Wonking Out: Taking the ‘Flation’ Out of Stagflation

A funny thing happened on the way to the Federal Reserve’s latest rate hike. The Fed went big on June 15, raising the interest rates it controls by 75 basis points, or 0.75 percentage points — a sharp rise for an institution that usually tries to move gradually. Why the urgency? As Jerome Powell, the Fed chairman, made clear, he and his colleagues were afraid that expectations of inflation were becoming “unanchored,” which some economists argue could lead to inflation becoming “entrenched.” (The trench is losing its anchor? Time to call in the mixed-metaphor police? Never mind.)

According to Powell, one factor in the decision was a jump in the University of Michigan’s measure of long-term inflation expectations, which he described as “eye catching.” I and others warned about making too much of one month’s number, especially because other measures of expected inflation weren’t telling the same story — and to be fair, Powell acknowledged that this was a preliminary number that might be revised. Sure enough, the number was revised down; apparently, inflation expectations aren’t losing their anchor after all. Oopsies.

In fact, the big story right now seems to be a quite sharp decline in market expectations of inflation over the medium term. Here’s the five-year breakeven — the spread in interest rates between ordinary U.S. government bonds and inflation-protected bonds that are indexed to consumer prices:

This spread is an implicit forecast of inflation over the next five years; it’s down about a percentage point since March. And the underlying picture is even better than this number suggests, because investors appear to believe that we’re only going to have a year or so, if that, of elevated inflation, and after that we’ll be back to roughly the Fed’s long-run target of 2 percent inflation as measured by the personal consumption expenditure deflator, which tends to run a bit lower than the Consumer Price Index. As of this morning, one market-based estimate (more or less in line with others) has inflation running at 4.4 percent over the next year, but only 2.2 percent in the following 5 years.

Why do these estimates matter? Not because either financial markets or consumer surveys are especially good at predicting inflation (after all, neither saw the inflation surge of 2021-22 coming). The point instead is that most economists believe expected inflation is an important determinant of actual inflation.

Think of prices that are set a year in advance, like many wage contracts, apartment rents, and so on. In an economy in which everyone expects everyone else to raise wages 10 percent over the next year, employers will tend to offer 10 percent raises every time salaries are renegotiated, just to keep up, even if supply and demand for workers are roughly balanced. And this means that inflation, once it has become entrenched in expectations, can become self-perpetuating; the only way to bring it down is to engineer an extended period in which demand falls short of supply — that is, a recession.

This isn’t a hypothetical scenario: It’s more or less where we really were at the beginning of the 1980s, when everyone expected persistent high inflation, and it took years of high unemployment to get things under control:

The Fed, understandably, doesn’t want to find itself in that situation again, so it’s hypersensitive to any indication that expected inflation might be getting out of control. At the moment, however, there appear to be no such indications. In fact, various straws in the wind suggest that the Fed may be about to experience the flip side of its errors last year. Back then it got behind the curve, failing to see the ongoing inflation surge. Is it now behind the curve in the opposite direction, failing to see the impending inflation slump?

To be fair, official price numbers don’t yet show inflation slowing. Measures that exclude volatile food and energy prices or, alternatively, exclude extreme price movements suggest underlying inflation that’s more or less stable at around 4 percent, which the Fed finds unacceptably high. But unofficial numbers, some of them more recent than the official data, suggest that many of the forces that drove recent inflation have gone into reverse. For example, remember freight rates? They’re plunging:

And more generally, the supply chain problems that helped drive prices up have gone into reverse: Major retailers are reporting that they’re sitting on piles of excess inventory and are set to slash prices in an attempt to get stuff off shelves and out of their warehouses.

Why might inflation come down fast? Special factors like Vladimir Putin aside, many analysts — myself included — believe that U.S. inflation took off in part because government spending and easy money caused the economy to become overheated. Even given that overheating, however, it was surprising just how much inflation increased.

Historical evidence suggested that the Phillips curve was quite flat — or to put that in English, the rate of inflation wasn’t all that sensitive to how hot or cold the economy was running. But that’s not how things looked in 2021-22, leading many economists to conclude that the relationship between employment and inflation gets much stronger when the economy is running close to capacity. Schematically, the picture may look like this:

But if inflation was highly sensitive to demand on the upside (the red arrow in the picture) it seems likely it will also be highly sensitive on the downside (the blue arrow).

And with growing evidence that the economy is weakening quite fast — it’s now looking altogether possible that the economy actually shrank in the second quarter — it seems reasonable to suggest that inflation will also fall fast. That, at any rate, is what the markets seem to be anticipating.

Now, this progress against inflation, if it happens, will come at a cost. The U.S. economy’s growth is clearly slowing, and the downturn could easily be sharp enough to be considered a recession, albeit probably a mild one. And because it will take a while for inflation to fully reverse its rise, there’s a good chance that we’ll see a brief period of economic stagnation combined with continuing inflation — stagflation.

But if I’m right, and the markets are right, the “flation” part of that story won’t last very long. And sooner than many people believe, the Fed may find itself reversing course, trying to undo the “stag.”