Inflation trend

Stagflation: A Primer

The term stagflation came into common use in the mid-1970s, when many advanced economies experienced higher inflation and slower growth than they had in the 1960s. At the time, the joint behavior of inflation and economic growth confused many economists. Throughout the 1950s and 1960s, growth and inflation generally moved in the same direction. Most important, inflation tended to fall during recessions and to rise in booms. Stagflation meant that these two key summary measures of macroeconomic performance moved in opposite directions. What caused this dramatic, painful, and persistent shift?

To understand the sources of stagflation in the 1970s—and how we subsequently avoided a repeat of that episode (at least so far)—we start with the simple premise that there are two types of disturbances hitting the economy: demand and supply. The first, changes in demand, moves inflation and growth in the same direction. The broad array of things that shift demand include fluctuations in consumer or business confidence, shifts in government tax and expenditure policy, and variation in the appeal of imports to domestic residents or of exports to foreigners. When any of these goes up or down, inflation and output rise and fall together.

Supply disturbances—which alter the cost of production—are fundamentally different. These stagflationary shocks move growth and inflation in opposite directions. For example, an adverse supply shock that raises the cost of production at least temporarily drives inflation up and growth down.

Importantly, these cost shocks cannot be the whole story behind a decade-long surge of inflation. Whether the consequences of a cost shock are one-off adjustments in the price level or an increase of the trend of inflation depends on the monetary policy response. Put differently, monetary policy determines whether we experience stagflation over any longer interval….

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Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

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The Price is Not Right: Measuring Inflation in a Pandemic

Are prices really plummeting? If you watch the official government gauge of prices in the economy, you would think so. Between March and April, the Consumer Price Index (CPI) dropped by 0.8 percent―that’s a decline of 9.1 percent at an annual rate! Even if we exclude food and energy, prices still fell at half that rate. And, both price measures already had begun to fall the previous month. Is this the new trend? Are we in the midst of a deflation? The short answer is no.

The pandemic is an enormous shock to both supply and demand (see our earlier post). The productive capacity of the economy is lower both now (with the lockdown) and in the medium term (with the need to make economic activity biologically safer). Similarly, demand is lower both temporarily while people stay at home and in the longer term as the propensity to save rises to enable people to pay off elevated debts and build precautionary buffers. Determining which of these shifts prevails is essential for policymakers. If the demand contraction dominates, then trend inflation will fall and policymakers will need to implement further expansionary policies. Conversely, if trend inflation rises (implying that the supply constraints prevail), then policymakers will eventually need to introduce restraint.

In this post, we discuss the difficulties of measuring inflation during a pandemic—when demand and supply both shift dramatically. Our conclusion is that some indices provide better high-frequency signals of the trend. Unsurprisingly, headline measures of inflation are especially poor. Yet, traditional measures of “core inflation” that exclude food and energy may be equally bad. Instead, we suggest focusing on the “trimmed mean,” a statistical construct that disregards all goods and services whose prices change by the largest amounts (either up or down). In recent months, the trimmed mean CPI shows suggest that inflation has edged lower, but remains between 1½ and 2 percent per year….

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The Fed's Price Stability Achievement

Over the past decade, critics of all stripes have assailed Federal Reserve monetary policy. At one end of the spectrum, some argued that the Fed’s expansionary balance sheet policy risked currency debasement and high inflation. While some of these critics sought merely to influence ongoing policy, others called for replacing the Fed altogether, and restoring the Gold Standard. And then there were those promoting oversight over monetary policy operations that would significantly curtail central bank independence.

At the other end, a different set of critics worried about outright deflation: according to monthly averages from Google Trends, since 2004, U.S. searches for deflation were twice as frequent as those for hyperinflation. Some economists called for a higher inflation target. Squarely in the second camp, officials inside the Federal Reserve System developed deflation probability trackers like this one (here is another from the Federal Reserve Bank of Atlanta).

These diverse perspectives form the backdrop to this year's report for the U.S Monetary Policy Forum (USMPF) that we co-authored with Michael Feroli, Peter Hooper and Anil Kashyap. In that paper, we document that the trend in U.S. inflation has been remarkably low and stable since the early 1990s....

 

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