his guns despite painful recessions, businesses all over the country realized inflation was done for and stopped raising prices.

This change was long-lasting. In a well-known 2000 paper, economists Richard Clarida, Jordi Gali and Mark Gertler estimated how much the Fed changes interest rates in response to changes in inflation. They found that there was a big shift in the Volcker years — after the late 1970s, the Fed reacted more to price changes than it had before. The regime shift was real.

This probably works in the other direction as well. Looking at past episodes of hyperinflation — price changes so astronomical that they wreck an economy utterly — economist Thomas Sargent hypothesized that these catastrophes begin when people start to believe that the central bank will keep printing money to finance ever-increasing amounts of government borrowing. Anticipating an exploding money supply and an accompanying rise in prices, businesses start to raise prices in anticipation of the shift, which thus becomes a self-fulfilling prophecy.

With interest rates low and deficits set to rise, this second sort of regime shift is certainly on the minds of the people warning about inflation. Democrats seem to have finally tired of the one-sided game where Republicans run up the debt but still get credited as the party of fiscal responsibility; now, both parties seem more content to let deficits go up. That could be a real regime shift.

It could take only a modest bump in inflation to start the ball rolling. Right now, one reason prices are rising is that the economy is having difficulty adjusting to the end of the pandemic. As consumption patterns shift, there will be acute shortages in the things people suddenly want to buy more of. For example, people are so interested in buying new houses that the price of lumber has shot up.

A global semiconductor shortage is pushing prices up in that industry, too. Other items like steel and corn are seeing shortages as well.

This is what economists call "cost-push" inflation. It's not going to get extreme, but the worry is that when combined with exploding government deficits, it might be high enough to kick off an inflationary spiral. The scary scenario here is that businesses see cost-push inflation, they see President Joe Biden and Congress borrowing a ton of money, and they see the Fed keeping interest rates low, so they decide that prices are going to have to go up, and they start raising their own prices immediately to beat the rush. Of course, when everyone tries to beat the rush, that becomes the rush.

So that brings us to the Fed, and to the question of interest rate hikes. Why can't the Fed just hike rates if inflation gets bad? Well it can, but it's a little more complicated than that.

Fiscal Dominance

In addition to a large and increasing deficit, the U.S. government has a large existing stock of debt — about $21.7 trillion, or just over 100% of GDP. Because interest rates have been low for a while, the federal government doesn't have to make big interest payments on that debt.

But if the Fed were to raise interest rates, that could change. The nation's current stock of debt is much bigger than when Volcker did his thing in the 80s — now, even a relatively modest rate hike might send interest payments soaring.

That understandably might make the Fed nervous about raising rates. If government interest payments go too high, the U.S. would have to either hike taxes, cut spending or borrow even more to cover the greater interest costs. If the government, fearful of a recession, chooses the "even more deficits" option, that could raise inflation even more and force the Fed to hike rates yet again.

Eventually this process would lead to some sort of bad end — either Congress would finally capitulate and enact a punishing austerity program, or borrowing would continue and inflation would spiral out of control, or the government would decide to default on its debts. The austerity option would be the least bad, but any of these would be extremely painful for American workers and consumers.

This kind of macroeconomic trap is known as "fiscal dominance" — as in, fiscal policy is so important that it dominates monetary policy. Sargent and co-author Neil Wallace warned about this sort of situation in a famous paper in 1984.

Fiscal dominance is really bad news, so the government should work very hard to avoid it. One way to do this is to borrow at longer maturities. The longer the average maturity of government debt, the less it has to be rolled over, and the less Fed interest rate hikes will spur higher borrowing costs. Essentially, borrowing long allows the government to lock in low rates, leaving the Fed more space to fight any inflation that arises. Troublingly, the average maturity of U.S. debt has changed little since the 1980s.

Another way the government might be able to avert fiscal dominance is for the Fed to threaten to raise rates. As long as Americans believe that their central bank isn't constrained by the size of the debt, they won't believe that policy has entered a pro-inflationary regime shift; thus they will not start hiking prices, and the Fed won't have to raise rates.

This is undoubtedly what Yellen was doing when she talked about rate hikes. Though she's no longer the Fed chair, her words carried weight, as evidenced by the stock market's reaction. That reaction suggests that the country — or at least, the stock market — still believes the Fed can and will hike rates to head off inflation. In other words, people don't think we're in fiscal dominance yet.

The danger is if this belief starts to crack. If asset managers and pundits keep talking about inflation, and if federal borrowing keeps exploding upward while interest rates seem pinned near zero, people might decide that inflation really is coming — and that could summon the beast into existence. That won't immediately send consumer prices to the moon — countries typically get at least a couple years of lead time before things get really bad. But if inflation stays significantly above the 2% target for several months, it will be time to worry.

At that point, the only really sensible move is austerity. The president and Congress will have to quickly hammer out some combination of tax hikes and spending cuts to bring down deficits and make it clear that inflation isn't going to be tolerated. That will be economically painful, but waiting will result in even greater pain down the road.

It's still far from clear that the U.S. is facing an inflationary threat. But over the next year the picture should clarify, and Biden and Congress will have to be prepared to beat inflation down if it rears its head.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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