The Case for Humility: The experts grapple with understanding inflation.

• Author: Ullmann, Owen

When he ran the Federal Reserve during his legendary career, Alan Greenspan used to joke that he found economic models to be of great use to him as he contemplated the Fed's interest rate policies. Not, mind you, to predict where the economy was headed, but to look backwards and explain how it got where it is. The problem with models, he would chuckle, is that they are good predictors until some unanticipated trend comes along to make the models outdated in forecasting the future--and something unexpected always comes along.

Greenspan's contempt for models seems particularly appropriate today as some of the brightest economists on the planet engage in a high-stakes debate about the future trajectory of inflation in the United States.

The hand-wringing inflation-phobic camp is led by such luminaries as former U.S. Treasury Secretary Larry Summers and, to a lesser extent, former International Monetary Fund chief economist Olivier Blanchard. They have warned that the United States is headed toward an inflation explosion unseen in half a century because the Biden Administration is pouring trillions of dollars of fuel on top of an already blazing economy, as Jerome "Jay" Powell's Fed is helping to spread the fire around the world with ultra-low interest rates and an unabated bond-buying spree.

By 2022, according to this view, an inflationary spiral will be well underway, forcing interest rates to jump, the dollar to drop, and the stock and bond markets to swoon. Early evidence they cite as of mid-June included red-hot economic growth in the second quarter and soaring price increases for homes, used cars, food products, and commodities, from lumber to oil--all contributing to the highest increases in the consumer price index in more than a decade.

On the other side is a not-to-worry coalition led by Powell and U.S. Treasury Secretary Janet Yellen. They contend that inflation likely will rise in 2021 to as much as 3 or 3.5 percent, but then drop back into the 2 percent range in subsequent years. They base their projections on the belief that the Covid-19 pandemic which shut down the U.S. economy for several months in 2020 created price spikes because of temporary supply shortages, but supply and demand will return to balance once the economy returns to normal supply-and-demand patterns as the pandemic wanes.

Yes, they acknowledge, there is huge pent-up demand and $2 trillion in consumer savings itching to go on a buying spree, but that is offset by a labor force that remains weak compared to its pre-pandemic state. The labor participation rate as of mid-2021 was still below its level at the start of 2020, and there were still six million more people out of work than before the pandemic struck.

At its June 16 meeting, the Federal Open Market Committee raised its forecast for growth and inflation in 2021 and said its zero interest rate policy would likely end in late 2023. That was sooner than early forecasts that saw the first rate hikes coming in 2024. Even so, Powell stuck to his belief that the economy still needed to heal, that inflation would abate in 2022, and that the Fed had no timetable for curbing its bond purchases. In a sign of how skittish investors are about the Fed's changing forecast, the Dow Jones Industrial Average sank more than five hundred points two days later, when St. Louis Reserve Bank President James Bullard said he expects the Fed to start raising rates as soon as the end of 2022. But by the following Monday, the Dow had soared more than five hundred points.

So who is right? As the old adage goes: Time will tell, but not the economic models...