Previously published on December 30, 2022 in
By Milton Ezrati, Chief Economist at Vested
The Federal Reserve has made remarkable progress in its counter-inflation efforts. Flows of new money into the economy—the ultimate inflationary fuel—have slowed and, by some measures, reversed. Meanwhile, consumer price pressures seem to have moderated. Signs are indeed encouraging.
It would, however, be a mistake to look for a quick end to inflationary concerns. Inflation such as what this country has suffered neither lifts quickly nor easily. It will take time, and the Fed will have to continue its counter-inflation efforts for a while longer before the country can declare itself inflation free.
The news on money flows is especially noteworthy. The Fed began its counter-inflation policies only last March. It nudged up interest rates and began to unwind its “quantitative easing” program, through which it used outright bond purchases to inject liquidity directly into financial markets. Subsequently, Fed policymakers stepped up their game, raising interest rates more aggressively and reversing the “quantitative easing” program so that policy has withdrawn liquidity from financial markets.
In response, the so-called monetary base—mostly Fed-provided reserves at banks from which banks create circulating money—has reversed direction. After growing at an astronomical rate of 35 percent per year between 2020 and 2022—surely a major cause of the inflation—this base has declined by almost 13 percent in just the seven months between March and October, the most recent period for which data are available. The broad M2 measure of money in circulation also declined over this same time by almost 2.5 percent.
As these liquidity patterns have begun to remove inflationary fuel from the economy, the latest inflation measures have also offered encouragement. The consumer price index (CPI) rose by only 0.1 percent in November. Measured over 12 months, the CPI still showed a disturbingly high rise of 7.1 percent, but it was nonetheless a considerable improvement over the frightening 9.1 percent 12-month rise reported in June.
Price details, however, warn to not take these signs of relief too much to heart. Food prices, for example, rose at a 6.2 percent annual rate in November, and shelter rose at an almost 7.5 percent rate. Neither did prices in these two important parts of household budgets show any significant deceleration from earlier months. Indeed, except for fuel prices and the prices of used cars—both of which show less a fundamental moderation than an adjustment from an earlier, untenable spike—the rest of the CPI showed an uncomfortable inflationary momentum, if slightly slower than earlier in the year.
The history of inflation offers its own warning. Take the experience of the last great inflation during the 1970s and 1980s. After a 12 percent rate of CPI inflation in 1974, for example, the pace moderated to a relatively moderate 5 percent in 1976. Those who saw that as the end were shocked when 14 percent was recorded in 1979.
More recent figures tell a similar story. Take 2003, for example, a year when the inflation average came in right on the Fed’s preferred 2 percent rate. The year began with a 0.5 percent CPI jump in January, a 6.1 percent annual rate of advance, enough to cause inflationary concerns. April and May, however, each saw CPI declines of 0.3 percent each, enough, if taken by themselves, to raise fears of outright deflation. But since the year came in right on target, either focus (and the attendant fears they brought) would have been dangerously misplaced.
Another lesson from the past emerges from wage patterns. Wages have been rising at historically rapid rates of just more than 5 percent per year. Earlier in the year, when inflation was running at its highest, these wage gains failed to keep up with the cost of living, but in recent months, wage gains have outstripped living cost increases. The problem is that worker productivity is on the decline. Output per hour has fallen at almost a 5 percent annual rate in 2022.
If companies continue to pay more in real wages than they see in worker productivity, the only protection for the bottom line is to raise prices, given these trends that seem likely in the coming months. During the last great inflation, this pattern—what economists refer to as the “wage-price spiral”—kept up a keen inflationary momentum even after the original cause of the inflation disappeared.
This potential for a wage-price spiral and these other cautionaries should send two essential messages to policymakers and the public. First, even though moderated, inflationary pressure remains. Second, it would, as a consequence, be a mistake for the Fed to abandon its counter-inflation policies any time soon—moderate them perhaps but a reversal risks future trouble.