On Inflation Surge, the Fed Is Running Out of Excuses: WSJ

The only explanation remaining is that inflation will still be transitory–not as temporary as hoped, but that it will go away on its own. Investors still buy the story, but the risk is rising that the Fed has to act much more aggressively.

Here are the inflation excuses:

Temporary. For the first time since 1989 monthly inflation has been above an annualized 2% for 12 months in a row. Those who banked on inflation being temporary and are still arguing that it will go away by itself have some explaining to do.

Prices versus before the pandemic. Over the summer, Fed Chairman Jerome Powell highlighted the fall in prices of many items where demand fell during the pandemic and was merely rebounding more recently. For those allowed and willing to fly, airline fares were briefly as cheap as in 1995, while work-from-home outfits meant that by December men’s suits and coats were cheaper than they had been in data going back to 1978.

Many of these prices still haven’t fully recovered. But the rise in other prices since Mr. Powell made these points has more than offset the savings, with the annualized rate of inflation for all items since February 2020 running above 4%.

Pandemic problems. Mr. Powell pointed out that price rises were confined to a relatively narrow range of items where demand had soared and supply chains were constricted. He highlighted durable goods, where car prices had gone through the roof–and said used-car prices appeared to have stabilized. The reprieve was brief, with used cars and broader durables resuming their rise in October. Nondurables have joined in, rising an annualized 4.7% since before the pandemic. The price of the median item in the CPI basket is rising fast, too.

Another way to see this is to strip out the prices that move the most both up and down. The Cleveland Fed says that without the top and bottom 16% of items, October’s monthly price rise was the highest since its calculations started in 1983. Mr. Powell prefers a different measure from the Dallas Fed, which strips out more of the highest-rising prices than of the slowest-risers, but even that’s been increasing and is likely to be up more still when October data is out.

It could be that supply-chain disruption has spread to other areas, thanks to the on-off nature of lockdowns around the world, and so price pressures will fade when the world economy eventually returns to something like normal. But it’s also reasonable to think that something’s changed both in our acceptance of higher prices and in business desire to pass on soaring wage and input costs.

FAIT. The Fed last year introduced a policy of making up for undershoots of its 2% inflation goal by allowing overshoots, calling it flexible average inflation targeting. I think this is hard to justify, but even on its own terms it is running out of road. There’s no formal period over which the average is meant to be measured, but consumer prices have now risen exactly 2% annualized since the original 2% objective was introduced in 2012. Put another way: The whole miserable pre-pandemic “new normal” period of disinflation has been wiped out in just over a year of rising prices.

The Fed still has a little way to go on FAIT because it uses the personal consumption expenditure measure of prices, which is lower than consumer prices. If PCE prices rise in line with October’s CPI jump for the next three months, the Fed would be bang on target at 2% since 2012. Of course, the word “flexible” is there because the Fed doesn’t want to be tied down, so it can do anything.

Transitory. Take away all the excuses, and what’s left is hope: the hope that inflation will go away by itself. The shockingly high October inflation persuaded traders to bet on rate rises earlier than before, with Fed-funds futures priced for a one-in-five chance of two or more rate rises by next June. But while investors expect the Fed to respond a little earlier, in the long run they are sanguine both about inflation and about rates, expecting the pressure to go away.

The inflation rate priced into bond markets for the five years starting in five years is up a bit, but at 2.3% (on CPI) remains in line with the Fed hitting its target. This is reasonable enough for anyone who trusts that the Fed will eventually clamp down on runaway inflation.

What’s surprising is that investors don’t really expect any clampdown, either. Real yields on Treasury inflation-protected securities are at or close to their lowest levels ever. If investors thought real rates were going to have to rise, longer-term TIPS yields should go up a lot, and they just haven’t.

There are two big mistakes the Fed could make. First, the Fed might be wrong that inflation is transitory, as both consumers and businesses prove more willing to accept higher inflation. This would create a self-fulfilling wage-price spiral, unlikely as that might seem. The Fed would then have to clamp down hard because it waited too long to act, raising rates quickly and hitting the economy and asset prices, as in many of the rate cycles of the second half of the 20th century.

The second mistake is that the Fed is right, but comes to think it is wrong. There’s no science to measuring inflation expectations (surveys are all over the place, and the bond market is notoriously unreliable) so the Fed could easily worry that people believe inflation will last, but be wrong. It would then raise rates fast, whacking an economy that was cooling anyway. 

Navigating between these two messy outcomes is tricky, but for now at least investors think the Fed will get it about right.

Write to James Mackintosh at james.mackintosh@wsj.com