What is inflation and when you should really start worrying about it

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Some investors worry that fiscal and monetary stimulus will drive up inflation.

  • Economists are bracing for the strongest US inflation in decades as the country reopens.
  • Where some expect inflation to be temporary, others fear a dangerous spiral, or “runaway” inflation.
  • Here’s what you need to know about inflation, where it stands today, and when you should really start to worry.
  • See more stories on Insider’s business page.

After decades of weaker-than-expected price growth, America has inflation on the brain.

Inflation – or the general rate at which prices climb – has taken center stage as the US economy climbs out of its year-long slump. Economists expect the combination of a swift reopening and trillions of dollars in stimulus will lift prices at their fastest rate in recent history.

For some, forecasts of stronger inflation bring up memories of the 1970s and 1980s, an era sometimes called the Great Inflation, when prices grew at such a furious pace that the Federal Reserve had to lift interest rates to historic highs.

For younger observers, healthy inflation is a long pursued but seldom seen goal. Price growth has trended below the Fed’s 2% target for most of the past quarter-century. People under 40 simply don’t know a world with runaway inflation – or what the beginning of such a world might look like.

But recent economic headlines – gas shortages, troubles in the labor market, and big-government programs – have a distinctly ’70s flair. Just when should Americans know when to be really worried that inflation could be back in a big and problematic way?

Here’s a look at what inflation actually is, why it’s a tricky concept that is a bit of a self-fulfilling prophecy, and how it’s actually unfolding in 2021.

Table of Contents: Masthead Sticky

Why are people worried about inflation?

The basic notion of soaring prices is concerning. Roughly 10 million Americans are still out of work, and millions more were unemployed for at least some of the past year. At a time when many Americans are looking for stable financial footing, people are more worried about inflation than they have been in years.

The way in which prices have been climbing has already made some worried. While the Fed and President Joe Biden’s Council of Economic Advisors have repeatedly said they expect stronger inflation to be only temporary, others are less optimistic.

Former Treasury Secretary Larry Summers, one of the loudest voices raising concerns of rampant price growth, castigated Democrats’ $1.9 trillion stimulus in March as the “least responsible” fiscal policy in 40 years and kindling for an inflation crisis.

“I think there’s about a one-third chance that the Fed and the Treasury will get what they’re hoping for and we’ll get rapid growth that will moderate in a non-inflationary way,” he added.

A return to the inflation seen in the 1970s would be disastrous for the already ailing economy. In that decade, swaths of easy money were initially viewed as a way to combat unemployment, but inflation quickly broke out of its trend and spiraled out of control. The Fed was forced to step in with interest rates as high as 20% to choke off the price growth, and that had its own detrimental effects on the economy, including a deep recession in the early 1980s.

Conservative economists have warned Biden’s $1.9 trillion stimulus package was unnecessary and could spark a similar disaster. Whether price growth stays elevated or trends back to about 2% will tell the tale of whether Biden’s plan was safe or fuel for a 1970s-like crash.

What would healthy inflation look like this year?

The Fed, America’s central bank, has an “inflation target,” which it uses to guide price growth. In a major shift, the central bank replaced its 2% target in August with a goal for inflation that averages 2% over time. This update allows the Fed to pursue inflation above 2% immediately after the crisis as it tries to run the economy hot and drive a stronger recovery.

The Fed’s own projections point to the stronger-but-transitory inflation it expects to see over the next few months. Policymakers expect year-over-year personal consumption expenditures – the Fed’s preferred inflation measure – to reach 2.4% this year before cooling to 2% in 2022, according to a March release.

The Fed’s new inflation target opens the door for a period of economic overheating as the country reopens. It’s this gamble that concerns conservative economists, or “hawks.” After decades of not letting inflation trend above 2%, it’s embarking on an experiment to let the country run hot in hopes of a faster recovery.

Fed Chair Jerome Powell has been less exact with his forecast, but expects inflation to trend above 2% for “some time” before falling in line with the central bank’s long-term goal.

How does inflation look now?

Signs of an inflation pick-up have emerged, which the Fed says it expected and critics say merits caution.

The PCE price index jumped 0.6% in April, marking the strongest one-month jump since 2008. The measure also notched a 3.6% year-over-year gain, though the data is somewhat skewed by last year’s readings. Inflation “doves” say such a big jump is only natural after the pandemic and widespread lockdowns brought price growth to a near crawl.

The core PCE price index, which excludes volatile food and energy prices, rose 0.7% in April and 3.1% on a year-over-year basis. The core measure is the Fed’s preferred gauge of nationwide price growth.

Separately, the Consumer Price Index showed prices climbing 0.8% in April. The gauge rose 4.2% year-over-year, also indicating the strongest inflation since 2008.

Inflation expectations are also a gauge worth watching. Median US inflation expectations for the next 12 months gained to 3.4% in April from 3.2%, according to the Federal Reserve Bank of New York. Expectations can serve as a kind of self-fulfilling prophecy. When Americans anticipate faster price growth, businesses tend to lift prices and workers in turn demand higher wages. While inflation expectations typically surpass real inflation, they can hint at the direction inflation will trend, and even affect prices and wages in that direction.

Taken together, the gauges show inflation firming, but still far from the peak economists are bracing for. The median estimate for April year-over-year CPI sits at 3.6%, a rate that would be the fastest since 2011.

What can the Fed and the government do about inflation?

Inflation has been half of the Fed’s dual mandate since its inception in 1913. The central bank was tasked by Congress to ensure stable price growth for the US economy. Its main lever for doing so is its benchmark interest rate, which dictates borrowing costs across the country.

When rates are high, Americans are more incentivized to save money. When rates are low, or near zero as they are today, Americans are pushed to borrow and spend. The Fed’s ability to change rates allows it to stimulate economic activity in times of recession or cool spending when the economy is running hot.

The latter is primarily how the Fed dampens strong inflation. By raising interest rates, the central bank weakens the incentive to borrow and spend. That then drags on demand and weakens the rate at which businesses lift prices.

Powell said in March that lifting its threshold for future rate hikes can allow it to more aggressively pursue its maximum-employment target.

“There was a time when there was a tight connection between unemployment and inflation. That time is long gone,” he said. “We had low unemployment in 2018 and 2019 and the beginning of ’20 without having troubling inflation at all.”

During those years, unemployment and wage growth among low-income households and racial minorities started to fall in line with broader measures. By letting inflation run above its historical average for some time, the Fed aims to foster not just a tighter labor market, but one that’s more inclusive and beneficial for all Americans.

The risk is that higher inflation in pursuit of a more inclusive economy can spark a new crisis as price growth runs out of control.

Read the original article on Business Insider