The Economic Question Of Our Time

Have we entered a “high inflation regime”?

At this point, asking that question feels like Bill Murray’s Phil Connors finally losing his patience while reading the teleprompter spiel in the film “Groundhog Day”. (“Once again the eyes of the nation have turned here to this — tiny village in western Pennsylvania. Blah Blah Blah Blah.”)

There’s quite a bit of truth to the contention that this is the economic question of our time. And it’s inextricably bound up with the kind of out-in-the-open, overt fiscal-monetary coordination that, for years, has largely unfolded behind the scenes under the banner of “Quantitative Easing,” a deliberately opaque term that could scarcely be any less amenable to public interest.

Now, everyday people do care about the intersection of fiscal and monetary policy. Thanks to the pandemic and efforts to educate the public on the realities of federal government finance (spearheaded by Stephanie Kelton and her bestseller), citizens in advanced economies are gradually waking up to the idea that spending doesn’t necessarily need to be “paid for” — certainly not upfront and quite possibly not down the road, via taxing and borrowing either. While still far from being “common knowledge,” it’s probably safe to say that more everyday people are now aware that, in fact, the government has been buying debt from itself (via bank intermediaries) in unfathomable quantities for years on end.

These realities (laid bare by the swiftness with which the government stepped in to avert economic collapse during the lockdowns) have naturally led to calls for more spending. The collision of policy largesse with base effects and pandemic distortions across supply chains catalyzed a surge in realized inflation, providing ammunition for Fed critics and anti-Progressives alike.

Note that while off the extremes (other measures are similarly down from recent highs), the option-implied probability of US inflation dropping below 1% in five years’ time has plummeted, while the probability of inflation exceeding 3% is near a record (figure below).

Consumers’ inflation expectations have accelerated in tandem, raising the specter of a self-fulfilling prophecy and increasing the odds of a tragically ironic dead end in which policies designed specifically to ameliorate societal inequities exacerbate them instead, via what’s been dubbed the “K-shaped” inflation phenomenon.

That phenomenon could itself be exacerbated by the fact that those most affected by surging prices are also the least likely to own assets like stocks and commodities that can serve as hedges (figure below).

It’s not an exaggeration to say that the outcome of this experiment will determine how future generations think about monetary and fiscal policy in advanced, currency-issuing economies with sufficient monetary sovereignty.

If things go “wrong” and inflation spirals, one of two things will happen. Either i) politicians will keep spending anyway for fear of losing votes, and monetary policy will become, at best, impotent, and at worst, totally beholden, or else ii) independent central banks in the developed world will attempt to correct the situation by donning their hawk costumes and adopting draconian policies to rein in inflation, causing a recession.

It’s not clear whether the latter scenario is even tenable in the 21st century. I don’t think that gets enough attention. Nowadays, people want scapegoats for everything. In a deep recession triggered by a succession of rate hikes to combat a burgeoning price spiral, nobody on Main Street will want to hear how “noble” the Fed’s efforts are. Voters will blame politicians for scorching inflation, then they’ll turn right around and blame the Fed for the recession that results from efforts to douse the fire.

If, on the other hand, things go “right,” inflation doesn’t spiral, growth proves robust and we discover that the term “full employment” made no sense outside of a literal interpretation (i.e., literally every single person who wants a job has a job), then the whole game changes. Those who, for decades, claimed that “printing money” faster than economic growth (see the figure below for a somewhat crude illustration) is everywhere and always a one-way ticket to ruin, will be at least partially discredited.

Crucially, in such a scenario, the line of thinking that treated the relationship between money creation and output as something akin to an eleventh commandment, would have an extraordinarily difficult time making a comeback in developed economies. And not necessarily because it has absolutely no merit. But rather because, having seen that it doesn’t always hold, it would be political suicide to assert it anew.

On Monday, while responding to a reader question, I mentioned that I rarely set out to write a specific article outside of those dedicated strictly to data releases. Sometimes, I just start typing and see where it goes. Other times, I start out with one thing in mind and before too long, something else has materialized. This is an example of the latter. As a rule, I cut myself off around 1,000 words, otherwise, readers won’t read all the other articles published here on a given day.

Ultimately, I doubt there’s much of a middle ground between things going “wrong” and things going “right” as described above. Either conventional wisdom on inflation is antiquated or it’s not. I tend to believe it is for two reasons.

First, virtually everyone admits there’s no reliable model for inflation. It’s not clear (at all) that any of the Fed’s multitudinous critics have a better model than policymakers. Saying someone else’s model doesn’t work isn’t the same as saying yours does.

Second, and more importantly, I think things are now so complex, that the average consumer, no matter how intelligent, simply doesn’t have time to make a mental sketch of the path to a long-term surge in inflation. Everyday people understand supply and demand intuitively. But their interest in ratios like that shown in the third figure (above) is de minimis.

Once pandemic supply/demand imbalances work themselves out (and most will, even if it takes longer than the Fed thinks), there has to be a psychological catalyst that prompts consumers to change their behavior and/or chips away at the shared myth we call the “dollar.” Absent that, people will still covet dollars (and euros and yen), if for no other reason than alternatives are volatile (e.g., Bitcoin), cumbersome (e.g., precious metals), perishable (e.g., foodstuffs) or simply undesirable because the issuing authority has an even larger credibility deficit than that you might fairly ascribe to Washington or Brussels. Nobody wants a vault full of physical Turkish lira, after all.