By Christian Whittle
The rapid rise in inflation seen in 2021 caught many off guard. The Federal Reserve went into the year expecting some price increases but assured the public that any rise in inflation resulted from a base effect from the pandemic and supply bottlenecks. Then in May, the Consumer Price Index (CPI) jumped 5%, the largest 12-month increase since August 2008. The numbers were a shock, especially for Joe Carson, former chief economist at Alliance Bernstein.
“I made a bet with someone a decade ago that you can never get 5% inflation in America again because of the way we measure it. It took me 12 years to be wrong,” Carson told Consumers’ Research.
Carson never expected a 5% rise because modern inflation calculation does not account for the cyclical nature of the housing market, he explained. While in the past, inflation data reflected rising prices in the housing market as well as consumer goods, current data has a narrower scope.
“When you’re talking about the 1970s, we included house prices in the measure for consumer price inflation. That was removed in the early ‘80s, and on top of that, the government statisticians can no longer measure the owner-occupied rents from the owners market because the samples got too small,” Carson said.
If economists today used the same measures for inflation that were used in the 1970s, Carson believes the situation would appear to be much worse.
“If you just do an apples-to-apples comparison, a 5% inflation rate in 2021 is almost comparable to a double-digit inflation rate in the 1970s,” Carson said.
Economists may have missed signs that the CPI was about to rise faster than predicted, but skyrocketing prices for everything from food to computer chips are now impossible to ignore. The U.S. economy is grappling with high prices in a broad spectrum of industries, but the question remains: how did we get here?
While supply bottlenecks related to the pandemic are causing much of the price increases, Carson pointed to unprecedented stimulus as one of the main drivers for the latest rise in inflation.
“The reason we got there is because we have the most aggressive monetary policy in history. Money growth was over 20% for a whole 12 months. In addition to that, the government is spending five trillion dollars in fiscal stimulus in the past year. That’s roughly equal to 25% of GDP,” said Carson. “I never thought we’d have these types of policies, but we do.”
The Fed has tried to relieve concerns over inflation by labeling the increase as transitory. In his testimony to a congressional oversight committee, Fed chair Jerome Powell said the rise in inflation was due to pandemic-related supply issues and comparing low prices in 2020 to prices in 2021. As the economy reopens, Powell said shortages would occur in industries caught off guard by a sudden surge in demand, such as car and vacation rentals.
“Those are things that we would look to, to stop going up and ultimately to start to decline as these situations resolve themselves,” Powell said. “They don’t speak to a broadly tight economy — the kind of thing that has led to high inflation over time.”
However, Carson believes the Fed did not anticipate how broad the inflation problem would be this year. If other factors are taken into account, such as the Purchasing Managers Report, one can see that rapidly rising prices are impacting much more than a few leisure and service-related industries.
“If you look at the Purchasing Managers Report, there must be 10-12 industries experiencing shortages, and that doesn’t include the housing market, and there’s a lot of pent-up demand on the service side,” said Carson. “It’s really, in my opinion, naive to think that this can be accomplished in a way that the markets autocorrect without any removal of policy stimulus to prevent the inflation situation from getting much worse.”
Unfortunately, the removal of policy stimulus can be a thankless and painful task. It’s easy to know when to stimulate a flagging economy, but deciding when to end that support is challenging to gauge, said Carson. Adjusting course in today’s politically charged environment is easier said than done.
“It’s always difficult to admit a mistake, and it’s probably even more difficult in the political environment that we live in today. No one’s perfect in any of these things,” said Carson.
“I think what [the Fed has] to do is stop being held hostage to financial markets. They have to stand up and make a policy decision today that they think is right for the financial markets and the economy. That takes courage. That probably spends a lot of political capital in this world. Easy money has a lot of friends, and there are very few friends when you take away easy money.”
Not only does the Fed face the problem of winding down stimulus, but many of its defenses against a crisis are already deployed. With interest rates already near zero, the Fed cannot cut them any further to kickstart the economy if needed.
“What happens now if a crisis unfolds down the road when we start removing the stimulus with the funds rate at 0 and a Fed balance sheet of $8 trillion-plus? That’s a deficit of $3 trillion. Your policy defenses are gone!” explained Carson. “You need the good economic times to build up your defenses to use them in bad economic times. What we’re doing is using our policy defenses in good times, and we’re not going to have any bullets left later.”
An important role for the Federal Reserve is to correct imbalances in the housing market by restricting demand, something Carson believes it has failed to do recently.
“Back in the 2000s, even though we had a housing market boom, the Fed did raise interest rates from 1% all the way back up to 5%. They were slowly but steadily breaking the momentum of the housing market by lifting the cost to borrow,” explained Carson. “Today, they’re not even doing that. In fact, they’re doing the exact opposite because they are keeping rates down in the mortgage market by buying securities. They are encouraging more risk and encouraging more inflation.”
Although it may prove difficult for policymakers to adjust course, they need to find a solution to rising prices soon, said Carson.
“Policymakers today say they want actual outcomes before they move… how many more actual outcomes do they need other than 20% increase in housing and 5% CPI and GDP growing 6 or 7%?” said Carson.
“When we had the commodity price cycle back in the ‘70s, the silver crisis, and all these things, a lot of people got hurt, not just those industries that were directly involved where the inflation is. It impacts others. It impacts workers because income goes up then falls quickly. It hurts banks that lend money to those sectors. There’s a lot of spillover effects, and they become bigger the longer it goes on.”
Joe Carson has spent over 40 years researching in the field of economics, focusing mainly on financial markets and policy analysis. For 16 years he served as the Chief Economist & Director of Global Economic Research for Alliance Bernstein, an investment management firm. Prior to that, he held Chief Economist positions on the sell side of Wall Street – Chemical Bank (which is now part of JP Morgan), Dean Witter (now part of Morgan Stanley), Deutsche Bank, and UBS. He started his professional career as a staff economist at the Department of Commerce, and later worked as an industry analyst at the General Motors Corporation. Carson now shares his research and opinions at The Carson Report.