What is needed to tame US inflation?

The Federal Reserve's preferred measure of prices—the personal consumption expenditures (PCE) price index—rose 5.8 percent over the four quarters of 2021, the largest surge in four decades. For inflation to retrace its rise in coming quarters, some combination of factors would have to break the right way: The inertia of inflation (through expectations or other channels) would have to be low, economic slack would have to increase notably, and adverse supply shocks would need to subside or even reverse.

In a PIIE Policy Brief, David Reifschneider and David Wilcox show the importance of the first factor, because even with little change in slack and only gradual fading of supply shocks, the anchoring of expectations and the low weight on past inflation lead to a sharp reduction in inflation in their model. But given the risk that last year's high inflation will affect price-setting more substantially this year, the prediction of their model seems more like a best-case than the most likely scenario.

To keep inflation expectations anchored (or reanchor them) and restore slack, the Fed will need to tighten policy considerably, moving from its very accommodative current stance to a neutral stance and perhaps beyond. Doing so will entail both reductions in the size of its balance sheet and significant increases in the federal funds rate.

If the equilibrium real funds rate is 0.5 percent, as currently implied by Fed projections, and expected inflation is just 2 percent, the funds rate would need to reach 2.5 percent to achieve a neutral stance. Because relevant inflation expectations are probably higher and a tighter-than-neutral stance may be needed, the Fed should move toward a federal funds rate of 3 percent or higher over the coming year. Such an increase would create a material risk of a sharp slowdown in economic activity—but not tightening policy significantly now would increase the chance that inflation stays high, which would require even tighter policy later.

Inflation Optimism Has Been Turning into Inflation Worry

The experience of the 1970s and early 1980s underscored the critical importance of using monetary policy to keep inflation low. As inflation reached double-digit levels, households whose incomes had not kept up were stretched thin, and households and businesses found that making financial decisions was harder because of the uncertainty about where prices were headed. In addition, because inflation became so deeply embedded in expectations, bringing it back down required a deep recession and its attendant costs.

The surge of inflation in 2021 was accompanied by optimism that the context was very different from that of the 1970s. Although supply shocks played a role in igniting inflation in both episodes, most analysts initially saw little reason to expect that inflation would persist at high levels or rise further. The supply shocks were viewed as likely to subside, and three decades of low and stable inflation gave people confidence that inflation would not become self-perpetuating.

This confidence is reflected in the pattern of revisions to projected inflation from the Blue Chip Consensus over the last year. Successive increases in expected inflation in 2021 led to much smaller shifts in expected inflation in 2022 (figure 1).

However, incoming data over the past few months should shake that optimism. Not only has inflation risen to its highest level in four decades, its composition has evolved. After initially appearing primarily in categories with evident supply shocks (such as cars), categories that were catching up after pandemic-induced weakness in 2020 (such as travel), and categories with idiosyncratic developments (such as energy), higher-than-usual inflation is now broad-based. And that is even before the shock to energy prices from Western sanctions on Russian energy exports. Moreover, households' expectations of inflation in the short term have risen, and there are growing anecdotal reports of wages chasing higher prices and prices responding to higher costs.

Even so, the December projections of Federal Open Market Committee (FOMC) members show PCE inflation for 2022 centered around 2.6 percent. Although the projections that will be released at the March FOMC meeting will almost certainly show higher figures, FOMC members' expectations still seem to be for inflation this year that is roughly half the rate recorded last year. And the latest readings in future markets imply that participants in financial markets expect that the FOMC will leave the federal funds rate below the range cited by FOMC participants as the appropriate level over the longer run—suggesting that those participants expect inflation to be tamed fairly quickly.

Whether a sharp reduction in inflation can be achieved with monetary policy that would remain at least slightly accommodative is unclear. Economists do not have a very good understanding of how inflation will be propagated this year, in part because the low inflation of recent years has provided limited evidence about post-1980s inflation dynamics. The stakes are high, because gauging the likely path of future inflation—as well as the plausible range of deviation around that path—is critical to plotting the appropriate course of monetary policy.

