Since prices began their rapid rise in 2021, Americans have been eagerly waiting for sticker shock at the grocery store and gas pump to ease. But a sustained period of inflation may be in store for the US economy. That’s a key insight from a review of recent research by Pierre Yared, the MUTB Professor of International Business in the Economics Division at Columbia Business School.
It’s clear to Yared that, after a year of wild changes, most people don’t know what to expect from the economy. And the numbers don’t send the layman a definitive message: Indeed, inflation measures have eased following the Federal Reserve Board’s interest rate increases of more than 5 percentage points since last year. Yet consumer prices, as measured by the Personal Consumption Expenditures Index, rose more than 3 percent in the first two quarters of this year. It’s a decline from last year’s 7 percent inflation but still above the Federal Reserve’s 2 percent inflation target.
In a conversation with CBS, Yared discussed the challenge of reining in inflation without quashing economic growth, the relationship between the labor market and rising prices, and how higher inflation may become our new normal.
CBS: The Federal Reserve has increased interest rates by more than 5 percentage points since March 2022. How do you regard its success so far?
Pierre Yared: It takes time for interest rate increases to impact the economy. Markets have been surprised by both the initial increase in inflation as well as how long it’s taken inflation to respond to countermeasures and come down. Inflation forecasts have been wrong, but June was the first time in a while that inflation surprised on the downside — with a larger than expected drop.
CBS: Consumer prices have been rising more modestly after the Fed’s rate increases, rising just 3 percent year over year in June, and core inflation is also easing. Are we nearing an end to rapid inflation increases?
Yared: The fight against inflation, whether successful or unsuccessful, is something that may be permanently here with us. At the end of the day, longer term inflation, not temporary change, is determined both by external pressures on prices as well as the Fed’s determination to rein in those pressures.
Through the 2000s and 2010s, external pressure on prices was disinflationary because of forces like globalization. But it may be that we are shifting towards a regime where external pressures on prices, like tighter immigration policies and deglobalization, are inflationary. In that case, we may be in a situation where the Fed is constantly fighting against inflation.
CBS: That’s a potentially alarming scenario. What does your research show about how it could play out?
Yared: We’ve been fortunate so far to be fighting against inflation in a period where the economy continues to expand and jobs continue to be created every month. If we are, in fact, staying in this new regime longer term, we might find ourselves with inflation persisting and the economy contracting. With rising costs for international trade, we can’t benefit as much from global competition, which would otherwise drive prices down. And when we have to deal with more expensive sourcing, firms face pressure to pass the additional production cost down to consumers. From that perspective, the level of inflation ultimately depends on the central bank’s commitment to preserving inflation stability — how much it is willing to accommodate those pressures versus rein in those pressures.
CBS: What happens if the scenario you describe becomes permanent?
Yared: Let’s say that deglobalization, reduced immigration, stronger unionization efforts, and labor shortages are a permanent state of affairs. Those factors raise the costs of production, which results in upward price pressures. A central bank that is fully committed to inflation stability would not accommodate those upward price pressures at all and would do whatever it takes to maintain inflation stability, even if that means contracting the economy. But that’s a politically difficult thing to do, and if central banks accommodate that political pressure, we might end up with inflation that is higher for longer — so somewhere above 2 percent for an extended period of time.
CBS: You’ve mentioned the average inflation target of 2 percent. Why is 2 percent the Fed’s target?
Yared: The Fed would like inflation to be low enough that it is not something that households and businesses need to think about on a regular basis, and the thinking is that 2 percent is a low enough level that achieves this end. That being said, there are two main reasons why central banks view 2 percent as preferable to no inflation altogether. First, a higher inflation rate implies higher interest rates in the long run, which allows a larger cushion for monetary policy to reduce those interest rates during a recession. Second, a higher inflation rate makes it less likely for the economy to enter deflation, a situation that’s viewed as detrimental, particularly in credit markets, given that debt contracts become more expensive to service in a deflationary period.
CBS: To what degree do you see changes in how we measure inflation affecting the Fed’s response?
Yared: The Fed is supposed to maintain inflation on average around 2 percent, and it’s very clear that they have not succeeded, since inflation has exceeded 2 percent for over two years. When inflation originally started rising in 2021, the Fed made a decision to not respond, in part because of the data that it was observing. Now, a question is whether this was a mistake.
On the one hand, much of the inflation in the first half of 2021 emerged from specific outliers — it was isolated to the goods sector and not the services sector, and wages were not increasing rapidly. The Fed was still concerned about a repeat of the 2010s and relative stagnation that followed the global financial crisis. Based on that logic, one can argue that with the information it had at the time, it would be premature for the Fed to react too aggressively in 2021.
On the other hand, a lot of other indicators suggested things were indeed quite different relative to the aftermath of the global financial crisis. For example, the rollout of the vaccine and end of lockdown suggested that consumer demand would rise rapidly. There were two factors which were very different in comparison to the aftermath of the global financial crisis: a healthy banking system and bloated household balance sheets due to reduced spending under lockdown and government stimulus checks. So one could naturally expect a different type of recovery. Based on that logic, one could argue that the Fed should have reacted sooner.
CBS: How did the pandemic contribute to an inflationary environment?
Yared: Disrupted supply chains and higher energy costs increased the costs of production, as did the labor shortages that resulted from immigration restrictions, early retirement, and an incapacitated workforce that either suffered from illness or had to drop out of the labor force due to childcare. In the face of higher operating costs, businesses often pass on those additional costs to their customers, resulting in higher inflation. The only way that a central bank can counteract these effects is to raise interest rates to reduce customer demand, thus reducing the strain on price pressures but also contracting economic activity in the process.
CBS: You’ve highlighted a key economic challenge central banks face. How can they strike a balance between encouraging economic growth and reining in rampant inflation?
Yared: The hardest thing to do is to maintain credibility. While there is a tradeoff in the short term between encouraging economic growth and reining in inflation, this tradeoff is less salient in the long term, and it becomes imperative at that point to ensure that a central bank remains committed to its inflation target. As we transition from the short term to the long term, the Fed needs to neither underreact nor overreact, and this can be challenging.
CBS: When you consider these sometimes contradictory pressures, what will you be watching for in the months ahead?
Yared: We have to be open to the possibility that this inflationary period is not temporary. If we accept that the world is permanently altered in a direction that raises inflation pressures, then this means that more central banks across the world are going to be facing political pressure to succumb to inflation. Therefore, even if inflation dips back down temporarily below 2 percent during this cycle, it may be more challenging for central banks to keep inflation on average at 2 percent for the longer term. And as this happens, we will see the private sector revise its expectations for longer term inflation.
As part of the Future of Capitalism series in the Business and Society Hub, CBS hosted a conversation on the future of capitalism between Oren Cass, founder and executive director of American Compass, and CBS Dean Emeritus Glenn Hubbard. Watch it here: