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The Changing Inflation Outlook

Last year’s, this year’s, and next year’s.
April 18, 2022
The Changing Inflation Outlook
WASHINGTON, DC - APRIL 11: Gasoline prices hover around $4.00 a gallon for the least expensive grade at several gas stations in the nation's capital on April 11, 2022 in Washington, DC. The high fuel prices are a combination of the lingering effects of the coronavirus pandemic, supply chain breakdowns, high inflation and the ongoing invasion of Ukraine by Russia. (Photo by Chip Somodevilla/Getty Images)

[The April 15, 2022 episode of The Bulwark’s “Beg to Differ” podcast began with panelist Noah Smith explaining how the economic factors contributing to inflation have changed over the last five months.]

Mona Charen: Noah, the last time we discussed this with you, you mentioned that you felt it was very important that the Fed send the correct signals—you were concerned about inflation expectations creeping into the economy, and you felt that if the Fed did its job, namely, signaling that it was going to wrestle inflation to the ground by raising interest rates sufficiently, that this would nip in the bud inflation expectations, and therefore, we wouldn’t be in for a serious recession. How are you looking at it now?

Noah Smith: Well, so, I think the most important thing to understand is that the sources of inflation have changed. And that a few months ago, what we saw was high core inflation, which is stuff like cars and houses and TVs. . . . Durable goods that people can wait to buy . . . we saw significant inflation there. That’s the kind of inflation that the Fed typically responds to, and the Fed did respond to it. And if you look, core inflation actually did decelerate a bit in the last data release. So that’s a good sign. It means that the basic sources of inflation that we had in 2021 are now ebbing.

And there were two sources: The biggest source was the COVID relief bill—the stimulus spending we did, including Fed policy and other things that weren’t on the federal budget. But that was the biggest thing, and that’s all over. The Fed is tightening and we stopped that stimulus spending. And so that driver is gone.

And the second driver, of course, was supply-chain problems—those are starting to work themselves out. So, the Fed really did its job and inflation, core inflation, was and is beginning to subside.

The problem is then you had the Ukraine war. Russia invaded Ukraine—that disrupted food and then we put a big package of sanctions on Russia. And that disrupted oil and gas, and also more food. And so, now what we’re having is inflation in energy and food—those are traditionally not things the Fed responds to. They’re not in core inflation because they tend to be very volatile, so the fluctuations cancel out. That may not be true this time. So we’re getting a different kind of inflation than we did before. And that’s a problem.

But fortunately, if you look at something called the “5-Year, 5-Year Forward Expectation Rate for Inflation”—that’s the expectation from inflation from 2027 to 2032, then you’ll see that it’s still. . . .

Charen: Wait, what are you talking about? What is that? I’ve never heard of it. Whose expectations are these? Tell us.

Smith: This is a market expectation, so you can buy forward contracts basically for inflation-adjusted bonds. And so, you can construct, from the price of inflation-index bonds relative to non-inflation-index bonds, you can get what the market is betting on in terms of future inflation. So, you can see what professional investors are betting that inflation will be. And that’s not always a perfect guide to what inflation will actually be. But it’s a good guide to what market participants think inflation is going to be. So that’s what tells us about those expectations getting out of control, which is the thing I talked about that I was scared of on the last podcast. And so if you look now, you’ll see that they’re still not really out of control—they still think that inflation is going to be fairly temporary and contained. It’s just going to take a little while, and the war has lengthened the time period that it’s going to take to contain that. . . .

Noah Smith

Noah Smith is an economist and the author of the Noahpinion Substack. Twitter: @Noahpinion.