When the clock struck midnight on New Year’s Eve, one of the biggest economic stories of 2021 became one of the biggest economic stories of 2022.
Inflation jumped precipitously in April and lodged itself in consumer minds as the year wore on. Since May, costs have risen at least 5% each month on a year-over-year basis, cresting at 7% in December — the highest 12-month rate since 1982.
While consumers have been stung by ballooning prices for items as varied as meat and used cars, economists are monitoring a more pernicious risk: the threat of broad-based, runaway inflation that plagued the U.S. in the 1970s. The Federal Reserve acknowledged the danger by decisively shifting its posture in mid-December. Just weeks after announcing a plan to taper its bond-buying program, the central bank said it would act faster and more aggressively. That included penciling in at least three quarter-point rate hikes this year. Just three months earlier, many policymakers hadn’t anticipated even a single move.
Capital Group economist Anne Vandenabeele believes inflation will recede in the latter half of this year — though she acknowledges the potential danger of rising prices becoming entrenched.
“The consensus base case here is that the high inflation trends we’re seeing will moderate,” she says. “Higher prices have proven to be durable, but we’re expecting inflation to come back down this year, probably in the second half, though perhaps not to the Fed’s 2% target.”
The reasons to believe that inflation will subside start with the numbers themselves. The recent price increases seem to be driven by surges among some goods, Vandenabeele explains, rather than by the kind of across-the-board pressure that is a prerequisite for a self-sustaining price expansion. Additionally, some inflationary forces have subsided in recent months — most notably, federal stimulus programs have largely ended.
Of course, variables complicate the outlook. COVID-19 is still roiling economies, and new variants, such as the recently identified Omicron, could pack additional surprises. Consumer sentiment and wage demands also pose unusual perils, as the psychology of inflation can be just as critical to sustained price increases as the cold reality of corporate bottom lines.
“It’s important to be humble when forecasting inflation,” Vandenabeele adds. “While we do think the pace of price increases will slow, the potential for elevated inflation is higher than it has been in decades.”
Inflation is a simple concept, as it’s just a measure of how prices rise over time. The actual mechanics of tracking and computing inflation, however, are deeply complex. Prices can be quantified in dozens of ways and pushed and pulled by hundreds of factors. It’s difficult to forecast in typical economic environments, but today economists must also contend with a once-in-a-lifetime pandemic, a historic economic decline and recovery, tangled supply chains and sporadic lockdowns.
Still, there are signs that this episode isn’t a replay of the 1970s.
First, some inflationary factors have peaked or even stopped. For example, the U.S. government gave billions directly to consumers during the worst depths of the coronavirus shutdown. But those one-time payments, as well as enhanced federal unemployment insurance support, have ended.
Second, price increases have not been evenly distributed. “What we’re seeing is a series of one-off price jumps, which is very different from high, sustained inflation,” Vandenabeele explains.
Many of those increases were driven by lockdowns, which triggered the swiftest recession in modern history and set the stage for last year’s powerful recovery. The whipsaw in demand has had an enormous effect. Energy prices, a traditional source of price volatility, rose nearly 30% for the 12 months ended December 31. Prices for used vehicles swelled by almost 40% as rental agencies sought to replenish their fleets just as commuters started returning to the road.
In contrast, “sticky” prices, such as rent and medical care, which are less prone to rapid changes, have risen far more modestly. Taken as a whole, these differences imply that today’s inflation isn’t a broad, self-sustaining phenomenon but is rather the result of discrete markets and sectors reacting to recent, unprecedented events.
For the past several decades, economists have worried about insufficient inflation. Indeed, most central banks struggled to foster even modest price increases. The U.S. has only rarely breached the Fed’s 2% annual inflation target since 2000. Now, with 12-month price growth clearing 5% for the better part of a year, consumers are more conscious of inflation than they have been in a generation.
“Part of inflation is very psychological,” Vandenabeele says. “This is especially true for households. If potential price increases are forcing them to plan when they fill up the car or when they go grocery shopping, that changes everything.”
The self-sustaining inflation spiral in the 1970s was partly rooted in consumer awareness. Workers defrayed consistently high inflation — sometimes topping 10% annually — by demanding higher wages. Those payroll costs were in turn passed on to consumers, spurring further wage increases.
The risk is accentuated because so many of today’s price increases are in areas highly visible to the average consumer, such as gas. Additionally, many sectors are experiencing a worker shortage, putting pressure on wages.
“We’re not at self-sustaining inflation yet,” Vandenabeele says. “But if the mentality and inflation dynamics change, price growth has the potential to become more ingrained this year.”