What 2021 has taught us about inflation

By John Authers,

If 2020 was the year we all learned about epidemiology, 2021 has taught us more than we ever wanted to know about inflation. Price rises had remained calm and controlled for four decades, ever since the US Federal Reserve under Paul Volcker hiked interest rates aggressively in the early 1980s. Barely anyone working today has any practical memory of inflation as a serious and problematic reality.

That explains the intensity of 2021’s year-long debate over whether new stirrings of inflation were merely “transitory,” or whether the US and global economies should prepare for a regime where inflation was once again a fact of life. At year’s end, US inflation has reached a stunning 6.8%, the fastest annual rate since 1982, and the Fed has admitted it is more than a passing side effect of the pandemic. The debate is effectively over.

The question is whether — and how — we could have seen this coming. Earlier this year, we introduced Authers’ Indicators, a heat map to track and assess early signs of inflation. Now, the gauge accurately yields a week-by-week picture of growing inflationary pressures. But we can also see why the debate was so fierce. For several months, inflation could just as accurately be read as no more than a transitory phenomenon. Only in the last few months has it grown into a broad and persistent trend.

In this heat map, squares darken as an indicator rises further above its norm for the previous decade (when inflation was thoroughly under control). Note that the entire map darkens as the year goes by. But, in May, when alarm about inflation began to take hold, only a few indicators were extreme. Most had barely started to rise.

To better understand this dynamic, it is best to zoom in on two of the most reliable measures of inflation, the core and trimmed mean indices, both included in our heat map. The US Bureau of Labor Statistics calculates its price index, which is meant to capture a realistic ongoing cost of living, by continually surveying the prices at which more than 200 different goods and services are selling. It’s a massive undertaking. “Core” inflation takes the full basket of goods in the CPI and subtracts food and fuel, whose fluctuating prices are driven by factors largely beyond the reach of economic policymakers.

Meanwhile, “trimmed mean” inflation is calculated by excluding the biggest outliers in both directions and taking an average of the rest. There will always be goods whose prices have moved sharply for some specific reason unconnected to the broader economy. Excluding them gives a clearer measure of underlying inflationary pressure.

Historically, the distinction between these two measures has been little more than academic. They’ve tracked each other very closely.

That changed in the early months of this year. While “core” CPI shot upwards, the trimmed mean barely moved. The gap between them hit a record. The numbers revealed not only a historic resurgence of inflation, but a historically anomalous one.

This bolstered the “transitory” argument. While May’s headline number was shocking, the huge gap between the core and the trimmed mean showed that it was driven to an unprecedented extent by a few outliers. And there was a clear explanation for those outliers: Covid-19.

Demand for things such as cars and hotels collapsed during the pandemic. Car rental companies sold off their fleets, while the major auto manufacturers cut back their orders of components as they anticipated buyers would delay purchases. When demand bounced back as vaccines were rolled out in the spring, rental companies and used-car dealers were left without any product, and prices skyrocketed. At one point, used-car inflation hit 112%.

It seemed reasonable to expect that core inflation would eventually retreat, coming back into alignment with the trimmed mean. This is what happened the last few times a big gap has opened between them. And indeed, price rises for things such as used cars and lumber did prove transitory. Their shifts during the year (measured here in standard deviations compared to their averages for the previous decade) look like a drunkard’s walk:

But core inflation never fell. Rather, month after month, the trimmed mean rose steadily. It’s now even more extreme compared to its history than the eye-catching headline numbers.

Why did inflationary pressure broaden after the spring? The trend wasn’t foreordained by the pandemic or an inevitable result of policy missteps. Inflation is a complicated concept and a set of overlapping factors combined to entrench it.

First, monetary policy acts with a lag. It was only after a matter of months that the true effects of Covid-19 stimulus and the runup in the stock market made themselves felt. If consumers are provided with more money, they will naturally bid up prices. Entering the year with record amounts in their bank accounts, Americans began to spend it once worries about the pandemic began to fade with the arrival of vaccines.

Second, early signs of inflation — and the firestorm of commentary they provoked — helped to build expectations for future inflation. This encouraged many consumers to bring forward their purchases and drove workers to demand higher wages, putting further upward pressure on prices.

Finally, inflation has not proved transitory because the pandemic has also not been transitory. Renewed interruptions to shipping caused by a Chinese Covid-19 outbreak in the spring and then the “delta” wave during the summer ensured that supply continued to fail to meet demand. To ration limited supplies, prices had to rise.

You can see these effects gradually take hold using the indicators in our heat map. Official measures of inflation showed no reason for alarm in January. They rose sharply in May, thanks to transitory impact of the pandemic. Only then did price pressures steadily broaden.

The five specific inflation components we chose to follow also all rose during the second half of the year even if, as with college tuition fees or prescription drugs, the pandemic had tended to push prices down rather than up. The only exception was car rentals.

Commodity prices were harder to read; fast moving and volatile, they shift in response to big moves in global supply and demand. Early in the year, lumber prices skyrocketed, in a transitory effect of the pandemic. Gyrations in the oil price garnered much attention and fed into the extreme “headline” inflation numbers, but energy costs remained at or below the average for the previous decade. In hindsight, the price of basic industrial materials, not traded on futures markets, provided the most accurate gauge. Purely responsive to the ebbing of supply and demand within industry, not to animal spirits in financial markets, they rose steadily to a new all-time high in November.

We can also clearly see the gradual buildup of inflationary expectations in surveys of businesses, which showed concern as early as January. Managers had a privileged view of the problems that snarled supply chains would create and saw inflation coming. By May, businesses said they had a serious problem with rising costs, while consumers had also begun to brace for higher prices.

The next question is how bad the situation will get in 2022. If inflation is to become a part of the landscape, then wage rises, which have been very low ever since the global financial crisis, will need to start to take off. While still far from extreme, several measures of wage pressure increased steadily throughout the year to their highest levels of the post-crisis era, particularly for the lowest paid.

On the other hand, financial markets offer the most appealing evidence that a new era of inflation is not inevitable. As far as the bond market is concerned, inflation may be elevated for the next five years. But the prices of longer-dated bonds show that dealers haven’t wavered in their belief that it will come back under control after that.

If supply chains begin to move more smoothly — which looks as though it is already happening — at least one key pressure will be removed. Still, the task confronting the Fed and other policy makers remains frighteningly difficult. They will have to withdraw money from the system without prompting a downturn, convince consumers that rising inflation isn’t inevitable and, critically, persuade workers that they don’t need to raise their wage demands.

With the US midterms approaching, and inflation now named by pollsters as the single most important issue, the battles over how exactly to do so will make this year’s inflation argument seem like a relaxed academic chat. One debate may have ended; another is just beginning.