Is Inflation Back for Good?

Prices are up all over the economy. Here are scenarios about what might happen next.

This month brought the most worrying inflation news in decades. 

On June 10, the Bureau of Labor Statistics (BLS) reported that the Consumer Price Index (CPI) "increased 0.6 percent in May on a seasonally adjusted basis after rising 0.8 percent in April," bringing the year-over-year price increase on all items to 5.0 percent. 

"This was the largest 12-month increase since a 5.4-percent increase for the period ending August 2008," the BLS noted. And when you take out food and energy, the resulting yearly rise of 3.8 percent was "the largest 12-month increase since the period ending June 1992."

CPI, whose components are constantly being adjusted, may well undercount inflation as most Americans experience it. As William Levin noted in National Review, medical costs account for just 8.9 percent of the CPI basket, even though they amount to 17.7 percent of GDP. And a massive one-quarter of the index is calculated not by assessing actual rental prices, but by asking homeowners the comparatively unscientific question, "If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?"

Consumers are being faced with obvious and serious price hikes everywhere from Costco to Home Depot (lumber prices tripled! But are already adjusting down), from Uber and Lyft rides (up 40 percent) to Airbnb rentals (up 35 percent).

So does this mean that sustained, damaging, economy-wide price inflation is definitely back? Let's check out the arguments. 

Point: Inflation is back! Be very afraid.

These are among the many items becoming measurably more expensive this year: used cars, meat, oil, plastics, metals, toilet paper, semiconductors, polyurethane, packaging, cereal, soybeans, coffee, and corn. Bloomberg reports: "A United Nations gauge of world food costs climbed for a 12th straight month in May, its longest stretch in a decade. The relentless advance risks accelerating broader inflation, complicating central banks efforts to provide more stimulus."

The monthly Logistics Managers' Index (LMI) in its May report sees the prices of moving goods from place to place continuing to grow "at a meteoric pace." And the much-noted shortage of labor suggests that the price of workers is also going to go up.

Two main schools of thought contend among those who believe that massive sustained price inflation is either inevitable, or already here: Milton Friedman's monetarism, and the more bubble-focused analysis associated with the Austrian school of economics. 

Friedman's theory, which was widely accepted in the economics and finance professions decades ago but has been waning since asserts that "inflation is always and everywhere a monetary phenomenon." The correlations were indeed observable in the 1960s and 1970s, but the theoretical prediction of increased money supply leading to economy-wide price inflation has been failing to come true for many years now. 

Why might that connection between money supply and price be slipping? Theories include the Federal Reserve paying banks interest to just sit on uncirculating money. Another is that the "velocity" of money—the rate at which one dollar is used to purchase goods and services in a given time period—has fallen by nearly half since the beginning of the century.

But America has seen a lot more money lately, with the overall supply of the M1 monetary measure more than quadrupling in just the past 15 months. We have also in COVID times seen government injections of cash into the hands of business and citizens into the trillions, with the Federal Reserve committed to buying as much government debt as the government wants to feed into its spending machine.

GDP grew at a 6.4 annualized rate in the first quarter of 2021, and is expected to soon surpass its pre-COVID levels. The mindset that "inflation won't be a problem because it hasn't been a problem in decades" is itself the type of thinking that contributes to what the free-market Austrian school has long warned about: price bubbles caused by monetary growth. 

Austrians, like monetarists, also see a necessary logical connection between increased money supply and higher prices (adjusted for the amount of goods and services available for the money to buy). But they don't automatically assume that more money will mechanistically translate into economy wide CPI inflation. Rather, inflation might mostly be expressed in specific sectors, such as stocks, crypto, housing, collectibles, and any other available means to get out of dollars and into something with more perceived promise of holding value.

But those specialized areas where dollars flood into can all too often prove to be bubbles of "malinvestment" which, once popped, can produce economic wreckage and damaging policy reaction, the Austrians warn.   

Counterpoint: Everything's fine, don't worry about inflation!

Modern Monetary Theory, the hot modern excuse for the government to spend whatever it wants to spend, posits that as long as any resources of labor or capital in the economy are not currently being used productively, then more money in whatever amount presents no inflationary threat. MMTers will tell you that their hypothesis comports to the reality of the past few decades better than the monetarist insistence that more money equals more (inflationary) problems.

So what's the MMT and/or governing-Democratic explanation for the recent surge in CPI and sectoral inflation? It's all about unleashed demand as lockdowns fade and bank accounts swell with federal stimulus bucks, with manufacturers temporarily bidding up prices to make sure they are ready for the pent-up, post-COVID buying spree. After the recovery shakes out, the argument goes, prices will stop noticeably rising. 

An example bolstering the keep-calm thesis comes from the May BLS report, which shows that a whopping one-third of the seasonally adjusted CPI came from one sector: used automobiles, which rose 7.3 percent in May alone. Maybe if you can avoid buying a used car, you won't feel the inflationary pinch too much.

The White House Council of Economic Advisers (CEA) argued in April that the CPI spike seems scary only because of the "base effect" of rising from very low inflation in the pandemic-scarred year 2020. Fed Governor Lael Brainard assured us last month that we just need to be "patient through the transitory surge." (Inflation hawks are quick to retort that this is what the Federal Reserve folk insisted back in the 1970s, before our nation's last big inflationary spree, when for three years, 1979–81, CPI was rising over 10 percent per year.)

The Fed swears it will start tapering off its seemingly endless run of buying Treasury and mortgage-backed securities if the central bank's inflation target of 2 percent looks poised to be breached long-term. Temporary surges worry the bankers less.  

And even if CPI inflation continues to increase like it has this spring, the central bankers are confident they can rein it back in. As Brainard wrote: "If, in the future, inflation rises immoderately or persistently above target, and there is evidence that longer-term inflation expectations are moving above our longer-run goal, I would not hesitate to act and believe we have the tools to carefully guide inflation down to target."

But those tools are mainly recession-inducing hikes in interest rates. Will the political powers that be (and yes, the Federal Reserve, protestations to the contrary, is quite political) allow that to happen, or will savers, those living on fixed incomes, and those who don't want to be forced into speculative investments just to stay afloat, have to suck it up and endure a pricier existence?

A government in as much debt as the United States can be expected to be quite reluctant to let interest rates get too high—a very different situation from the 1970s and '80s when debt as percentage of GDP was about one-quarter what it is today. It's hard to believe that an economy drowning in debt and addicted to massive monetary stimulus will be ready to bloodlessly quash inflation via cutting off the cash spigot and/or raising interest rates significantly. 

So there is plenty of reason to suspect that the CPI spike of spring 2021 is not something that the Fed is prepared to cope with if it has legs beyond the COVID supply crunch hangover.