opinion | That was the stagflation that was


On Wednesday, five-year break-even inflation fell to 2.48 percent. If that doesn’t mean anything to you—which is totally forgivable if you’re not a professional economics watcher—try this: The wholesale price of gasoline has fallen about 80 cents a gallon since its peak a month ago. Only a small portion of this drop has been passed on to consumers so far, but we’re likely to see a broad drop in prices at the pump in the coming weeks.

Besides, what are the chances that falling gas prices will get even a small fraction of the media attention devoted to rising prices?

These numbers and a growing accumulation of other data, from rents to shipping costs, suggest that the risk of stagflation is diminishing. That is good news. But I fear that policymakers, especially at the Federal Reserve, are slowly adjusting to the new information. They were clearly too complacent about rising inflation (like me!); but now they may be holding on to a hard money stance for too long and creating a gratuitous recession.

Let’s talk about what the Fed is afraid of.

It is clear that we have had serious inflation problems over the past year and a half. Much, probably most, of this inflation was the result of what is believed to be temporary supply disruptions, ranging from supply chain problems to the Russian invasion of Ukraine. But part of the increase in inflation was certainly also the result of an overheated domestic economy. Even those of us who are mostly monetary pigeons agreed that the Fed needed to raise interest rates to cool the economy — and it did. The Fed’s rate hikes, plus the expectation of further hikes, have caused interest rates that matter to the real economy, especially mortgage rates, to rise, pushing overall spending down.

Indeed, there are early indications of a significant economic slowdown.

But the just released minutes of last month’s meeting of the Fed’s Open Market Committee, which sets interest rates, hint at a strong fear that economic cooling alone will not be enough, that expectations of future inflation are “unanchored.” become entrenched and that inflation “may become entrenched.”

In principle, this is not a foolish concern. During the 1970s, just about everyone began to expect continued high inflation, and this expectation was built into wage and price formation — employers were willing to lock in pay increases of 10 percent per year, for example, because they expected all their competitors to be the same. to do. To purge the economy of those entrenched expectations, it took a long period of very high unemployment – stagflation.

But why did the Fed believe such a thing could happen now? Both the minutes and comments from the chairman, Jerome Powell, suggest that a key factor was a preliminary release of the University of Michigan survey results, which appeared to show a jump in long-term inflation expectations.

Even at that time, some of us warned against putting too much weight on one number, especially considering that other numbers didn’t tell the same story. Sure enough, the Michigan figure was a blip: Most of that jump in inflation expectations dissipated when revised data was released a week later.

And for what it’s worth, the financial markets are now sounding more or less perfectly clear about continued inflation. That five-year break-even is the spread between ordinary interest rates and the interest rates on bonds that are protected against rising prices; it is thus an implicit prediction of future inflation. And a closer look at the markets shows that not only do they expect inflation to be relatively low over the medium term, but they also expect it to decline after about a year and then return to levels consistent with the long-term target of the Fed.

To be fair, bond traders don’t set wages and prices, and it is in principle possible for inflation to become entrenched in the minds of workers and companies even if investors decide it is under control. But it’s not likely.

There may also be an element of self-denying forecasting here, with investors softening their expectations of future inflation precisely because they expect the Fed to hit the brakes too hard.

Still, it’s troubling to read reports suggesting the Fed is becoming more aggressive even as the economy weakens and the outlook for continued inflation wanes.

I’m not exactly sure what’s going on here. Part of that may be policymakers’ all-too-common tendency to double down on a price even when the facts no longer support it. Part of it may be that after they get through inflation incorrectly, Fed officials, perhaps unknowingly, are prone to harassment from determined Wall Street types. hysterical about future inflation† And in part, they may simply be compensating for their previous underestimation of inflation risks.

Anyway, there’s an old joke about the motorist hitting a pedestrian and then trying to correct the mistake by backing up – running over the pedestrian a second time. I fear something like this is about to happen in economic policy.

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