On Wednesday, the minutes from the Federal Reserve’s late-April meeting were released, and the Dow proceeded to drop 586 points.
Which was strange, since there was nothing all that surprising or incendiary in the central bank’s discussions. The sell-off’s apparent trigger was a passage stating that “a number” of Fed governors had “suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”
Even if one presumes that the Fed will always make its internal machinations sound more milquetoast than they are, it’s hard to discern cause for alarm here. Was anyone under the impression that the Fed wouldn’t begin to discuss a plan for slowing asset purchases if the economy made rapid progress toward full employment and its inflation target?
Traders appeared to recognize their own overreaction, and the Dow pared back most of its losses by the day’s end.
Nevertheless, the market’s hypersensitivity to any sign of Fed tightening reflects widespread anxiety about burgeoning inflation. April’s unexpectedly high growth in the consumer-price index has encouraged fears that unprecedented stimulus spending, combined with durable disruptions to global supply chains, will produce an inflationary spiral, forcing the central bank to raise interest rates and “cool off” the recovery before it’s fully taken hold.
But this nightmare scenario remains a distant hypothetical for two reasons: There’s a strong case for thinking today’s inflationary trends will be temporary, and America’s price level still isn’t in the vicinity of where the Fed wants it to be.
The economy is going through a lot of changes right now, but will (probably) get things together if we give it some space.
Prices are rising. In April, U.S. inflation rose at its fastest pace since 2009. Futures of global commodities integral to economic growth — including oil, gasoline, corn, and copper — cost twice as much now as they did a year ago. But there’s little reason to assume that these price increases signify a long-term, self-reinforcing, structural imbalance between demand and supply that can only be redressed through tight monetary policy.
Rather, we’re quite likely looking at a bout of transitory inflation fueled by the sorts of temporary mismatches between demand and supply that routinely surface in the first stage of a recovery.
For one thing, nearly 60 percent of last month’s CPI growth was concentrated in industries whose operations were upended by the pandemic. The fact that the prices of airfare, hotel rooms, and restaurant food were much higher this April than they were during the first full month of America’s COVID-19 crisis is not terribly concerning: Freshly vaccinated Americans can book vacations and reservations a lot faster than new hotels and restaurants can spring up to replace the ones that went bankrupt last year.
Meanwhile, the combination of pandemic-induced disruptions to supply chains — and booming demand for consumer goods, as affluent households the world over cut back on services and ramped up online ordering — wrong-footed the global-shipping industry, which still hasn’t regained its balance. As a result, transport costs are at their highest level since 2010. And that’s put upward pressure on the price of a wide array of imported goods.
At the same time, producers of semiconductors failed to anticipate this year’s strong demand for chips, which has been fueled in part by the burgeoning popularity of electric vehicles. The global chip shortage forced U.S. carmakers to slow production last month despite healthy demand, which in turn drove up the price of used vehicles.
But all these sources of scarcity are imminently eliminable. The tourism, shipping, and semiconductor industries face no intractable obstacles to expanding and/or rationalizing their operations. And the hiccups we’re seeing now are a familiar symptom of postcrisis periods (even if the peculiar nature of the COVID crisis has saddled this recovery with especially cumbersome adjustments). As Matthew C. Klein notes for Barron’s:
The news from companies today isn’t that different from the early stages of the last recovery, either. “Going forward, a big question is how well suppliers are positioned to ramp up production. Bottlenecks and other headaches may occur as spot shortages cause unexpected price hikes and hamper companies’ ability to meet demand,” warned an article from January 2010. A news item from August 2010 noted that “Nissan was forced to suspend production on several car assembly lines because Hitachi, which supplied certain engine parts, could not source enough processors.” Then there’s this, from Tyson’s CEO at the time, Donnie Smith, during a call with reporters in February 2011: “I don’t believe consumers at retail have seen the type of food inflation they will see because of rising commodity costs. There is more yet to come.” The rate of inflation peaked shortly thereafter.
Recent developments in the housing market suggest today’s inflation will follow a similar trajectory. COVID-induced changes in policy and demand patterns hit housing about as hard as any other industry. The combination of ultra-low interest rates, rise of remote work, legions of homebound professionals, and fiscal stimulus all propelled demand for new homes and renovations to exceptional heights — even as public-health ordinances, zoning regulations, and a global lumber shortage hampered production. The 2008 crash wiped out a lot of the world’s sawmills. Those that remained were not prepared for the COVID boom. Thus, home prices shot up 15 percent over the past year, while the price of lumber rose by 400 percent.
For all this to produce durable inflation, however, buyers would need to provide demand for historically expensive homes — and builders, for extraordinarily pricey lumber — in perpetuity. As Bloomberg’s Conor Sen notes, that doesn’t seem to be in the cards:
There have been anecdotal reports of some builders deciding to pause or slow down rather than continue to operate in a market with such high prices. Those stories were backed up by some hard data in the April housing starts report, which showed that single-family starts for the month were at their second-lowest level since last August. The only lower month was February, when Texas was in a deep freeze …
The July lumber futures contract has fallen by 25 percent from its May 7 peak, a sign that the market has found a level where buyers are balking rather than continuing to pay up. And for the first time since buying surged last spring, the inventory of homes for sale has increased for two consecutive weeks, a sign that normal seasonality might be returning.
This looks a lot more like a market resolving a temporary imbalance than one being propelled ever higher by unsustainable demand.
The Fed wants to make up for lost price hikes.
It isn’t just the quality of today’s inflation that makes it unlikely to shift Fed policy, but also its quantity. Last August, the central bank announced that it sought to achieve “inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” In other words: 2 percent is the Fed’s target for average long-run inflation, not a ceiling on the level of price growth it will tolerate. So, if inflation runs closer to 1 percent for several years, the central bank will let it run closer to 3 percent for a similar time period before tightening the money spigot.
This means that prices have a lot of room to grow before the Fed blinks. The central bank’s preferred measure of inflation — the personal consumption expenditure price deflator (PCE) — grew at a roughly 1.5 percent rate between mid-2012 and today. That’s left a 5 percent gap between where the PCE index currently sits and where it would be if the Fed had hit its target year in and year out. Closing that gap will require letting inflation run higher than 2 percent for quite a while.
Wednesday’s volatility notwithstanding, traders seem to take the Fed at its word. As Klein writes:
There is just a 3 percent market-implied probability that CPI inflation averages less than 1 percent a year for the next half-decade — the lowest reading on record. On the eve of the pandemic, the implied probability was closer to 20 percent. Unlike a few months ago, traders now believe the Fed won’t allow this recovery to be like the last one.
At the same time, traders aren’t yet worried about inflation coming in too hot. Caps and floors imply there’s a 40 percent chance that the CPI rises by more than 3 percent a year for the next five years on average, but that’s no different from what people thought in the first few months of 2011.
The global economy is in uncharted territory. It’s possible that inflation will prove stronger and more durable than it now looks, or that the Fed will depart from its stated commitments in response to external pressures. But the structural forces that had the developed world mired in disinflationary stagnation before the pandemic — aging populations, technological advances, trade-union weakness, and inequality-induced limits to consumer demand — are all still with us. Given those realities, we should wait to see high, sustained inflation before we believe it.