By Hugo DanteThe early 1980s were interesting years for bankers and economists alike: 30-year fixed rate mortgage rates at 18 percent; short- to-long-term CD rates at 15-20 percent; 10-year Treasury yields at 15 percent; and breakaway inflation approaching 14 percent, despite an unemployment rate of more than 10%.
The Federal Reserve was thrust to the forefront of public policy, as policymakers and the general public grappled with an unprecedented crisis. Ultimately, the Fed succeeded in getting inflation under control, but lessons from the 1980s continue to live on, in economics textbooks and in the minds of the public.
Today, policymakers are facing a new unprecedented crisis due to a global pandemic. Business shutdowns led to the sharpest quarterly economic decline in U.S. history and the unemployment rate reached its highest level since the Great Depression. The government response drove the federal deficit to $3.1 trillion in fiscal year 2020, the Fed balance sheet ballooned to more than $7.5 trillion, and the monetary base expanded by more than 50 percent.
These developments stirred fears of runaway price gains and stinging memories of double-digit inflation.
However, conditions today are very different from the 1980s. Over the past decade, inflation has been mostly anemic, remaining firmly below the Fed’s 2 percent target. Inflation is holding near a decade-low-core personal consumption expenditures prices up just 1.4 percent in 2020—as massive unemployment and broad concern for the unknowable drove public savings to unprecedented levels.
Moreover, inflation expectations have not budged. The latest survey of the ABA Economic Advisory Committee—made up of the chief economists of most of the nation’s largest banks—shows inflation holding firmly below 2 percent through at least 2022. Similarly, the Cleveland Fed’s indicator of 10-year expected inflation remained near multi-decade lows at 1.42 percent in February of 2021. As a result, the Fed has announced a shift in its monetary policy framework, outlining a plan to allow inflation to run modestly above its 2 percent target as the economy gets back on track.
Inflation hawks counter that various signals indicate that the economy may run hotter than anticipated, including more than $1.3 trillion in additional savings and deferred consumption by households in 2020, a steady rise past 2 percent in the 5-year and 10-year breakeven rate (the difference between interest rates on regular and inflation-indexed Treasurys, or TIPS), and rising longer-term Treasury yields. While dynamic recovery would be welcome, resultant increased demand versus a downturn-driven slowdown in production could drive prices quickly higher.
When the economy fully reopens, the recent rise in energy prices and higher-than-normal demand for airfare, travel and services from deferred consumption could temporarily move inflation past the 2 percent target. However, the economy is still operating far below potential, with GDP still below 2019 levels. Thus, while a surprise in inflation is possible, there are signs that inflation risks do not lie meaningfully past 2 percent over the longer run.
The unemployment rate remains high and businesses have held back on investment, hiring, and expansion. Inflation forecasts remain conservative because there is still breathing room left for demand growth. Even the “breakeven inflation rates” may not currently be reasonable indicators of inflation expectations, as pointed out by economist David Beckworth, because Fed purchases of CPI-tied TIPS have driven down their relative yields. The Fed also retains various tools to control inflation, including bank reserves, open-market operations and the fed funds and discount rate.
The U.S. economy will undoubtedly experience significant shifts once vaccinations reach a critical level and the public again feels safe to engage. However, the recent trend of below-target inflation appears here to stay—at least for now.
Hugo Dante is an economic research specialist at ABA. In addition to the ABA Banking Journal, his writing has appeared in The Hill, the National Interest and Townhall.