If you are under 40, odds are you’ve never experienced serious inflation. Since the mid-1980s inflation has not only been fairly low, averaging about 2.5% a year, but remarkably predictable. Previous generations were haunted by the risk of inflation, and didn’t know if their portfolio and income could keep pace with prices. Seniors on fixed incomes faced the possibility their savings would disappear.
Such worries now seem quaint to a newer generation of economists and commentators. For them, a period of inflation volatility feels as remote as an explicit debt default. But there may be reason for concern.
Economists still don’t fully understand what sparks a run of inflation. More trade and globalization may be responsible for the low inflation in the last few decades. It made more goods available for cheap. A spike in oil or commodity prices can bring on inflation, like it did in the 1970s. Economists used to think a tight labor market would bring on inflation, but a bout of stagflation in the 1970s— which combined high inflation and high unemployment—led to a major rethink of inflation’s causes
Economists now think a big factor is expectations. When people expect more inflation they demand wage increases or raise prices. This makes inflation self-fulfilling. Many credit the US Federal Reserve for the last 40 years of low inflation. By managing expectations, consumers and their employers expect low and predictable inflation. In 1981, Paul Volcker, chairman of the Federal Reserve, took the economy into a recession to fight inflation, which showed the Fed was serious and would do whatever it took. It could be argued we still enjoy the benefits of his aggressive policies.
One gauge of current inflation expectations is the breakeven rate, or the difference between nominal and inflation-linked treasury bonds. The difference in their five-year interest rates reflects what the market expects inflation will be over the next five years. It also includes how confident people feel about their inflation estimates. The more uncertain people are about inflation, the higher the breakeven rate, because inflation-linked bonds provide more insurance against price increases. Insurance is more valuable when the world is riskier, and that extra value is reflected in bond prices. The breakeven rate is still fairly low, within the 2% range, but it is starting to creep up.
Is it time to be worried? Probably not yet. The Fed has signaled its commitment to low inflation by increasing interest rates. But modern monetary policy hinges on a crucial assumption: the Fed can manage inflation expectations. And if the world becomes more uncertain, we may one day look back on this assumption as naive. After all, for the last several years the Fed did appear to have control of expectations, inflation stayed below the Fed’s target even as unemployment fell. If the Fed can’t produce higher inflation, can it also still reduce inflation?
Imagine there is a trade war and the US barely trades with China. Less trade means fewer low-priced goods are imported to the US. Fewer goods means higher prices, which could trigger inflation. The Fed could then raise rates to control inflation, but it would have to do this just as the economy will be heading into a recession from less economic activity. It is questionable whether the Fed would increase rates just as unemployment increases, a return of the stagflation of the 1970s. This would not only be devastating but could damage the credibility the Fed has gained in the last 40 years.
If there is one thing we should have learned from the 2008 financial crisis it is we should never count out any risk. The last 40 years of data tell us nothing about the next 40.