Will Inflation Turn Out to Be 'Transitory' After All?

A year and a half ago, Fed Chair Jerome Powell described inflation as "transitory." That word caused a kerfuffle at the time and has since come to represent Powell’s Chairmanship for a lot of people. The conventional wisdom is that he was completely wrong about that, that inflation was entrenched in the American economy even at that early stage, and that if he had understood that and started raising rates back then, we wouldn’t be in quite such a pickle now.

Looking back, though, the market’s consternation back then wasn’t because Powell was using the supposed "transitory" nature of inflation as an excuse not to hike rates and get it under control; it was because he was using it as a reason not to cut them, as this CNBC report clearly states. First, there is an important lesson there for anyone who believes that the market always knows best. It does in some ways, but you must understand that what is best for the short-term interests of traders is not always the right path for the country or the economy.

Traders always believe that what is best for their short-term profitability is the correct course. They don’t prioritize the short-term impact of a policy over the long-term because they don’t even look at the long-term. That doesn’t make them bad people, of course, they are just doing their jobs. However, look at where we are now and imagine where we would be if Powell had, eighteen months ago, done what traders were demanding and cut rates. Despite not doing what would, with hindsight, clearly have been stupid in the spring of 2021, Jay Powell was then and still is pilloried.

Now the accepted take is that it was ridiculous to suggest that the inflation that has climbed to the highest levels since the early 1980s could ever be dismissed as transitory, a word that suggests something we shouldn’t worry about because it is impermanent, a temporary nuisance rather than a real issue. Ironically, though, the danger now is that Powell may have been right all along, but that nobody really understood that while transitory implied impermanence, it said nothing about how long it would be before its effects faded.

It would certainly have made sense from a logical perspective for 2021's inflation to have been transitory. The year before, the global economy had suffered a truly unprecedented disruption as Covid-19 gripped the world. As the pandemic-related shutdowns ended, a combination of pent-up demand and suppliers struggling to get back to pre-pandemic output levels created a perfect storm. Demand was strong for goods that were in short supply. Price rises were inevitable, but things would presumably return to normal before too long, right?

That logic is still sound, yet here we are, eighteen months later, with inflation still elevated. Over the last few weeks, however, data, including this morning’s PPI numbers, have begun to indicate that inflation has already peaked. If so, while I’m sure the Fed and a lot of politicians will claim credit for getting it under control quickly, it indicates that it was indeed transitory. It was just a bit longer than what most people assumed that word implied. Typically, strong inflation doesn’t respond to rate hikes until they cause a sharp drop in economic activity and begin to impact the jobs market, and we aren’t at that point yet. So, price rises are probably slowing because of something else.

That something else could be that the post-pandemic inflation really was transitory and the temporary disruption it caused is now beginning to fade. The irony here, though, is that after being right all along, Jay Powell now seems to be convinced he was wrong. He is now displaying the kind of zealotry that converts often do, indicating that rate hikes will continue for the foreseeable future. That creates a bigger threat to the economy than his failure to act eighteen months ago could, and we should all therefore hope that Powell, having reversed course a short time ago, will trust the data enough to reverse again soon.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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