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Financial 2022: Inflation is Back in the News


By Jeffrey Lacker and John Weinberg

For anyone under the age of 50, inflation may seem like a topic from the history books.

And, in fact, even those of us old enough to remember have gotten used to — and maybe become complacent about — the low inflation we’ve seen in the U.S. (and other developed countries) in recent decades.

Then came the pandemic. After a brief bout of falling prices at the outset, for the last year inflation has been running persistently at rates we haven’t seen since the early 1980s; around 6 percent or so, depending on the measure, well above the 2 percent that has prevailed since the mid-1990s. It’s once again a topic for headlines and the twitterverse.

So, what’s going on?

First, a definition. Inflation refers to the rate of change common to all goods and services. It’s sometimes tempting but almost always a mistake to “blame” inflation on something peculiar going on in a particular sector, such as energy, health care, or used cars. There are always industries in which prices are advancing more rapidly than in others. Inflation is the broad sweep of price changes averaged across all sectors.

Ultimately, inflation will depend on how the central bank (the Fed) conducts the nation’s monetary (interest rate) policy, particularly how it reacts to unanticipated disturbances.

So, what has caused inflation to rise? The old saying, “too much money chasing too few goods” while simplistic, isn’t far off base.

Fearing a sharp and lasting contraction in economic activity from the pandemic, Congress promptly passed a very large economic relief package, and then two more last winter.

At the same time, the Fed pulled out all the stops — taking the short-term interest rate it controls essentially to zero, resuming the purchase of large amounts of Treasury and mortgage-backed securities, and opening up programs to lend to a large range of financial intermediaries and others.

Taken together, these measures added up to very large distribution of cash to consumers and businesses. While they provided much needed relief for the many Americans who bore a disproportionate burden from pandemic dislocations, they resulted in household financial conditions (on average) holding up remarkably well.

And after the initial shock in the Spring of 2020, particularly after the wane of last winter’s surge, households used their strong balance sheets to ramp up spending — the dollars chasing goods.

But while the effects of COVID on consumer demand were short lived, the effects on supply — especially of manufactured goods — were more lasting. Hence, the too few goods being chased.

Such a shock to pricing and the economy does not necessarily need to translate into persistently higher inflation. Prices could get driven up to new levels, but then continue to rise at the more modest rates of the past. Indeed, such a temporary burst of inflation was what policy makers at the Fed seemed to be banking on for a while.

But here is where the story gets tricky. Whether a burst of inflation proves temporary or translates into a lasting problem depends on how the Fed responds.

The longer the Fed lets an inflationary episode play out without raising rates, the greater the chance that higher rates of inflation get baked into people’s expectations, giving rise to an “inflation psychology”. If that happens, inflation takes on its own momentum and becomes much harder for the Fed to dislodge.

What we’re seeing now has some troubling hallmarks of such persistent inflation dynamics. After lagging inflation, the rate of wage increases is now rising as workers seek to catch up. Businesses are willing to accommodate wage pressures because they feel comfortable passing higher costs on to customers in the form of higher prices.

The challenge now for the Fed is to raise interest rates enough to cool inflation without tipping the economy into a recession. Raising rates increases the return to postponing spending, thereby dampening the current demand for goods and services. While such a “soft landing” is still possible, the Fed’s delay has raised the risks of either a recession or a prolonged inflationary episode. A lot is riding on the Fed this year.

Jeffrey Lacker

Jeffrey Lacker is a Distinguished Professor in the Department of Economics at the Virginia Commonwealth University School of Business and was formerly President of the Federal Reserve Bank of Richmond. He serves on the Board of Directors of Richmond Jewish Foundation.



John Weinberg

John Weinberg is Policy Advisor Emeritus at the Federal Reserve Bank of Richmond, where he served as Senior Vice President and Director of Research.



Editors’ Note: For other articles and commentaries under our Financial 22 Theme, see Community and Richmond Jewish Foundation.

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