Economy & Business Environment Blog

Should we finally start worrying about inflation?

With the Fed raising rates this week, the monetary policy debate on the next step will commence, focusing on whether or not the Fed made a mistake in raising rates too soon, and what it should do going forward.

There is clearly no consensus regarding the Fed decision. Some economists vehemently oppose raising rates in the near term. They argue that:

1. There is no danger of inflation on the horizon
2. The economic outlook for the US and global economies is already shaky, and raising rates will weaken them further, possibly leading to recession.
3. Even if inflation goes a little above 2 percent it is no big deal, and certainly not worth risking further expansion of the economy.

These arguments are all debatable. Let me focus on the first one which seems to be shared by an especially large number of analysts. In fact, it is reasonable to worry about inflation. Here’s why:

• The labor market is tightening, and wage acceleration is coming.

The labor market will likely be much tighter in 1-2 years than it is now. Baby boomers are retiring and the labor force is barely growing, so even modest employment growth will lead to tightening. Our forecast at The Conference Board is for 4.2 percent unemployment in late 2017, assuming the current expansion continues. Wage growth acceleration will follow. We expect wages and salaries in the Employment Cost Index to rise by about 3.2 percent in 2017.

• The impact of falling oil prices and a strengthening dollar on inflation is temporary.

In large part, inflation is weak now because of the drop in oil and commodity prices and the strengthening of the US dollar. But these trends have already had most of their impact. Unless we see a further oil price drop or a significant wave of dollar appreciation, neither trend will exert significant downward pressure on inflation within the next year. This by itself will bring inflation close to the Fed’s target of two percent.

• Rumors that the Philips Curve (decreased unemployment = increased inflation) is dead have been greatly exaggerated.

Why has inflation been low in recent decades? Prior to the Great Recession, the US economy experienced a massive expansion of aggregate supply from surges in technology, labor productivity, and imports from developing countries. These surges lowered prices. From 1997-2007, core goods inflation was negative, and even tight labor markets could not generate overall high inflation, despite core services inflation that climbed to about 4 percent in 2001. So we don’t view the recent weak relationship between labor market tightness and inflation as evidence that the Philips Curve is broken. Rather, technology and globalization masked the curve. Will this masking continue? Probably not. Factors that expanded aggregate supply seem to have subsided. Productivity growth has been nearly flat, and imports are shrinking as a share of GDP. Even if productivity will accelerate on a structural basis some time down the road, we should not expect technology and globalization to continue to lower inflation any time soon.

Could other factors keep inflation down? Maybe. The Phillips Curve, while not broken, may have shifted. There is evidence that the credibility the Fed has developed in keeping inflation low has anchored inflation expectations and lowered the likelihood of actual inflation going above the Fed’s target. In addition, disruptive innovations such as Uber and Airbnb may continue to squeeze pricing power across a growing number of industries.

• Low inflation in the recent past is no guarantee of low inflation in the future

The opinions of those who predicted high inflation when the unemployment rate was around 10 percent should be taken with a grain of salt. Their argument was based on the notion that expanding the Fed’s balance sheet would cause inflation. That hasn’t happened because the economy was too weak to create such pressures. But the wrong predictions of high inflation in 2010 may not be so wrong in 2017, when the environment for inflation will be stronger.

In sum, low unemployment rate will lead to faster wage growth, and the resulting increase in production costs will eventually be passed on to consumers. There’s always great uncertainty in forecasting inflation. But at the moment, the Fed has good reasons to worry about it and raise the interest rate now, and several times in the next year.