March 28, 2021
by Steve Stofka
At a Senate Banking Committee hearing this week, Fed Chairman Jerome Powell responded to Republican concerns about inflation. The American Rescue Plan signed into law two weeks ago had little Republican support. Without the passage of the law, millions of Americans would have been subject to eviction in the middle of March. Republican Senators expressed few worries about inflation in 2017 when they passed a tax cut that had the same ten-year cost as the American Rescue Plan. It can be difficult to separate the genuine economic concerns about inflation because the topic is used as a political tool.
Mr. Powell reassured Senators that the Fed has the tools to curb inflation. What they lack are the tools to counter deflation. Once the Fed sets interest rates at zero, they cannot lower them, a situation called the Zero Lower Bound. Higher inflation is a persistent worry among older politicians and voters who experienced the high inflation of the 1970s. Since then, the Fed has been given far more power by Congress to prevent a repeat of that decade’s stagflation, the unusual combination of high unemployment and high inflation.
Inflation is one of the many human behaviors that is a function of expectations. Let’s say that, ten years ago, I got scared by a neighbor’s dog who got loose and almost bit me. I changed my route home to avoid the dog. The homeowner may have put up a chain link fence to keep the dog inside the yard, but I don’t trust that the fence can contain the dog. The homeowner could have moved or the dog has died and the threat no longer exists, but my behavior has permanently changed. If I walk on the opposite side of the street, and I don’t see the dog out in the yard, that doesn’t mean that the dog is not a threat.
Fear keeps us alive. A six-year-old may have seen a small spider crawling up a wall, imagines that it could crawl inside their ear while they are sleeping and doesn’t want to sleep in their bedroom. Many of us stop worrying about spiders while we are sleeping, or we think we do. As we grow up, our spiders mature. We lose sleep worrying about financial and relationship issues, our health or our job. Inflation is one of those grown-up spiders.
In the popular understanding, inflation is higher prices. Economists understand inflation as higher wages, the main component of most goods and services. Inflation is both a short-term and medium-term process. In the short run, if demand exceeds capacity to meet that demand, prices will go up because workers have more bargaining power and wages go up. However, as Chairman Powell has noted, the insidious aspect of inflation is that not all prices and wages go up at the same time. Inflation distorts the distribution of income and, in the medium run, affects the accumulation of wealth.
Economists anticipate a return of demand this year; there is a lot of pent-up buying power. Credit card delinquencies are near all-time low, barely above 2%. They were almost 7% in the summer of 2009. The charge off rate is 2.6%, 8% less than it was in 2009. The country has the capacity to meet that demand. There are still ten million unemployed and capacity utilization is below 80%.
There is one troublesome area – housing, which makes up a third of the Consumer Price Index, one of the measures of inflation. For the first time since World War 2, household formation declined in 2020 (FRED Series TTLHH) in response to the pandemic. Last year, many millennials and Gen Z just starting their adult life moved back in with their parents.
Housing supply remains tight. The National Assn of Realtors announced that there were now more real estate agents than homes to sell. The number of housing starts has increased since the housing crisis more than a decade ago, but there are only 7 starts per 1000 working age adults 16-64, slightly above the number of starts during the 1990 recession after the savings and loan crisis.
In response to the Covid crisis, the growth in housing prices (HPI) has shot up from 2% annual growth to over 10% since last March. Although a small part of the total economy, the housing market and the 5% of the labor force that it employs is like the tail that wags the dog. Growth in construction employment went negative last year and is still negative at -4% (FRED Series USCONS). The last time it went negative was in the spring of 2007, six months before the 2007-2009 recession and financial crisis.
This trend is a powerful deflationary force that counteracts inflationary forces that might occur in the 2021 recovery. Understanding those deflationary forces and lacking the tools to combat deflation, the Fed is watchful but less concerned about inflation. One of the forces acting as a brake on inflation is our own expectations of inflation. At the hearing this week, Powell noted that those expectations have become anchored at low rates over the past two decades. During the 1970s, expectations were unanchored. People expected inflation to be as much as it was the past year or worse.
The anchoring process occurs slowly and changes slowly. People who are less than 50 have formed different expectations based on their life experience. Older Americans may still be suspicious, watchful for the least sign of a phenomenon that imprinted on them when they were younger. In the 1970s, people who would not think of stealing, stole gasoline from their neighbors to get to work. Neighbors in New York City beat each other up over their place in line to get gasoline. Retired people in subsidized housing froze to death because they couldn’t afford the skyrocketing costs of heating their home.
“Don’t go that way,” older Americans say. “That dog could bite you.” Younger Americans ask, “What dog?”
We make our journey through life avoiding that dog, the one that bit us. Our choices do not keep us safe from a dog biting us. What protects us from a dog bite is the choices of others, the ones that dog owners make to install fences or to keep their pet inside the house. We live in community with others; that makes our lives more convenient, but we are more vulnerable to the choices that others make. The pandemic has focused our attention on that fact, and those who have lived through this past year are imprinted.