The Return of Inflation

The outbreak of the COVID-19 pandemic in early 2020 heightened these fears. Lockdowns prevented households from spending on goods and, especially, services such as restaurant meals and holiday trips. Firms seeing actual or potential declines in the demand for their products laid off workers. In the United States, the seasonally adjusted unemployment rate rose from 4.4 percent in March 2020 to an alarming 14.7 percent in April. Suddenly, the incomes of US households were some $25 billion to $30 billion less a month than in a normally functioning economy.

Back in 2008–9, the administrations of George W. Bush and Barack Obama had responded to the Global Financial Crisis, which similarly depressed incomes, by ramping up public spending. The Obama Stimulus (formally the American Recovery and Investment Act of 2009) programmed $288 billion of tax cuts and $499 billion of spending increases over three fiscal years, or roughly $22 billion a month of additional spending power. This produced nary a whiff of inflation, but delivered a disappointing economic recovery by the standards of other post–World War II expansions.

On taking office in January 2021, Joe Biden and his economic team promised to do better. Doing better meant running the economy hot, since experience had shown, or was thought to have shown, that more extensive demand stimulus might bring down unemployment without creating inflation.

On his first day as president, January 20, 2021, Biden therefore announced a $1.9 trillion stimulus package, the American Rescue Plan. This came on top of two stimulus packages already passed by Congress in 2020, the $2.2 trillion Coronavirus Aid, Relief and Economic Security, or CARES, Act signed by President Donald Trump in March 2020, and the $900 billion COVID-19 Economic Relief Bill, signed into law by Trump at the end of December. Together with Biden’s initiative, Congress and the executive branch thus provided as much as $200 billion per month of tax cuts and spending increases to fill an income hole of $30 billion a month. Political pressure for a stimulus was intense: working-class households were in economic and personal distress over a crisis not of their own making. Models based on past experience suggested that this stimulus would work. Politicians in the United States and other countries responded accordingly.

In one sense, the Biden administration’s economic models were right: a massive stimulus could bring unemployment back down—the rate fell to just 3.9 percent at the end of 2021. It could avert an extended recession. But, equally, those models were wrong in that they did not forecast a significant rise in inflation. The 12-month change in consumer price inflation began rising almost immediately, exceeding the Federal Reserve’s 2 percent target already in March 2021, before reaching 7 percent by December 2021 and then 9 percent in mid-2022.

The modelers’ predictions that inflation would not rear its head were predicated, as modelers’ predictions generally are, on the belief that the economy would continue to behave as it had in the past. The problem was that there was no past precedent for what was about to unfold.

What unfolded, specifically, was not one but a series of supply-side disruptions. First, COVID caused a substantial number of individuals to drop out of the workforce, creating labor shortages and limiting productive capacity. School and daycare shutdowns forced working parents to stay home with their children. Jobs that required workers to labor in close proximity were newly risky for individuals with impaired immune systems and preexisting conditions—and, in the pre-vaccine period, for people generally. Arguably, generous relief checks reduced the urgency of returning to work. In the United States, it took until mid-2023 for the rate of labor force participation of workers under the age of 55 to return to pre-pandemic levels. Even then, participation rates for older workers remained depressed relative to the pre-COVID norm. Labor economists dubbed this change the “Great Retirement.”

Second, COVID caused a shift in consumption, to goods from services. Consumers scrambled to buy cars in which they could travel in isolation in lieu of subway rides. They purchased personal electronics rather than theater tickets. In all, nominal spending on goods rose by 20 percent relative to pre-pandemic trends over the three-year period 2020–22. But goods-producing firms experiencing this increase in demand could not immediately secure the parts, equipment, and workers needed to ramp up operations. Shortages of semiconductors, a key input into consumer electronics, motor vehicles, and other goods, were a case in point. Limited chips meant limited new cars. But building a new chip fabrication plant could take as long as three years, while expanding an existing “fab” could take as long as nine months. The result was persistent shortages and rising prices for motor vehicles, consumer electronics, and other newly in-vogue goods.

Third, the shift in consumption to goods from services created logistical problems, since many of the products in question were imported into the United States and other advanced economies from emerging Asia, particularly China. Suddenly there was a shortage of shipping containers and container ships. As in the case of chip shortages, this problem was not easily rectified, since it takes 36 months to build a container ship. Large numbers of container ships filled with newly in-demand goods piled up—or, more precisely, floated for extended periods—in the waters off the Port of Long Beach, a principal destination for ships bound for the United States. Lockdowns and COVID precautions slowed port operations. Shortages of truck drivers and chassis prevented goods from getting from ports to warehouses and big-box stores.

Finally, there was inflationary fallout from Russia’s February 2022 invasion of Ukraine, a leading global grain exporter. Food prices shot up with the outbreak of the war, owing to disruptions at Ukraine’s Black Sea ports. Energy prices exploded as Russia curtailed its exports to Western European countries critical of its incursion, and then with the September 2022 destruction of the Nord Stream 2 natural gas pipeline connecting Russia to Germany. The inflationary effects of these shocks were greater in Europe than in the United States, which is largely self-sufficient in energy and foodstuffs. The negative economic effects of food- and energy-price inflation were most severe in low-income countries heavily dependent on imports of these commodities, where households spend a disproportionate share of their income on food and fuel.

