US inflation can spring nasty surprises even if it seems to be cooling down
The latest US inflation report, showing that price increases slowed in October, suggests that the economy just might get the ‘immaculate disinflation’ that everyone is hoping for: Inflation will fall to its pre-pandemic levels and remain there, and the US will avoid a recession. Allow me to make the pessimist’s case that we’re not out of the woods yet. The sunnier view does have a lot going for it.
Optimism comes not only from the decline in actual inflation, but also from the decline in expectations of future inflation. But take a closer look and it’s clear that some measures of expectations have not improved that much even as inflation has fallen. That means the situation is unstable and inflation could go back up again.
It’s not enough for inflation to hit the US Federal Reserve’s target of 2%. For a stable economy, inflation needs to be low and predictable going forward, like it was pre-pandemic. In many ways, the predictability of inflation is just as important as its level.
Unpredictable prices act as a kind of tax on consumers. An asset offering variable returns is worth less, all else being equal, than one that offers fixed returns, because the predictability of knowing what your money is worth has tremendous value. Uncertainty around inflation means a dollar is less valuable because you don’t know how much groceries will cost, or how far you can stretch your pay-cheque week to week.
It also increases interest rates on longer term bonds, because investors and lenders need to be compensated for the extra risk taken.One of the dirty little secrets of economics, however, is that we have no good model for predicting inflation. The best we have is expectations of inflation. Expectations can be self-fulfilling.
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