The Fed’s expectation that it could fall below 3% next year and eventually return to 2% is too optimistic
Now that inflation is back, it’s not going away soon. The Federal Reserve expects it to fall below 3% next year and eventually go back to 2%. But there are reasons to think that’s far too optimistic. We are living in a new world. Even after things get back to normal that could mean inflation averages 4% or even 5% for the foreseeable future.
There are many reasons that inflation became so low and stable in the past 30 years. One popular explanation is that during the last serious bout of price increases in the 1970s, Fed chair Paul Volcker raised interest rates high enough to cause a recession. This created confidence the Fed would do what it takes to keep inflation in check. That credibility helped keep inflation low, because the economy is now largely driven by expectations about what future inflation will be.
These are some of the reasons to believe that even after the dust settles on the pandemic, and hopefully on the war in Ukraine, we might still be in a higher-inflation world. So far, the Fed has not indicated it deserves or will maintain its credibility for keeping inflation in check. It was slow to acknowledge that price increases were a serious and persistent problem, and it still plans to increase rates only slowly to a level that may be below inflation.
Meanwhile, some deflationary forces may soon reverse. Economist Charles Goodhart expects an ageing population, especially in China, will spell the end to the cheap labour that produced low-priced goods. Efficiency could suffer long term from the supply chain disruptions if firms maintain bigger inventories as a cushion against future shortages. The White House is pushing more domestic production and encouraging less trade, which will make goods more expensive.