Friday, March 18, 2022
Inflation and its Discontents
Policy makers often talk about a “Goldilocks scenario” which is when inflation and economic growth are neither “too hot” nor “too cold”, allowing the economy to advance at just the right temperature. If the economy is at trend growth and is not experiencing exogenous shocks, central bankers will have a reasonable chance of achieving price stability and maximum employment. For the Federal Reserve, the policy objective is inflation humming around 2 percent and the labor market producing a natural rate of unemployment, which is the rate where wage inflation is minimal and labor markets are healthy enough to allow for normal gyrations within the labor force.
After the March 15-16 meeting, the Federal Reserve published the Summary of Economic Projections and within this report, FOMC participants’ baseline forecast is a soft landing over the next few years and by the end of 2024, the FOMC is expecting a typical “Goldilocks scenario.” But in the near term, the largest risk to their outlook is their projected inflation path. To understand their projections, we need to understand some of the main drivers of inflation, which are introduced later in this blog post.
The Fed is rightfully concerned about the nefarious effects of inflation on the consumer. Rising prices put a squeeze on discretionary spending and real wages. Additionally, businesses must cope with rising input costs, a challenge for firms protecting profit margins and also market share. In response to these challenges of rising input prices, some suppliers find product downsizing less offensive to customers than outright price increases. Product downsizing – or shrinkflation – is often the preferred choice for manufacturers in highly competitive markets where individual firms do not have pricing power. Rather than risk losing market share or risk retooling the input process, firms shrink the package and deliver less product to the consumer. So expect to get more air and less chips next time you buy a snack. This scenario is likely when the economy is experiencing cost-push inflation which is described below.
Cost-push or Demand-pull?
Drivers of inflation can come from multiple sources. When input prices rise or the cost of labor rises and demand remains unchanged, the overall price level rises from the higher cost of inputs. Cost-push inflation is typically associated with a price shock in raw materials or increased costs of production. For example, when a natural disaster inhibits the supply of a raw material, the economy will experience cost-push inflation.
Whereas, demand-pull inflation historically accompanies a strong economy and rising wages. As an economy grows and consumer income grows, demand for goods and services increase, perhaps faster than firms can respond with higher output. Demand-pull inflation is somewhat related to Milton Friedman’s description of “too many dollars chasing too few goods” although Friedman often ascribed this notion to overly loose monetary policy.
So is the Fed forecast achievable?
Many global economies are reeling from inflationary pressures which came from a combination of both cost-push inflation and demand-pull inflation. As economies reopened after the depth of the pandemic, inventories were depleted and firms did not have the labor to ramp up production to meet demand. Concurrently, consumers had stimulus checks to spend, diverting funds normally spent on services like vacations and buying durable goods such as recreational equipment and home furnishings. But, cost-push and demand-pull inflationary pressures can revert quickly, which the Fed is expecting.
The Personal Consumption Expenditure (PCE) Price Index is the preferred inflation measure for the Fed and is forecast to come back to below 3 percent by the end of 2023. As shown in the chart, prices can quickly fall back to a range more comfortable for policy makers. Historically, the PCE Price Index reverted to lower levels after supply and demand came back into balance and the Fed is expected this time will be no different.
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