The inflationary impact of commodity-price shocks depends in part on their persistence. When thinking about this, analysts distinguish headline and core inflation. Core inflation strips out the effect of the most volatile prices, such as those of food and fuel, on the grounds that these will be quick to revert to prior levels. Some economists also refer to “super-core inflation,” which additionally strips out used car prices and shelter costs. The rationale is that these prices introduce more noise than information into measures of the underlying rate of inflation and into forecasts of its future direction. But in the current exceptional circumstances, there is also the possibility that high rates of food- and energy-price inflation will persist—if, for example, the conflict between Russia and Ukraine grinds on, causing global food and energy supplies to be further disrupted.

Unavoidably, this surge of inflation elicited comparisons with the 1970s, an earlier instance when the US and global economies were hit by energy- and commodity-price shocks and inflation took off. In that instance, the better part of a decade was needed for the Federal Reserve and central banks in other countries to bring inflation back under control. And once Fed Chair Paul Volcker pushed interest rates into the double digits starting in 1979, the US economy fell into severe recession, with unemployment rising to more than 10 percent.

There were good reasons for doubting that this history would repeat. First, central bankers today have a better understanding of the connections between monetary policy and inflation. In the 1970s, Volcker’s predecessors as Fed chair, Arthur Burns and G. William Miller, and monetary policymakers generally doubted the capacity of central banks to contain inflation.

Burns, one of the more influential business-cycle scholars of his era and an adviser to presidents, saw price and output fluctuations as shaped not by monetary policy but by powerful firms and unions with market power. This led him to endorse President Richard Nixon’s August 1971 wage and price controls. When these controls failed to halt inflation, Burns blamed poor harvests and excessive government spending. His conclusion was that monetary policy was essentially powerless to solve the problem. Reflecting these doubts about the potency of the standard monetary medicine, Burns’s Fed was slow to act.

The difference now is that no one in the central banking community doubts the capacity of monetary policy to bring down inflation. Four additional decades of economic research have documented its powerful effects, operating admittedly with variable and uncertain lags. Still, there is a consensus among experts that interest rate increases, by discouraging borrowing, dampening investment, subduing frothy asset markets, and cooling the economy, will counter inflation regardless of whether it is caused by firms with market power, high grain and energy prices, or excessive government spending. The question is how quickly and at what cost.

This points to yet another lesson from the 1970s, namely that the longer a central bank waits to rein in inflation, the higher the output and employment costs. The longer the phenomenon is allowed to persist, the more deeply entrenched become inflation expectations. When the central bank finally concedes the problem and raises interest rates to cool the economy, firms and unions, having come to expect inflation to persist, continue pushing up prices and wages. The central bank, at last committed to defeating inflation, is forced to raise interest rates still higher, cooling the economy even further. The result, ultimately, is a deep recession, such as the Volcker recession of 1981–82. Early action against inflation, the implication follows, is the least painful course.

This points to yet another difference from the 1970s: the extent of central bank independence. In 1972, an election year, Nixon pressured Burns to pursue a loose monetary policy, threatening to pack the Federal Reserve Board and planting false stories in the press about Burns wanting a salary raise. Other central banks, such as the Bank of England, were not independent of their treasuries; they were legally obliged to carry out instructions from the relevant cabinet minister.

Today, in contrast, central bank independence is the norm. The Bank of England, for example, has been fully independent of the British government since 1998. The European Central Bank answers to no one government: it is the most independent central bank in the world. Although Trump, in the course of his presidency, criticized Fed chairs Janet Yellen and Jerome Powell, there is no evidence of his words having a discernible impact on central bank policy, given broad political and doctrinal support for Federal Reserve independence. Even if central bank policies to contain inflation create a risk of recession, to the dismay of politicians running for reelection, those politicians are likely to hold their tongues. Central bankers steeling themselves to fight inflation are less likely to be deterred.

These considerations together suggest that inflation will return eventually to the neighborhood of its pre-pandemic levels, and that this return to the status quo ante will be faster than it was in the 1970s. There may be exceptions. Turkey, where the central bank lacks independence and the ultimate decision maker, President Recep Tayyip Erdoğan, questions the established relationship between inflation and monetary policy, springs to mind as an example. But the exceptional nature of this case itself highlights the generality of the rule. And even Erdoğan, since his reelection in 2023, seems to be coming around.

Even so, saying that inflation will return eventually to the neighborhood of pre-pandemic levels is not entirely helpful. There is uncertainty and disagreement among the experts, in other words, about how long it will take for the effects of monetary action to be felt. It is unclear whether monetary actions already taken will result in recessions, in which case inflation rates will collapse to lower levels. Where inflation shows a tendency to linger, we have yet to learn whether central banks will attempt to push it all the way back down to pre-pandemic levels, or whether they will allow a modestly higher level to persist.