Models Failed Us in 2021 But Are Still Useful

Model forecasts reflect historical relationships between the variables in the model. They are thus likely to be most accurate when applied in times that are fairly representative of the period over which the model is estimated. The potential for model forecasts to lead us astray in unusual times is therefore of concern—as underscored by the fact that model-based inflation forecasts for 2021 were so wrong. That said, careful consideration of the elements of the Reifschneider-Wilcox model is a useful jumping off point for assessing inflation over the coming year, both because it makes what is likely the best case for inflation moderating largely on its own and because it spells out how economists think about the drivers of inflation.

A key feature of the piece is the model they estimate. That model, like other standard models of inflation, includes three components. The first—a combination of lagged inflation and measures of inflation expectations—is intended to capture the ways in which price-setting can depend on both expected inflation in the period ahead and inertia from recent past inflation. The second component is slack, the degree to which the economy is operating below the sustainable level of its productive capacity. When output is below its sustainable level, inflation is pushed down; when demand is so strong that it output rises above its sustainable level, inflation is pushed up. The third component is a combination of measures of supply shocks and an error term that includes the effects of other supply shocks, which can be disinflationary (such as bursts of productivity) or, as in 2021, inflationary (such as bottlenecks at ports and increases in energy prices).

The evolution of these three components will determine the path of inflation this year. For inflation to retrace its rise, these components will need to play out in favorable ways.

Lagged Inflation May Again Be a Key Determinant of Inflation

The preferred specification of the Reifschneider-Wilcox model—which reflects coefficients estimated using data since 1990—shows a limited role (small coefficient) for lagged inflation and a significant role for long-term inflation expectations. In this specification, little of last year's surge in inflation carries over to this year, and the relative stability of measured long-term expectations bodes well for this year also. The limited role for inertia and the relative stability of long-term expectations can be justified by arguing that price-setters put significant weight on the Fed's demonstrated ability in the past few decades to maintain low and stable inflation. 

The estimated coefficients change when based on data for an earlier period (1969-1989), with the sum of the coefficients on lagged inflation at 0.82 rather than the 0.45 based on estimates over just the last few decades. The key question is whether inflation dynamics today will be closer to those observed in the post-1990 period or those observed previously. In particular, because inflation in 2021 was so much higher than the Fed's target, the extent to which the driver of inflation is the target versus lagged inflation is the most important factor quantitatively in predicting inflation this year.

On the one hand, because the dynamics observed in the late 1970s and early 1980s emerged after a lengthy buildup of inflation that begin in the mid-1960s, it seems unlikely that they would return fully after only a year of high inflation. On the other hand, inflation in 2021 was the highest since that earlier period, so the dynamics of the past few decades probably do not fully apply either. In particular, the sharp run-up of inflation last year may mean that price-setters are now paying more attention to inflation than they have in decades, which may increase the weight given to last year's inflation performance relative to the Fed's target. For example, internet searches for the word inflation surged in recent months (figure 2), following more than 15 years of relative stability at a low level, even though headline inflation in some of those years, such as 2005, was high.

On balance, it seems reasonable that current inflation dynamics bear some imprint from both the recent period of low and stable inflation and the earlier period of higher inflation. If lagged inflation now affects current inflation to an extent that is midway between the two model estimates, the impetus of inflation in 2021 for inflation this year is likely to be substantially greater than in Reifschneider and Wilcox's preferred prediction.

Economic Slack May Increase Only a Bit

The second basic component of economists' approach to predicting inflation is economic slack.
In 2021, the desire to spend ramped up strongly, as vaccinated households across the income distribution emerged from a year of pandemic-constrained spending with unusually high levels of saving. Households' savings were bolstered by historically large amounts of fiscal support—support that played a crucial role in reducing hardship during the pandemic but also left households with substantial pent-up spending power.

