On the Other Side

Where inflation will end up on the other side of the base effects and supply bottlenecks is the central question facing monetary policymakers today. To be sure, monetary policymakers don’t know when the economy will reach the other side, and they don’t know what awaits them on the other side. They are betting that the inflationary impulses from both the base effects and supply bottlenecks will be transitory and that there will be no legacy effects on the other side.

But some are worried about a policy error, resulting in inflation higher than the moderate overshoot the Committee is aiming for. Here we discuss the inflationary dynamics associated with the base and bottleneck price level effects.

The “Shock” and “Normalization” Phases of Price Level Shocks

The term base effects in this context refers to the sharp declines in the prices level of some price-index components especially affected by the pandemic-induced recession. The shock phase is the initial decline in these prices. The normalization phase is the rebound in these prices to their earlier levels. In terms of the monthly impulses, the base effects appear to now be mostly behind us.

The term bottleneck effects refers to the unexpectedly large increases in the price levels of some commodities resulting from the larger- and earlier-than-expected surge in demand as the economy opened up that has outpaced supply. The result is the higher prices for these commodities that we are witnessing today. The normalization phase where supply catches up with demand is ahead of us, although the timing of that catch-up is much more uncertain than in the case of base effects.

Temporary Inflationary Impulses from Price Level Effects

The inflation dynamics associated with price level shocks are more complex. Here there are three stages.

In the case of base effects, the first phase is a temporary disinflationary impulse from the sharp decline in the price levels of some commodities during the pandemic-related recession.

The second phase is the temporary inflationary impulse from the reversal of the earlier price level declines.

In the third phase, after the temporary inflationary impulse is over, there is another temporary disinflationary impulse during which inflation falls back to its underlying level.

A similar story for supply bottlenecks.

The first phase, in this case, is the inflationary impulse from the shock phase, where we are today.

The second phase is the disinflationary impulse from the normalization of prices as supply catches up.

In the third phase, once the disinflationary impulse is over, inflation rises to its underlying level.

Where Are We Today?

We are near the end of the normalization phase of the price level shock associated with base effects, but in the shock phase of the price level increases associated with the supply bottlenecks, experiencing its temporary inflationary impulse. As supply catches up with demand, we should be at the end of all the disinflationary and inflationary impulses associated with the price level shocks related to the pandemic and its aftermath. At that point, we will be on the other side.

Legacy Effects

Inflation should return to its underlying level at that point, provided that there are no legacy effects from the deflationary and inflationary impulses associated with the price level shocks and their normalization. There are at least two potential legacy effects.

First, the temporary inflationary impulses may have left some inflationary momentum in the economy that continues to keep inflation above its pre-pandemic level, for example in 2022.

Second, and more serious, the inflationary impulses in play in 2021 may raise inflation expectations above the Committee’s 2% inflation objective. That would be a dangerous outcome and call for monetary policy tightening.

On the Other Side

Even if there are no legacy effects on inflation of the price level shocks and their normalization, the economy will still be in a different place on the other side. That’s because the economy is expected to continue to grow at an above-trend rate and the unemployment rate is expected to continue to decline in 2022 and 2023.

That labor market tightening would result in inflation edging higher—via, yes, the Phillips curve—perhaps from the underlying rate of 1.8% in the pre-pandemic period toward around 2%. Indeed, FOMC participants projected that inflation would be 2.1% in 2022 and 2023.

But in 2023, growth is still expected to be above trend and the unemployment rate is expected to decline further, to 3.5% by the end of the year, ½ percentage point below participants’ median estimate of the NAIRU.

As the economy enters 2024, with growth still slightly above trend, the unemployment rate may edge lower still and inflation may edge up, to 2.2% or 2.3%. And inflation would persist above 2%, as long as the unemployment rate remained below the NAIRU. In that case, inflation expectations might well edge upward, above 2%, unless the FOMC begins to tighten policy.

The June FOMC Meeting

Looking at participants’ median macro and rate projections from the June meeting, we can perhaps understand what FOMC participants were anticipating on the other side and what that called for in terms of monetary policy: an unemployment rate well below the NAIRU and inflation already just above 2% in 2023. In 2024, the unemployment rate would likely be expected to decline further and inflation to rise further above 2%. In that case, inflation expectations might be poised to rise above the 2% objective, even in 2023, in the absence of a timely monetary policy response. That is perhaps what called for two rate hikes in 2023.

The question for the FOMC is why didn’t participants project two hikes in 2023 in March when the macro projections were nearly the same as they were in June? Participants are just beginning to offer their views on why two rate hikes would be appropriate by the end of 2023. The answer may be, as Bullard suggested, that participants were extremely conservative in shifting their dots in March when the macro projections were revised substantially from December. The change in the macro projections from December to June seems much more consistent with the shift in the dots over that period. I look forward to hearing from other FOMC participants.

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