Inflation is on Fire

The price acceleration index has never been this hot

Inflation in the United States in 2022 is on fire. It’s a metaphor I often use when I think about the Federal Reserve’s poor performance as a firefighter for the past decade. Yes, we want our homes to be warmed with a controlled blaze in the fireplace. But no, we do not want the authorities to keep splashing gasoline onto the roof and yelling “The rising temperature is temporary!”

Everyone is talking about inflation these days. I was at a funeral last month, and people were talking about prices. Prices for gasoline. For food. For housing. It feels like things have gotten out of hand, and there is a sense of real fear that I’ve not experienced before. Not since I was a boy, listening to the grown-ups talk about stagflation back in the 1970s.

Do the data agree? There is good news and bad news. Unfortunately, the good news amounts to, “Your house is not yet ashes.”

When the federal government released new monthly data for the Consumer Price Index (CPI-U), news headlines were misleading. David Henderson lamented the weak coverage a month earlier, but I think the problem is worse than he does. When headlines say that inflation has cooled to 8.3% year-over-year in April, down from a forty-year high of 8.5% in March, words like “cooled” and “slowed” totally miss the point. That’s like saying a three-degree burn was actually only a 2.9 degree burn.

Inflation is much worse than the headlines suggest. But first, let’s set the context. It was indeed forty years ago when inflation was far hotter than it is now. That’s the good news. This first chart shows the standard series for annual inflation, which compares the current CPI with the CPI from 12 months prior. For context, consider a second series that I calculated to show how the CPI compares to 48 months prior: for example, consumer prices today are 15.4% higher than in April 2018. Similar long-term inflation rates occurred in 2008 and 1991, but the raging, persistent price spikes in the 1970s and 1980s were far larger, with a peak rate above 50% in 1981.

Heck, long term inflation was higher during every month of the decade of the 1970s than it is today.

Don’t relax, though, because the bad news comes next. Let’s look at interest rates.

During the 1970s, the Federal Reserve was consistently “behind the curve” when it came to using monetary policy to cool off prices. Prices are not something the government can control, though kings and legislatures are endlessly hopeful that they can mandate what farmers and merchants are allowed charge for the fruit of their labors. Such price controls never work. The ancient Romans tried and failed. Nixon tried and failed. The only thing that can curb natural inflation is to restrain the money supply and thereby raise interest rates. This the central bank can and must do, as is its mandate.

The rule of thumb is that the Federal Funds rate has to be higher than inflation in order to cool off inflation. The wage-price spiral of the 1970s was a consequence of the Fed consistently trailing. Then came Paul Volcker, Fed chair from 1979-1987. To see his impact, take a look at the second chart, which shows both the CPI year-over-year and the interest rate.

What we notice is that Fed policy from 1981 to 2001 was notably strict: the spread between the interest rate and inflation was wide. And we see inflation cool to a steady 2-3 percent rate by the 1990s. Then, disaster. The inflation rate is allowed to simmer above the zero-bound Fed Funds rate for a decade, from 2009-2019. The current chapter in this dance is where we are now: prices on fire, and the Fed watching it happen. Look how much higher than red line of inflation is than the blue line of Fed rates in 2022. This spread is in the wrong direction, and it has never been so out of sync. I’m not going to get into the many creative tools our central bank has used to increase money supply and buy assets, because this is about the big picture.

Last chart. This index is simply inflation (CPI annual change) minus interest (Federal Funds effective rate). I call this the “Price Acceleration Index.” When it’s negative, inflation tends to decelerate. When it’s positive, inflation accelerates.

The index had never risen above 5 percentage points, though it flirted with that line in February 1975 (5.0) and June 1980 (4.8). This is my creation, the price acceleration index. And maybe I’m full of it, but the data is real and it is warning us that this is uncharted territory. It hit 5.3 last June and has been rising ever since, peaking at 8.4 in March and slowing (LOL) to 7.9 in April.

Inflation is on fire, and it is going to stay on fire until the Fed gets ahead of the curve. I do not have faith the central bank will be aggressive enough in the next year or even two, so sadly have to predict a very inflationary decade ahead.