OPINION: Market adjustments aren’t inflation

Inflation talk continues to animate the airwaves, or at least cable TV, and remains part of the political conversation. Economists should have something to say about this; after all, it has been a central area of research for much of the past century. Still, we should approach the issue with an abundance of epistemic humility.

Those who warned about high inflation in the wake of the Great Recession were wrong. A casual observer might view this with some relief, since we nearly all erred in overestimating inflation. Still, this should be of no comfort. The mathematical models we use to understand and predict inflation perform poorly, and there is plenty of opportunity for symmetry of error, so there is a real possibility of underestimating the risks of inflation this time.

The fiscal and monetary stimulus following the pandemic recession is much larger than that of the Great Recession. Of course, the economic damage of the pandemic is far worse. One great unknown is whether we have too much or too little stimulus today. Another great unknown is how much the adjustment of households and businesses in the post-pandemic world will affect prices and quantities. We also cannot know whether the big drop in labor supply is permanent or transitory.

None of these unknowns are really harbingers of inflation, they merely distort the measurements we use to understand price level changes. This is particularly true about anecdotes of inflation that fuel worry and political opportunism. In reality, there are few data-driven warnings of inflation. Measured inflation to consumers is slightly above a 20-year trend, but it is not a persistent increase.

The consumer price data measure the prices of identical products across the nation and place them into a "basket" of average goods consumed by families. It is not a perfect measure, and it has been attacked by many conspiratorial-minded folks since at least the 1970s. It was then that the "basket" of goods was updated regularly to account for different choices consumers made for goods and services. It’s no use trying to debunk a conspiracy theory, since their claims are always non-falsifiable and so cannot be disproved. Suffice it to say that for the past 40 years, serious economic research largely concludes we overstate rather than understate inflation.

Today, inflation is running far less than 1.0 percentage point off trend. Keep in mind we had a huge shock to prices in 2020, so comparing inflation today to a period of deflation last year distorts today’s price changes. As measured by surveys current to early October, consumer and businesses expectations of inflation show modest increases — roughly 2.3 percent over the coming years.

As the biggest warning of inflation, the yield difference on government bonds of different times to maturity signal "all quiet on the inflation front." So, despite what a politician or two may say, the financial markets in which well-informed buyers and sellers register their inflation alarm is quiet.

Still, some prices change quickly, driven by shortages. My favorite example is the price of used cars. I am the proud driver of a 2009 Honda Ridgeline with nearly 190,000 miles. This vehicle is now advertised for 55 to 75 percent of what I paid for it a dozen years ago. This won’t last, and there is no theory of inflation that isolates individual products or services. My newfound wealth in used cars is due to higher demand in the wake of a microchip shortage affecting new cars. This sadly, is a transitory price increase.

Many factors contribute to these shortages: the lingering effects of COVID on production and transport, the big surge in demand over the summer, and the hangover from Mr. Trump’s trade war. Nothing would have such an immediate effect on supply chains as ending the tariffs on European and Chinese imports.

The price changes cause markets to adjust in ways that are often slow and uncomfortable. Too few new cars prompt us to buy used cars, and too few used cars cause us to seek public transportation and ridesharing. Not enough turkeys over the holidays will cause us to shift to ham or roast beef. Long lines at restaurants prompt us to cook at home.

In response, auto manufacturers will find other firms to produce microchips, and reward them with longer-term contracts. Prices tell us a far fuller story than any other market signal, so desperate consumers buying turkeys will prompt farmers to raise more, and trucking companies to invest in more refrigerated trucks. Groceries will offer more pre-packaged goods and TV shows for novice cooks will find air time. These market adjustment processes aren’t fast or painless, but they are better than any human invention that matches people with goods.

Of course making all this happen takes people with skills, e.g. how to make microchips, clean and market used cars, drive public transportation, raise turkeys, stock shelves or cook restaurant meals. The most obvious element of price changes right now comes in wages, the price of labor. In some sectors, like hospitality and tourism, wages are up 12 percent over the past year. This is not solely inflation, and it’s not a technical or academic definition.

If wages rise by 10 or 15 percent, one of two things must happen. Prices for the goods or services must rise, or workers must become more productive. If a worker receives a 10% pay hike, and is able to produce 10% more value for the employer, there is no change in labor costs. Of course, as with producers of goods, a 10% wage increase will cause workers to more readily offer their services to firms.
 
We are in the midst of a great adjustment that will require months and years to fully sort out. This process will be disruptive and will cause some firms and occupations to disappear. Others will change their style and hours of work to increase productivity. Along this path, we might see inflation raise its unwelcomed head, but so far, data on inflationary pressures is slim.