Thread by @Noahpinion

1/Today's @bopinion post (actually yesterday's) is about inflation!

There are two big things everyone needs to understand about inflation, and neither of them concerns the price of lumber or cars.

bloomberg.com/opinion/articl…

2/We are now seeing strong month-on-month inflation (~7.2% month-on-month, ~3.6% core).

Keep an eye on month-on-month numbers, not on year-on-year numbers.

This is a fairly substantial rate of inflation. But should we be worried?

bloomberg.com/news/articles/…

3/What we're seeing now is cost-push inflation.

Supply crunches and bottlenecks are raising prices.

This is not scary, because cost-push inflation is never very large.

So what causes the scary kind of inflation -- the high, sustained, out-of-control kind?

4/What probably causes the scary kind of inflation is a REGIME SHIFT in people's expectations about the Fed's behavior.

Here is the key paper you need to read:

nber.org/papers/w28005

5/If inflation continues at current or higher rates for many months, and the Fed does nothing, it will be a clear signal that the Fed now tolerates higher inflation.

And THAT is when the shit could hit the fan.

6/But why the heck would the Fed start tolerating higher inflation? Its target is still 2%.

The answer is something called FISCAL DOMINANCE.

The Fed might be afraid to raise borrowing costs for the U.S. government.

7/Government interest costs are very low now, thanks to low interest rates. We have a lot more debt than in the 80s, but our interest rates are much lower.

But if the Fed hikes rates to contain inflation, those interest costs would also spike.

8/The Treasury can minimize this danger by borrowing in long-dated bonds, so it doesn't have to roll over debt frequently.

But it has not been doing this. The average maturity of U.S. government debt is about the same as it's always been.

9/So if the Fed is scared that raising rates (to contain inflation) would drive the Treasury's interest costs much higher, it might back off of rate hikes. That is FISCAL DOMINANCE.

And this could cause a REGIME SHIFT in expectations about inflation.

10/So the Actually Scary Scenario here is:

cost-push inflation --> Fed does nothing because of fiscal dominace --> expectations regime shift --> actually scary inflation

11/How likely is this scenario? Probably unlikely. If this inflation persists for another few months, the Fed will almost certainly hike rates, convincing people that the old Volcker-Greenspan-Bernanke-Yellen policy of inflation hawkishness remains in place.

12/But if this scary scenario DOES happen, then our least-bad option will be fiscal austerity (i.e., what Abba Lerner and the Functional Finance people say we should do to curb inflation).

That would entail a lot of economic pain.

13/So the Fed will be working hard to convince people that the old policy regime is still in place. But Biden and Congress need to keep an eye on the inflation numbers and be prepared to hike taxes and cut spending if we do start to spiral.

14/Anyway, this little burst of inflation is probably nothing. Wait til end of summer to decide if it's dangerous.

But at the same time, understand what the actually dangerous scenario would look like, and what we would have to do in response.

(end)

bloomberg.com/opinion/articl…