Based on insights from Zhengyang Jiang, Nicolas Crouzet, and Efraim Benmelech.
Inflation in the United States is surging. But depending on whom you ask, it’s either cause for alarm—a harbinger, perhaps, of 1970s-esque chaos—or just a temporary blip as the economy resets itself: nothing to see here.
The numbers themselves aren’t in dispute. The Labor Department’s Consumer Price Index is up 5.4 percent over the year—a steep climb from just 1.4 percent in January, and the largest 12-month increase since August 2008.
So why can’t economists agree on what these numbers mean for the economy going forward? And how concerned should you be?
Kellogg Insight recently spoke with three Kellogg economists to better understand the cases for and against sounding the alarm about inflation in the U.S.
Problem? What Problem?
When demand outpaces supply, prices rise, and so does inflation: a classic case of what economists describe as “too many dollars chasing too few goods.”
One reason many economists are not concerned about inflation today is because so many of the factors currently constraining supply are short-lived.
Efraim Benmelech, a finance professor and director of the Guthrie Center for Real Estate Research at Kellogg, offers air travel as an example. “While the demand for flights has increased, many airlines have reduced their fleets and cut their number of employees,” he says, driving up prices. “Once more airplanes are deployed and more employees are hired, air travel prices will go down even if demand remains high.”
Similarly, some of the constraints that are keeping workers out of the office or factory will likely soon ebb. For example, daycare centers will eventually reopen at full capacity and enhanced unemployment insurance will end, both of which could send more people back into the workforce to create all the goods and services that consumers demand. Bottlenecks in manufacturing and particularly energy production—a major driver of inflation—will ease.
And at the same time, there is reason to believe that demand for some goods and services will decrease. Support from the Treasury will taper off, helping to tamp down inflation from the demand side. “Most likely, we won’t have fiscal transfers to households of the same scale as we saw in 2020, so people’s disposable income is not going to keep rising—and neither is this urgent demand that we had over the past year or so,” says Nicolas Crouzet, an associate professor of finance at Kellogg.
In fact, Crouzet points out, while bottlenecks and other supply constraints are widespread around the world, the rise in inflation seems to be more specific to the U.S. In Germany, for instance, inflation is 3.1 percent—high but considerably lower than in the U.S. And in France, it is just 1.2 percent. This suggests that a large chunk of the rise in inflation in the U.S. should be attributed to the country’s unusually aggressive fiscal-policy response.
If You’re Not Worried, I’m Not Worried
More evidence on the not-to-worry side of the ledger: investors don’t currently seem that worried about inflation.
“The bond market has historically been a fairly good gauge of expected inflation. And the bond market at the moment is telling us that inflation is going to be slightly more elevated over the next five years, but not alarmingly so,” says Crouzet. He points to break-even inflation rates, or the difference between interest rates paid on a standard Treasury contract and an inflation-protected one. These rates essentially provide a measure of how much inflation the market expects to see in five or ten years. And they currently show no sign for alarm.
“The markets are saying that they expect inflation to be on average 2.5 percent,” he says.
This is key because inflation is as much about psychology as it is about economics. Expected inflation begets inflation: when people think prices are going to go up, they in turn raise their own prices, and inflation continues its dangerous spiral.
Oh, It’s a Problem
Some economists, however, are looking at the same signals and interpreting them very differently. Zhengyang Jiang, an assistant professor of finance at Kellogg, falls in this camp.
If “too many dollars chasing too few goods” is a major driver of inflation, he argues, then the problem is worse than we think because there are a lot more dollars out there than we think.
In his view, calculations about how much money is currently in circulation should include government debt. And government debt is really high, with no signs of decreasing or even leveling off, meaning that even if the government does reign in its spending, the U.S. could still be in a tough spot moving forward.
“Inflation actually comes in two fashions,” he says. “One is outright inflation: say, this Christmas a basket of gifts now costs $200 instead of $50. But another form of inflation is exchange rate depreciation”—where the value of the dollar depreciates against a basket of major foreign currencies.
According to Jiang’s research, when the government runs a deficit and increases the supply of money in the economy, “we first see an increase in the depreciation rate of the dollar before we see inflation with respect to domestic prices.”
Think about inflation as a sleeping dog, he offers.
“When there is only mild pressure from fiscal deficits, inflation can stay asleep while the exchange rate adjusts to buffer the shock. This is consistent with the dollar’s depreciation since its peak in March 2020. However, when the fiscal pressure is too high, inflation will be woken up and adjust in accordance to how much money and debt there is.”
Jiang suspects that there will eventually be a reckoning. It may not be next month, or even this year, but at some point investors will decide that the level of government debt is simply unsustainable.
“The market may allow the price to deviate from fundamentals for a while, but it will eventually let the price reflect the fundamentals,” he says. This will make it considerably more expensive for the government to borrow—and send inflation soaring.
Benmelech is sympathetic to this perspective. “History teaches us that large budget deficits and high levels of debt often lead to inflation,” he says. “We are living in a somewhat different time, with low interest rates and some economists [arguing] that we can sustain higher amounts of debt relative to GDP because of those low interest rates. But it is definitely a front we need to watch with caution.”
Bound to Stick Around
Even among economists in the “less concerned” camp, there is an appreciation that not all the factors driving up inflation are likely to be temporary.
In earnings calls and financial statements over the last two quarters, companies “have been talking about inflation a lot more than they have over the past two decades,” Crouzet says. “They’re actually saying now, ‘we’re going to start raising prices because we feel cost pressures, and if we want to maintain our margins, we need to increase price.’” This suggests that, even if investors aren’t yet concerned about inflation, individual companies might be. And remember, psychology matters.
Another reason to worry that inflation might not settle back into the 2–3 percent range has to do with housing costs. “When house prices start rising, they tend to have momentum,” says Crouzet. “I think there’s a perception that once you get a housing appreciation going, then there’s lots of reasons why people might want to keep it going, and it’s self-fulfilling.”
Rent, too, is on the rise: one report puts the increase at 7.5 percent for the year, or three times more than normal. If inflation continues to increase, we can expect rents to rise in tandem, as investors pass on any price increases they are experiencing to tenants. This, in essence, locks in inflation for at least the length of the rental agreement.
What Does It All Mean?
With only hazy crystal balls, many economists are in favor of watching and waiting. If inflation returns to 2 or 3 percent in the next year, the nation can breathe a sigh of relief—at least in the short-term.
Crouzet points out that a modest increase in inflation might not even be a bad thing. “Do we really care about getting back to 2 percent versus being at around 3 percent or 4 percent?” he asks. “I never quite understood the rationale for the 2 percent target, as opposed to, say, 3 percent.”
In fact, because one of the Fed’s main tools for fighting recessions is to lower nominal interest rates, there’s even an argument to be made that having a slightly higher inflation target is desirable, giving the Fed more wiggle room to ward off future crises. “That’s an argument that I find really compelling,” says Crouzet.
He is confident that the Fed will have plenty of time to step in if it looks like inflation is likely to continue to increase at 5 or 6 percent over a longer period.
Jiang’s takeaway? The Fed is in a pickle. Jiang has serious long-term concerns about fiscal expansions. “But on the other hand, if we take a very extreme measure of austerity by cutting down government spending and raising taxes, that is also going to create its own problems,” he says. “There’s never an easy way out.”
Benemelech, who grew up in Israel during a period of hyperinflation, will also be keeping a close eye on inflation figures. But he makes a different point about predicting the future: the virus, with its ever-changing variants, is the ultimate wild card. “It’s all about the balance between demand and supply,” he says. If a new wave of cases rocks the economy, it’s “hard to predict which of those will decline more.”