On the inflation debate - a note of caution

Arguably the most important macroeconomic debate of present times is whether inflation is transitory or persistent. Emerging signals and the commentary around it appear to be making opinion makers gradually veer around to the view that it may be persistent. We are at a critical moment in this debate since it's the time when the opinion flips definitively and actions follow suit. 

In case of something like inflation, where expectations are perhaps more important than even the dynamics of the substantive underlying forces, it's important to not let our guard down and allow the decision to be made purely on momentum. Persistent inflation is now a momentum trade on a strong upswing. In such times, it's important to keep track of the rear-view mirror and transitory inflation proponents. 

Consider the following. For inflation to become persistent, the following has to happen

1. The underlying inflationary contributors have to play out
2. These forces have to leave permanent effects
3. The price pressures have to become broad-based enough
4. They have to persist for long-enough
5. Enough opinion makers will have to be convinced of a definitive turn
6. And these opinion makers end up shaping expectations among the public at large

Apart from the first two substantive points, the rest are all subjective assessments. And by nature such assessments are vulnerable to being wrong. This should come as no surprise given the irrational exuberance that has come to characterise financial asset markets in recent years. All it takes is for a self-fulfilling spiral of inflation doomsday prophecies to somehow take root.

There is not one macroeconomic model or theory which can explain with consistency trends like inflation over decades. Every time inflation becomes an issue, supporters come up with a model to explain their argument overlooking the fact that it could not have explained the earlier episodes. Dom White hits the nail on the head

Given the failure of (all?) models, I think it’s important to recognize that any explanation for why inflation has surged over the last year is improvised – it has no track record of being right or wrong. We’re all Bayesians now! But some are more convincing than others.

On whether inflation is transitory or persistent, Adam Tooze makes the case that there is not enough evidence of broad-based and longish enough nature of the inflation trend to argue that it's persistent in either Europe or US. 

There are some important signatures which cannot be ignored. For one, as this graph on the US inflation conveys, almost two-thirds of the deviation in US retail inflation from pre-covid trend is contributed by motor vehicles and energy prices.

Then there is the services sector dog that did not bark. Services, which forms the bulk of CPI weights, remains largely unaffected by any new inflation trend. 

Martin Sandbu parses the latest US inflation data and is not convinced. He has a compelling case.

It's acknowledged that the supply-chain disruptions due to the pandemic have been the most important immediate trigger. The supply-chain disruptions likely became amplified when the pent-up demand got released and boosted aggregate demand at the extensive and intensive margins. The increased disposable incomes and pent-up demand (extensive margin) was coupled with the re-allocation of consumption (intensive margin) away from services to goods due to the pandemic enforced closures and work from homes. How long will these trends last is anybody's guess. 

Adding more uncertainty to the calculations is the future of Covid 19. Is Omicron the end-game for elevated Covid? If it's the case that Omicron is the end-game then several assumptions made by the persistent-camp becomes questionable. 

We need to be cognisant that "this time is no different" explanations may have only limited relevance given the unique nature of the shock - sudden supply and demand shocks, followed by equally sudden release of pent-up demand but very slow release of supply constraints (or even persistence of certain supply constraints), and all of this happening in a world awash with liquidity. 

In conclusion, this is an important observation from Adam Tooze,

All things considered, the main reason to worry about inflation may be precisely that people are talking about it. Whatever its effects in the markets, in the political arena inflation talk is not neutral. Inflation tends to hurt the Democrats... If one takes this argument seriously, then what the Biden administration needs is for the Fed to do the bare minimum necessary to anchor inflation expectations, calm public fears and the markets. Unfortunately, the calm in the markets is now based on pricing in four interest rate hikes. Let us hope that this is not more than the economy can bear.

Update 1 (23.01.2022)

NYT has this good summary of the demand for goods in the US,

Virus outbreaks shut down factories, ports faced backlogs and a dearth of truckers roiled transit routes. Americans still managed to buy more goods than ever before in 2021, and foreign factories sent a record sum of products to U.S. shops and doorsteps. But all that shopping wasn’t enough to satisfy consumer demand. The Port of Los Angeles is a window into the mismatch. The port had its busiest calendar year on record last year, processing 16 percent more containers than in 2020. Even so, it still has a huge backlog of ships waiting to dock, several of which, as of Friday, have been waiting a month or more... 

Giving households more money to buy camping equipment or a new kitchen table widened the gap between what consumers wanted and what companies could actually supply. As goods came into short supply and began to cost more to transport, businesses raised their prices. Government checks haven’t been alone in driving strong U.S. demand. As virus fears prevent consumers from planning a trip to Paris or a fancy restaurant dinner, many have turned to refurbishing the living room instead, making goods an unusually hot commodity. Lockdowns that forced families to abruptly stop spending at the start of the pandemic helped to swell savings stockpiles. And the Federal Reserve’s interest rates are at rock bottom, which has bolstered demand for big purchases made on credit, from houses and cars to business investments like machinery and computers. Families have been taking on more housing and auto debt, data from the Federal Reserve Bank of New York shows, helping to pump up those sectors.

Update 2 (30.01.2021)

Philipe Hildebrand makes the case that the inflation is being driven not by any demand but by supply-side shocks. He points to this BlackRock research paper which highlights the unprecedented nature of the supply disruptions.

It also points to the Covid induced shifts away from services to goods.