The boost to demand from these factors will probably be weaker in 2022, with the substantial step-down in fiscal support, the likely dwindling of excess savings, and the satisfaction of pent-up demand. It is not clear, however, how rapidly demand will ebb on its own. Recent data show brisk spending at retailers in January and household cash balances that are still higher than before the pandemic. In addition, strong labor demand should buoy real incomes through job growth and wage gains. 

Meanwhile, the economy's productive capacity in 2021 was less than many analysts expected. In particular, the labor force remained considerably smaller than it was before the pandemic. Although some people returned to the labor force as health conditions improved, many others who exited after being laid off or quitting did not return. Relative to before the pandemic, the US labor force participation rate was down by an average of 1.7 percentage points in 2021 and even now remains 1.1 percentage points lower than before the pandemic hit.

A number of factors suppressing labor supply are likely to reverse with time. These transitory factors include people "consuming" some of their pandemic savings as leisure, people being afraid of contracting or spreading the virus, and people grappling with shortages of childcare. But, as with demand, it is unclear how rapidly these factors will reverse. US labor supply is also being held back significantly by two forces that are likely to be more lasting—the ongoing retirement of the large baby boom cohort and limited inflows of working-age foreign-born workers, as a result of the tighter immigration restrictions imposed by the Trump administration, which remain in place. Those policies are estimated to have reduced the number of working-age foreign-born workers by more than 1 million relative to the pre-restriction trend.

Taking these considerations together, demand for goods and services is likely to exceed the economy's potential again in 2022, albeit by less than last year. Therefore, we cannot count on a substantial amount of economic slack helping to bring down inflation this year.

Supply Shocks Should Diminish this Year

The final driver of inflation this year will be supply shocks. Some of the bottlenecks in production caused by the pandemic—such as limitations in the production of key components caused by shutdowns in certain countries—will probably be alleviated in coming months, in part because of improvements in global health conditions and in part because producers have been building work-arounds. These developments will at least diminish further price increases and may lead to price reductions in some cases.

The current bottlenecks will not be resolved immediately, however, and other obstacles have already emerged. In particular, the increase in raw energy prices stemming from the Russian invasion of Ukraine will put upward pressure on consumer energy prices and other prices in the months ahead, and the cutting of many commercial ties between Russia and other countries will exacerbate supply problems.

On balance, some optimism about supply shocks in 2022 seems warranted.

Monetary Policy Should Be Tightened More than Financial Markets Currently Expect

In sum, for inflation to retrace all or most of its recent rise this year, there needs to be some combination of anchoring of inflation expectations with limited inertia, a substantial reduction in demand relative to overall productive capacity, and a significant abatement of negative supply shocks.

The first factor is the most important quantitatively. In the Reifschneider-Wilcox analysis, slack does not increase this year, but anchored expectations and a limited role for inertia (along with a diminution of adverse supply shocks) bring inflation back down sharply. However, the reemergence of inflation as a salient issue for businesses and households raises the risk that inertia in price-setting is becoming more important than it was during the decades before the pandemic. That there has been little moderation in inflation so far is consistent with that view.

To counteract this inflation inertia, ensure that inflation expectations remain at or return to the Fed's target, and increase slack in the economy, the Fed will probably need to bring accommodative monetary policy to an end over the coming year. Of course, the specific path of the federal funds rate and the size of the balance sheet should depend on the evolution of inflation and economic activity. However, based on what we know now, the necessary increase in the funds rate will be larger than most market participants appear to be expecting.

If the equilibrium real funds rate is 0.5 percent, as suggested by FOMC projections, then even if inflation expectations were fully anchored at the Fed's target of 2 percent, the neutral federal funds rate would be 2.5 percent. As actual inflation was much higher than 2 percent last year, and short-term inflation expectations have moved up as well, the neutral funds rate is probably above 2.5 percent today. A tighter-than-neutral stance may be needed to reinforce the Fed's commitment to low inflation and increase economic slack. Therefore, the Fed should move toward a federal funds rate of 3 percent or higher.