Cecil Bohanon & Nick Curott: The optimist’s and pessimist’s view of our pesky inflation situation

2021 will go down as the year of the great inflation surge. Consumer prices increased a modest 1.3% over the course of 2020. This year, prices have increased 6.8%—the highest inflation rate since 1982. For households, the most pressing economic question is obvious: Will 2022 bring relief from inflation, or even more economic pain?

To answer the question, it is helpful to deconstruct the price index to see what sectors have been hit most with rising prices. Turns out that 2.5 percentage points of the 6.8% inflation rate over the last year is due to rising energy costs. Another 1.8 percentage points of that 6.8% has occurred in industries with supply chain constraints.

Energy prices surged with the rise in demand after the economic reopening last spring. But U.S. oil companies have been reluctant to increase supply, instead taking advantage of higher prices to increase profits. Hence, Sen. Elizabeth Warren is notoriously blaming the “greed” of oil companies for inflation.

But this explanation is facile. Businesses are always greedy. Sometimes, greed causes businesses to lower prices; other times, to raise prices. In years past, energy companies would invest in expansion immediately when oil prices rose, only to suffer low return on investment when oil prices reversed. Today, energy companies are prudently waiting to ensure higher prices last to prevent overinvestment.

Regardless, energy prices are notoriously volatile. The optimistic view of inflation is that energy prices will come back down next year, bringing inflation down too. What happens in other supply-constrained industries will largely depend on the path of COVID-19. But unless shortages get progressively worse, prices for physical goods like automobiles and furniture will stop rising. This will also bring inflation down.

Federal Reserve Chairman Jerome Powell holds this sanguine view on inflation, repeatedly stating that the spike in inflation is merely “transitory.” Nevertheless, the stubborn persistence of rising inflation has caused Powell to walk back the word “transitory” and to belatedly begin reducing monetary policy stimulus.

The pessimistic view on inflation asks, what happens if policymakers get surprised again by higher inflation, as they repeatedly have been throughout 2021? In that case, the Fed might have to raise interest rates quickly to halt inflation. Let’s not forget, the Great Inflation of the 1970s was only reined in after Paul Volker hawkishly raised interest rates, bringing down inflation but causing the 1980 recession. Let’s hope the Fed steers a better course this time around.•

Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.

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