We woke the beast, and now we may have to learn to live with it. After more than 20 years of low, stable inflation, it's come roaring back — at more than 9% — and it may never return to pre-pandemic levels. We've already lost the benefits of our former economy: low interest rates and pay raises that actually make you richer. Now we also have to manage a new risk in our lives, the beast we thought we had tamed.
The pandemic changed many things, and it's forced me to give up, reluctantly, my long-held belief that inflation is something we know how to control; that policy makers can pick an inflation number, maintain it, and all will be well; that Americans will always know what our dollars are worth.
That certainty has a lot of value. If you have two different assets with the same average return, but one is more volatile than the other, the risky asset is worth less — especially to low earners on tight budgets. The same principle applies to your income. Knowing how much beef and gasoline will cost helps you plan and budget. So less certainty around prices means your income is less valuable. Essentially, the additional risk amounts to a wage cut.
Inflation going forward will not only be higher, but also less stable. And there are reasons for that.
History has given us a long track record of missteps in monetary policy. Central banks cause more inflation by printing too much money, or by cutting interest rates too much at the wrong time. High and unpredictable inflation was a feature of much the post-World War II economy. But it seemed economists had figured it out in the 1990s. If we just picked a target, say, a 2% inflation rate, it would become a self-fulfilling prophesy. People could rely on that level of inflation because the Federal Reserve could make it happen, and wages and prices would rise, accordingly.
When I was in graduate school, I was taught that best practice in monetary policy is to target a certain level of inflation, say 2%. But one of my professors from those days, Jean Boivin, now Head of the BlackRock Investment Institute and former Deputy Governor at the Bank of Canada, recently argued that economists may have not have actually solved the inflation problem after all; We may have just been very lucky.
Between more trade and globalization, especially with many goods coming from cheap-labor countries, the global economy had an over-abundance of stuff. More technology made that stuff — and services — even cheaper. Demand went up and down, causing recessions from time to time. But central bankers were pretty good at managing a demand-driven economy, and so inflation stayed low and stable. It appeared inflation was a problem of the past, something competent technocrats could manage.
Covid-19 shattered that illusion. The world shut down and there was less trade. Supply contracted in a big way for the first time in decades. This sparked inflation all over the world. But inflation is higher in the US because of our policy choices. Economists still don't have great models to predict inflation, but we do know that sending everyone checks, and paying for it by having the Fed buy the debt incurred from the spending, is inflationary. Add in the shrinking supply, and we have the worst inflation in 40 years. It's not only high, but it also keeps surprising us. And the uncertainty is almost as bad as the higher prices. The longer inflation is high and unpredictable, the more it gets baked into wages, interest rates and expectations; it seeps into the bones of the economy and it's very hard to get rid of.
The inflation problem we face is a supply and demand problem. The Fed can only influence demand, but that still gives it the ability to lower inflation. Lower doesn't mean back to a reliable 2%, though. Even if the war ends and China's economy goes fully back online, supply constraints may remain. Between less globalization, aging populations and our goals for a greener economy, we may end up with a supply chain that's less reliable and slower growing. This means less-effective monetary policy going forward.
Even before the pandemic, there were flaws in the idea that the Fed could choose the rate of inflation. Inflation was below-target for years no matter how low the Fed kept rates. Now many economists are speculating that once the Fed gets inflation down to 4% or so, it may give up on tightening further, especially if we are in a recession by then. At that point we will have years of above-target inflation arriving after all those years below-target. The Fed's 2% goal will start to feel like a cruel joke, stripped of the credibility it once had. Americans will have to adjust to living with higher inflation and less certainty about what their money is worth — and that represents a big decline in our welfare.
It also means our monetary policy needs a rethink, starting with less hubris at the Fed. The central bank can help manage demand and — if it avoids adding to its recent mistakes — make inflation a little less volatile. But between continuing supply issues and less credibility, it will no longer offer the predictability we are used to. We must learn to live with more uncertainty and let go of the comforting illusion that technocrats can manage this big source of risk in our lives. If it's any consolation, we know now it was always an illusion.
Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk." @AllisonSchrager
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.