“Transitory or persistent?” Introduced as an economist while attending a friend’s church on Sunday, my new acquaintance launched his question without so much as a how-do-you-do. Nor did he have to tell me that he was asking about inflation.
The consumer price index rose 6.2 percent between October 2020 and October 2021, the fastest pace since 1990 and the fifth month that inflation topped 5 percent. My new friend is retired and living on a fixed pension—when prices go up, his purchasing power goes down. If 6.2 percent becomes the new normal, he sees cat food in his future and he’s worried.
The Rochester Beacon reached out to Sevin Yeltkin, dean of the University of Rochester’s Simon School of Business, for some guidance. (Readers interested in assigning blame for the problem might read Neil Irwin’s New York Times post here.)
ROCHESTER BEACON: None of us like paying more for gasoline or to heat our homes, but why does inflation matter for the economy as a whole?
SEVIN YELTEKIN: If inflation rate was the same across all goods/services as well as across all salaries and wages, a stable, anticipated inflation would not matter. We would pay, let’s say, 5 percent more for utilities, but we would also be earning 5 percent more, so our purchasing power would not change, we would still be able to afford the same things we did before, in the same composition as before. Inflation becomes problematic when it is unanticipated. Many contracts, prices, wages, salaries are fixed before we know how big inflation will be. If inflation is higher than anticipated, it erodes purchasing power and real income. It also allocates resources from lenders to borrowers (think of fixed-term mortgage rates or loans), which stifles lending and subsequently investment and finally growth. And as inflation rises, its volatility also tends to increase, making the adjustments to keep real income, purchasing power stable even more challenging. As inflation rises, it also tends to become a self-fulfilling phenomenon. If people anticipate high inflation, or volatile inflation, they write contracts, make pricing decisions accordingly, i.e, bake in high inflation, which then translates into realized high inflation.
ROCHESTER BEACON: Do some price increases matter more than others?
YELTEKIN: Yes. Goods/services we cannot substitute away from easily are the most problematic. We cannot easily switch to electric cars, or heating our houses with electricity quickly, if gas prices rise. We may be able to switch from bananas to apples if banana prices rise, but if food prices overall rise, again, it is hard to substitute away from as a whole. So you have to ask, how big is the particular expense in my overall budget? Is there a cost-effective substitute I am willing and able to use? Is my income rising enough to cover the extra expense? If the answers to these are no, inflation does really matter for those goods/services.
ROCHESTER BEACON: So, if inflation is bad for the economy, shouldn’t someone in government step in and set a limit to price increases?
YELTEKIN: Absolutely, unequivocally NO. Price caps have historically been disastrous, not just in the U.S., but all over the world and for multiple reasons any economist can articulate. Price is a mechanism that brings supply and demand into equilibrium. Once you interfere with that mechanism, you create massive distortions. What are the likely scenarios? 1) Firms stop producing as much. They were mostly likely pricing their goods/services higher because their cost of production/transportation/labor are increasing. If they cannot sell their products at a price that covers those costs, they cut back on production. Hence, we end up with shortages. 2) Invariably a black market for goods/services where inflated prices prevail pops up. Those with the means to pay for higher prices and really want to get the goods, those who are willing to supply those products at the high prices start trading outside of the legal cap. So not only caps become ineffective, you now create equity issues by creating a divide between haves and have-nots, not to mention the all the issues that tend to arise with illegal trades, such as less tax revenue and increased crime. 3) As soon as price controls are lifted, a big surge in inflation happens, as the market mechanism tries to bring supply and demand into balance, eroding purchasing power if wages/salaries have not adjusted accordingly. We have many historical instances of these across the globe, so this should not even be a consideration. A better way for policy to work is to create an environment for cost-effective, more creative, possibly tech-savvy solutions to supply chain, transportation disruptions to develop, and also remove inefficiencies and provide incentives for innovation.
ROCHESTER BEACON: The rate of return on 10-year Treasury bills is under 2 percent. Why do some expect inflation to be higher? Aren’t interest and inflation rates closely related?
YELTEKIN: Well, the markets are basically telling you that they a) expect the current high inflation to be a temporary phenomenon or b) expect the Fed to interfere and raise short-term rates to arrest that inflation. The markets are still banking on no more than 2 percent average inflation over the long horizon, which has been an explicit monetary policy target for a decade. If we believe markets to be efficient pricing mechanisms, which I do, I would put more weight on the market expectations than individual projections or bets.
Sevin Yeltekin became dean of the Simon Business School at the University of Rochester in July 2020. Her distinguished career includes serving in faculty positions at the Tepper School of Business at Carnegie Mellon University and the Kellogg School of Management at Northwestern University. Yeltekin’s research spans fiscal policy design, social insurance design, computational economics and asset pricing implications of macro policy. She received her bachelor’s degree in economics and mathematics from Wellesley College, and master’s and PhD degrees in economics from Stanford University.
Kent Gardner is Rochester Beacon opinion editor and chief economist at the Center for Governmental Research.