Transitioning away from ‘transitory’ inflation


On Tuesday, US senator Pat Toomey channelled the mid-20th century British economist John Maynard Keynes’ dictum that “in the long run we are all dead”. Asking Federal Reserve chair Jay Powell about the current bout of above-target inflation, Toomey said, “I know you believe this is transitory. But everything is transitory. Life is transitory.”

Powell, wisely, said he would now ditch the word, acknowledging that describing high inflation as “transitory” is causing as much confusion as clarity. The phrase was originally introduced as “transient” at the end of 2020 when Powell looked ahead to inflationary pressures in the year ahead. It aimed to capture the idea that what a central bank had to consider was not a temporary spike in prices nor the “base effects” from comparisons to the year before but the bank’s ability to keep inflation sustainably at its target. In Powell’s own words, price increases “would not go on indefinitely”.

Critics of the Fed’s monetary largesse, as well as its change in focus to look at “average inflation”, seized on Powell’s continued use of the word to suggest the central bank boss had taken his eye off the ball. Indeed, Toomey also asked at the meeting of the Senate committee on banking, housing and urban affairs, “How long does inflation have to run above your target before the Fed decides maybe it’s not so transitory?” The US central bank has repeatedly had to revise up its own forecasts of price growth and acknowledge that the pressures are more broad-based than it originally anticipated.

Debates over the exact meaning of the term were unhelpful, as was the division of economic commentators into “team transitory” and “team permanent”. Retiring the use of the phrase will remove one distraction and unnecessary source of confusion. Aside from improving the central bank’s communication, however, Powell’s stance has only shifted slightly. While he indicated that the Fed may bring forward the reduction in its asset purchases by a few months, he said he still expected inflationary pressures to ease.

Powell will probably be proved right that inflation will fade. Surges in natural gas prices may not be reversed, but they will almost certainly not be repeated. Neither will the stunning jump in used car prices that has been a key driver of inflation. Indeed while the Paris-based rich country think-tank the OECD revised up its forecast of US inflation for 2022 on Wednesday — to 4.4 per cent from 3.1 per cent — that would still mean inflation will spend much of next year below the present rate of 6.2 per cent.

What matters to the central bank is any part that may not disappear. Above-target inflation may become self-sustaining if it leads to businesses and workers expecting price increases and incorporating them into their decision-making. Powell was right to say on Tuesday that this is an increasing “threat”. Accelerating the so-called taper of quantitative easing by a few months is a sensible response.

The new Omicron variant is a potential spoiler. Not only is it still unclear whether vaccines remain as effective against it, but so is its inflationary impact. The OECD noted that it was likely to exacerbate supply chain problems — as well as the shifts in spending from services to goods — that have provoked shortages. On the other hand, few travel or hospitality businesses are likely to feel as if they have significant pricing power, even if a heightened fear of infection contributes to labour shortages. Powell may have banished the word “transitory” but the inflation debate is here to stay.

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