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Transcript

Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guests today are Pierre-Daniel Sarte and John O'Trakoun. Pierre is a senior advisor and John is a senior policy economist in the Richmond Fed's Research department. Gentlemen, welcome to the show.

Pierre-Daniel Sarte: Thank you for having us.

John O'Trakoun: Thanks, Tim. It's great to be back.

Sablik: Our topic today is inflation, specifically a question that is on many people's minds, which is how long can we expect current inflation to last? Listeners who follow economic news might remember that when inflation pressures first started to emerge last year, there was a lot of debate over whether it would be transitory. That is, would price spikes in some sectors of the economy fade away once the supply chain disruptions from the pandemic had passed? Or, would inflation persist, requiring the Fed to adjust policy to bring it back down?

You both wrote an Economic Brief back in August looking at how persistent inflation has been in past periods. Can you talk a bit about the different components of inflation that you looked at?

Pierre, maybe we can start with you.

Sarte: Generally speaking, at any date changes in inflation are made up of a component that tends to be persistent and lasts, and another component that tends to dissipate relatively quickly. In the 1970s and early 80s inflation was dominated by the first component, by changes that lasted a while. That is less true after the year 2000.

One aspect of the inflation data that jumps out at you is that in the 1970s and '80s, changes in inflation tended to be persistent when inflation was high, much less so when inflation was around 2 percent between 2010 and 2020. Now that inflation is again well above 2 percent, the worry, of course, is that the high levels we are currently seeing will stay a while. But I don't think we're there yet.

O'Trakoun: I don't think we're there either. The good news is that it looks like core PCE inflation peaked around 5.4 percent back in February. Since then, it's calmed down but it's still over 5 percent as of September, and that's over double our long-run target. On a month-over-month basis, prices are still growing faster than is consistent with our target and they've done so every month for the past 18 months.

Sablik: If inflation persistence is high and, say, a price shock hits the economy, what would that look like?

Sarte: That actually depends, in part, on the nature of the shock itself. For example, if the price shock stems from a constraint on the availability of a good in a given sector — say, crude oil in the energy sector — the effect of the shock hinges on whether that constraint is expected to worsen and over what period.

O'Trakoun: I think that's the danger of inflation that's too persistent, actually. The more persistent it is, the closer inflation gets to something that economists call a "random walk." If inflation is acting like a random walk, we don't know where it's going to end up. It's completely determined by unknown things like these unforeseen shocks, rather than things that we can see and influence like interest rates. In that case, our best guess of what inflation will be tomorrow is whatever inflation is today.

That's one positive thing about where we are today. People don't expect inflation five years from now to be as high as it is today. Our job is to make sure that those longer run expectations stay anchored, close to our target.

Sablik: That's a great point, John.

Pierre, you were talking a little bit about the 1970s. How persistent was inflation then? That was a period that economists later dubbed "The Great Inflation."

Sarte: In the history of U.S. inflation, inflation was perhaps most persistent in the late 1970s and early 1980s. During that period, approximately 70 percent of inflation in a given quarter would be inherited by inflation in the following quarter.

Sablik: What was behind that high persistence?

O'Trakoun: Back in those days, the economy was a lot different than it is today. We had a lot more union workers who had their wages indexed to inflation. That resulted in something called a wage-price spiral, where these high wages and high inflation kept feeding into each other in a vicious cycle. That's much less of a factor today.

And, importantly, back in those days the Fed didn't have a 2 percent inflation target. People weren't quite sure whether the Fed was up to the job of controlling inflation. Today, we have more experience in getting high inflation back down and people seem to believe that we can do the job, although they have a wide range of views about what that might mean for the economy.

Sablik: Yeah, it sounds like inflation persistence has come down since that Great Inflation period. Is that what the Fed wants ultimately?

Sarte: First and foremost, the Fed prefers inflation to stay at its target of 2 percent. Of course, inflation is bound to bounce around some as different shocks hit the economy. However, the more inflation predictably stays at its 2 percent target, the easier it becomes for households and firms to make choices and go about their lives.

O'Trakoun: Pierre used the phrase "predictably at its 2 percent target." That's really the key for me here. We'd want inflation persistence to be low, which means it's further away from that unpredictable, super-persistent random walk behavior that I talked about earlier.

Sablik: From the data that you studied, can you tell whether inflation persistence has changed since the pandemic started? What would that mean for the current bout of inflation we're experiencing?

Sarte: That's a difficult question to answer. Our best estimates of inflation persistence since the pandemic carry considerable uncertainty simply because we do not have much data to go on since then. For now, it's still reasonable to imagine that the high inflation levels we're seeing will subside over the next few quarters, in which case we'll conclude that the high prices we saw since the pandemic were not persistent after all.

O'Trakoun: But if inflation has become more persistent, it'll take more time for inflation to return to target compared to like what we've gotten used to over the past 25 years before COVID. That could mean that it takes more time for the effective interest rate hikes to show up in the monthly inflation data as well. That adds to the challenges of policymakers who have to assess whether policy today is sufficiently restrictive and after what time lag should we expect to see some kind of progress. Because of this kind of uncertainty, there's likely to be some pain involved in terms of GDP or aggregate demand softening as the Fed gets inflation back to target.

Sablik: Are there any particular signs that you'll both be looking [for] over the next few months or quarters that could point to inflation becoming more or less persistent?

Sarte: Mainly, I'm looking for the after effects of the pandemic on supply constraints to continue dissipating and, given the moves that the Fed has already undertaken this year, for aggregate demand to cool somewhat. Both these considerations, in principle, would act to lower inflation over the foreseeable future.

O'Trakoun: In terms of the monthly data, the proof is really in the pudding. We'll have to see clear and consistent signs of inflation itself coming down every month.

Outside of those hard numbers, we've got economists traveling all over our district and engaging with businesses and community members. I'm listening closely to their narratives and input about how businesses are setting their prices or how they're setting salaries or making budget plans for next year, and about whether households are starting to make different choices in terms of what to buy and how to buy it.

For instance, in housing and in some big-ticket items, we're hearing about consumers pulling back on some purchases because they think that prices or interest rates are going to come down next year. The fact that they don't think that today's high prices are going to stick around forever is a really encouraging sign that persistence might be falling or maybe it's not as high as we fear. The more of these kinds of stories that we hear the better, because inflation isn't just about one particular category of prices. It's about the cost of living in general.

Sablik: Yeah, that's a good point to mention those on-the-ground stories. We've done a few episodes recently about the surveys that the Richmond Fed does. We'll include some links to those.

Pierre and John, thank you both for coming on to talk with me today about inflation.

Sarte: Thank you.

O'Trakoun: Thank you.

Sablik: And as always, I'll remind listeners interested in keeping up with the work our economists are doing, they can head over to Richmondfed.org. If you enjoyed the show, please consider leaving us a rating and review.