When the pandemic hit last year, the economy contracted sharply, and with a better than expected recovery ongoing, an economic expansion is sure to happen. Now is a good time for us to think about the next economic cycle in its entirety.
The life cycle of an economic expansion
The life cycle of an economic expansion is best viewed through the lens of the labor market. In the so-called “young” stage of the expansion, high unemployment from the preceding recession fuels the expansion. But once labor markets tighten, the cycle enters the “old” stage with fundamentally different characteristics: Hiring is more difficult, growth is scarcer, and vulnerabilities, such as inflation or bubbles, are larger.
Understanding inflation risks
In many ways, the popular and persistent fear of inflation is surprising, given the 30-plus year inflation downtrend in the U.S. and other economies. But this can all change in the post-Covid world. The risks of inflation post-Covid include:
- Transitory inflation: Current fears imminent inflation don’t qualify as risks since these spikes will be temporary. Year-over-year inflation has spiked in March and April, given that the same months last year capture the height of pandemic demand shock when prices were particularly weak. This was ignored by policy makers and markets, but the inflation numbers in the following month can tell a very different story.
- Non-recessionary containment of inflation: Sustained tight labor markets eventually lead to price pressures, which could lead to inflation. Monetary policy makers will strive to respond, effectively allowing pressure to ease and the cycle to continue.
- Recessionary containment of inflation: Those same inflation pressures may also be too strong for policy makers to manage, leading to policy tightening that introduces a recession. While plausible, this is not likely, given well-anchored inflation and the ability for policy to move slowly while still having impact. However, this can be a very real and damaging reality if the numbers suggest inflation is getting out of hand.
- Inflation regime break: Inflation that is uncontrolled by policy – or even encouraged by further policy stimulus – has the potential to undermine the well-anchored inflation regime. This is possible, but not plausible, particularly in the short run as it takes years of sustained labor market tightness and policy disregard to trigger a regime break.
There is additional risk from policy makers needing to manage market expectations. Such expectations have assumed easy monetary policy for many years to come and pivoting to a faster rise in rates might be difficult to execute without creating market turbulence.
That being said, the recent 4.2% Consumer Price Index (CPI) number announced today is surely surprising, as well as unexpected. Especially because the Fed previously predicted the number to be around 2%.
Although they later explained that the rising in inflation is temporary, the fear is real, as the plummeting stock market suggests.
Will the inflation get out of hand? Let’s look at the next CPI announcement.