The tightness of labor markets, and therefore the amount of wage inflation already in the pipeline, differs across countries. So, too, does the credibility of central banks’ commitments to price stability, and hence the persistence of inflation expectations. It is better to acknowledge these uncertainties than to offer unrealistically precise forecasts. And it is better to recognize the existence of differences across countries than to overgeneralize.

Finally, there is a school of thought postulating the renewed relevance of earlier theories emphasizing the market power of firms and suggesting a role, in inflationary circumstances like the present, for strategic price controls. This school seeks a historical precedent not in the 1970s but in the 1940s, when governments placed price controls on key commodities in order to limit inflation in the face of wartime shortages and production bottlenecks, while at the same time maintaining high levels of output and employment. During World War II, inflation was successfully contained in the United States, for example, even while the economy operated under high pressure of demand. The suggestion of these commentators is that a similar approach is feasible and desirable today.

Price controls may have fallen out of fashion after the 1970s, but with Russia’s invasion of Ukraine and the energy-price shock, they are back. The British government has limited typical households’ annual energy bills to £2,500 (roughly $3,000) and foresees lowering that limit to £2,074 under its most recent budget. The German parliament has adopted legislation capping gas prices for households and small firms at 12 euro cents per kilowatt hour and for industrial customers at 7 euro cents per kilowatt hour. The Netherlands has capped electricity and gas prices for households at January 2022 levels; the French government has required Electricité de France, the country’s main energy provider, to limit price increases to 4 percent. Since early 2023, the European Union has applied a price cap on natural gas to the entire euro area.

With what rationale? Proponents of strategic controls point to “tit-for-tat” behavior by producers and consumers. The initial effect of an energy-price shock is to reduce the incomes of everyone other than energy producers. Firms paying higher energy prices have their profit margins squeezed, while workers facing higher heating bills see the purchasing power of their paychecks reduced. But although the aggregate income of the non-energy sector has fallen, neither firms nor workers accept that their individual incomes should decline.

Seeking to retain their share of the pie, firms raise prices in order to restore their profit margins. Workers attempt to minimize their losses by demanding higher wages. The effects are mutually reinforcing: the higher prices charged by firms seeking to restore their profit margins evoke demands for even larger wage increases from workers, while those wage increases further squeeze profit margins, causing firms to raise their prices still higher.

The result of these second-round effects—faster inflation—forces the central bank to raise interest rates even more sharply, heightening the risk of recession. By implication, a circuit breaker—in the form of controls limiting the ability of firms to raise prices, perhaps accompanied by wage controls limiting the increase in labor costs—can help to contain inflation while limiting recession risk.

This tendency for companies to raise prices to restore profit margins may have been especially pronounced during the pandemic and its aftermath. Normally, the tendency for firms to raise prices is constrained by the danger of losing sales to competitors who continue to charge lower prices. The competitor who raises prices least stands to enjoy higher sales volume and revenue. But COVID-related supply-chain disruptions and shortages stifled such competition.

Automobile companies whose strategy under normal circumstances would have been to maintain their profits by limiting price increases while increasing output and sales were unable to get their hands on additional semiconductors needed to expand production. Other companies, whose normal strategy would have been to institute only moderate price increases in order to avoid losing additional sales to their competitors, felt no compunction about raising prices to higher levels. Prices rose even faster than under normal circumstances, when competition is more intense. Workers responded with even tougher demands for wage increases. The inflation spiral, pressure on the central bank, and recession risk were all accentuated.

Moreover, even if supply-chain disruptions and shortages do little to actually limit competition and increase the market power of individual firms, they can still affect the inflation narrative. Firms have an implicit economic and social contract with their customers, especially their repeat customers. Raising prices too quickly can alienate those customers, damaging brand loyalty. But a narrative of broken supply chains and soaring energy costs can be invoked as justifying exceptional price increases. Hence the case, once again, for a circuit breaker.

But there is also another way to shape the inflation narrative: a central bank can announce, loud and clear, that it will respond quickly and forcefully to wage and price increases, and especially to second-round effects. The central bank’s contribution to the narrative is that it will not tolerate persistent inflation, whatever its source. In this case, firms with market power will understand that an attempt to restore profit margins by raising prices will result in a larger loss of sales. Workers will feel less urgency about obtaining wage increases because they have less reason to believe that inflation will persist.

The advantage of this approach is that policymakers don’t have to somehow determine who has market power and who does not. They don’t have to decide at what level to set their myriad price controls. They just raise interest rates as needed to cap the rate of inflation. They simply have to convince firms, workers, and the public of their intent.

By implication, how effectively central banks shape the narrative will depend on their anti-inflation credibility—that is, on perceptions of the depth of their commitment to price stability. This anti-inflation credibility is built over time. It is a function of history. As such, the ability of a central bank to combat inflation is a function of history as well.