Inflation Could Come Back When You Least Expect It

The latest inflation report, showing that price increases slowed in October, suggests that the US just might get the “immaculate disinflation” that everyone is hoping for: Inflation will fall to its pre-pandemic levels and remain there, and the US will avoid a recession. Allow me to make the pessimist’s case that we are not out of the woods yet.

I acknowledge that the sunnier view has a lot going for it. Optimism comes not only from the decline in actual inflation, but also from the decline in expectations of future inflation. Take a closer look, however, and it’s clear that some measures of expectations have not improved that much even as inflation has fallen. That means the situation is unstable and inflation could go back up again.

It is not enough for inflation to hit the Federal Reserve’s target of 2%. For a stable economy, inflation needs to be low and predictable going forward — just as it was pre-pandemic.

In many ways, the predictability of inflation is just as important as its level. When prices are unpredictable, they act as a kind of tax on consumers. An asset that offers variable returns is worth less, all else being equal, than an asset that offers fixed returns, because the predictability of knowing what your money is worth has tremendous value.

The uncertainty around inflation means a dollar is less valuable because you don’t know how much groceries will cost, or how far you can stretch your paycheck week to week. More uncertainty also increases interest rates on longer term bonds, because investors and lenders need to be compensated for the extra risk they take on.