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Picture: 123RF/DELTAART
Picture: 123RF/DELTAART

With inflation reports coming in so high, it’s getting harder to defend my membership on “Team Transitory”. Yet I remain committed to the view that higher inflation is, in fact, transitory. After a few years of above-average inflation, prices will return to a steady state of about 2% annual growth, as has mostly been the case since the early 1990s.

The case for Team Transitory is not about whether the next pending inflation numbers will come in high or low. Instead it consists of the following two propositions:

  • The Federal Reserve can control the rate of price inflation.
  • The Federal Reserve does not want inflation to be very high.

The first claim seems obviously true. Central banks aimed for rates of price inflation at 2% or slightly below for many years. They achieved them regularly — even though, after the Great Recession, some academics insisted that the Western economies were stuck in liquidity traps.

But central banks have many policy instruments at their disposal, including the management of expectations, and it is usually a mistake to bet against them. And the implication of a liquidity trap is that the Fed cannot increase the rate of inflation in deflationary times, not that the Fed cannot reduce it in inflationary times.

If there is a reason to take issue with Team Transitory, it is with the second claim. That the Fed wants to reduce inflation is true in the abstract, but the political price of doing so may be too high. After all, bringing down price inflation requires the Fed to engage in contractionary monetary policy, which runs the risk of a recession. Contractionary monetary policy lowers aggregate demand, and in a world of sticky wages and prices this can lead to lower output and employment, as it did in the early 1980s.

The key question is whether the Fed, at current margins, is more concerned with fighting inflation or lowering the chance of a recession. Admittedly there is uncertainty about the answer to this question, as there should be, but still I end up on Team Transitory.

One way to view the Fed is as an independent institution with a mandate (half of a dual mandate) to maintain stable prices. Chair Jerome Powell has made this goal more flexible by instituting “average inflation targeting”, and this policy does give the Fed some leeway in deciding when the rate of inflation should fall. But it doesn’t grant the Fed licence to allow 5% annual inflation for the next five or 10 years. If the Fed broke with its mandate, it would lose much of its credibility. So from a policy and institutional standpoint, it is in the Fed’s interest to control inflation.

An alternative way to view the Fed is as a political entity, motivated by self-preservation or a desire to help the incumbent Democratic Party. Putting aside whether this is true, voters correctly perceive higher inflation as lowering their living standards. A marginal rise in unemployment might affect 5% of the electorate and may disproportionately affect low-skilled individuals, who are also less likely to vote. In contrast, inflation affects all voters, and most of them hate it. So even a cynical calculus also suggests the Fed will bring down inflation rates.

Perhaps most important, there is the market’s perspective — and the market expects the Fed to bring down inflation rates. As I write, the 10-year treasury yield is 1.64%. That yield has been rising, but it hardly seems to predict hyperinflation, or even 5% inflation for the next 10 years. The most negative piece of evidence so far is from the treasury inflation-protected security (TIPS) market, which is predicting inflation of about 3% over the next five years.

You might be wondering whether “the market” understands inflation and the Fed. Well, investors are obsessed with the Fed and study it closely. When I encounter Team Transitory sceptics, I ask them: “What is it that you understand about the Fed that the broader market does not?” I have yet to receive a compelling answer.

In contrast, the case for “Team Permanent” relies on a series of unlikely events: the Senate is unable or unwilling to confirm new candidates to the Fed’s board of governors. (There are two open seats, plus the chair and vice-chair positions.) Meanwhile, a political crisis strikes the White House, say perhaps President Joe Biden falls ill, and it does not offer any new candidates. There is then a power vacuum at the Fed, which is less able to take decisive action.

In such a world, all bets would be off. But for now — in consideration of the Fed’s institutional and political incentives, as well as the market forecast — I am sticking with Team Transitory.

Bloomberg Opinion. For more articles like this please visit Bloomberg.com/opinion.


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