Deflated Thinking on Inflation

When inflation reared its ugly head in 2021, the administration, and various running dog economists, pronounced that it was “transitory.” Then in a defeat for Team Transitory, it lasted for months and months, before beginning to abate in recent months. But now TT is declaring victory–“See! It was transitory after all! It just lasted a little longer than we expected.” (Redolent of “two weeks to flatten the curve”, no?)

No, actually. This reflects the sloppy thinking about and descriptions of inflation.

This is something of a pet peeve of mine, probably originating from a standard Chicago econ prelim exam question back in the day (when inflation was last a big deal) about the difference between a one-time increase in the price level and inflation.

The argument that the transitory people (read that how you wish!) made was that the spike in prices in 2021 was due to an adverse supply shock–a shift of the aggregate supply curve to the left, for you Keynesian types–due to COVID. Once the supply shock ended, they said, inflation would end.

Wrong! The end of the supposed supply shock should have caused the AS curve to shift back to the right, leading not just to an end of inflation, but an actual decrease in the price level, i.e., a deflationary period. That is, the supply shock should have led to a one time increase in the price level (smeared out over time due to price stickiness) followed by a one time decrease in the price level (smeared out over time due to price stickiness.) with the price level ending up roughly equal to its pre-shock level.

An increase in the price level, followed by an abatement in the rate of increase but no decline in the price level–which is what we have experience recently–is contrary to the predictions of the mental model that TT relied on. We have had a permanent increase in the price level.

The pattern we have observed is in fact much more in keeping with the predictions of the Fiscal Theory of the Price Level (developed initially by Thomas Sargent: advanced students can tackle John Cochrane’s recent excellent book on the subject–great timing, John!)–something that the administration and its acolytes are desperate to deny. In that theory, a large increase in government expenditure–like that which occurred during the COVID policy botch, and a whole-of-government botch it was–unaccompanied by a belief that the government would run larger surpluses in the future to pay for it, leads to a permanent increase in the price level. That is, government spending excess caused the large and permanent increases in prices.

In a model with completely flexible prices and one-period government debt, the price level jumps up at the time of the fiscal shock and stays there. In a more realistic model with sticky prices and long-term government debt, the increase in the price level is spread out over time, leading to a period of month-on-month inflation, with the rate of inflation damping out as the fiscal shock recedes further into the past and the price level reaches that consistent with the new level of government debt that results from the spending shock.

That’s pretty much what we’ve observed in the past couple of years.

So the good news is that the impact of past policy blunders on the price level is abating. The bad news is that the price level impact has not gone away and will not go away. The worse news is that the deflated thinking about inflation that pervades the conventional wisdom not only fails to understand what the policy error was, but aggressively denies it. Which means that it is all the more likely to be repeated.