Yes, Inflation Is Really Back | Opinion

Never turn your back to the ocean—it's a phrase that generations of parents have used to help their kids stay safe on the beach. But this simple instruction also has a deeper message: Don't lose respect for something powerful that you can't predict or control. If you do, you could suddenly find yourself drowning.

Unfortunately, we've turned our backs to inflation during the past decade, and we're about to relearn a painful lesson about respect. The Fed and the Biden administration are dismissing the latest inflation data, claiming that the jump in prices is merely temporary. Besides, they continue, it will be good to let the economy run hot for a while. In other words, don't worry—higher inflation won't be a big deal.

They're wrong, on all counts. First, we didn't put enough effort into understanding why inflation was so peculiar over the past decade, which makes it tough to interpret what is happening now. If we solve the mystery of the missing inflation—why inflation has averaged under 2 percent per year for the past decade despite the tremendous increase in the money supply—then it appears that inflation was already on its way back even before the pandemic.

Inflation hasn't actually gone missing—you just need to know where to look. Inflation has shown up in the prices of assets like bonds, stocks and real estate, rather than in consumer goods. Most people aren't used to thinking about skyrocketing stock and home prices as inflation, but much of the 214 percent increase in the S&P 500 and the 73 percent increase in the Case-Shiller home price index over the past decade was due to all the extra money the Fed dumped into the financial system through quantitative easing. Too much money chasing too few of anything, including assets, is inflation.

Inflation in asset prices can spill over into consumer prices. Higher home prices drive up rents—or shelter services, as they're called in the official price statistics. Speaking of services, that's another place where the inflation has been lurking. The inflation rate in consumer services returned to a relatively normal rate of about 3 percent by 2018 and has remained there since.

The prices of consumer goods have been holding the headline inflation rate down for the past decade. Many factors played a part in this, but several of them acted together to create an environment in which businesses simply couldn't raise prices. Start with the continued effects of globalization—especially the fact that China had become the world's factory, and China's recovery from the global financial crisis was based on making that factory a lot bigger. This pushed prices down. Next, the rise of the mobile web made price competition absolutely brutal by placing a price-comparison tool in everyone's palm. And to top it off, wages stagnated for at least half of Americans, so that they couldn't pay higher prices even if they wanted to.

Federal Reserve headquarters in Washington, D.C.
Federal Reserve headquarters in Washington, D.C. Smith Collection/Gado/Getty Images

The usual suspects—technological improvements that drove down the prices and increased the quality of all things electronic, including a huge fraction of consumer durable goods—also played a role in holding prices down. And the icing on the cake was the fall in energy prices, primarily due to the explosion of hydraulic fracking in the U.S.

But the perfect storm of falling goods prices started to blow itself out over the past few years. This process started with the rise of populism, which began to reverse globalization by imposing tariffs and other trade barriers that add costs to imported products. The labor market also finally started to heat up, not merely by raising middle-income wages but by increasing wages fastest for those earning the least. This put more spending money in people's pockets and raised costs for businesses. And even the frackers were reined in by the financial markets, which began to refuse funding new oil production when it wasn't actually profitable, so energy prices also began to rise. Not all of the forces pushing prices down abated, but enough of them did so that a return to historically average rates of inflation was already in motion by the time the pandemic forced the massive economic shutdown last year.

On top of these long-term trends, we now have the legacy of the pandemic: a cocktail of pent-up demand, multiplying supply-side disruptions, missing workers and free-flowing money from both the Fed and the Treasury. Even though economists still haven't figured out exactly how wage-price spirals begin, it seems like the current economic conditions could be the catalyst for a new one. If we look back at the spiral of the mid-1970s, it also featured "temporary" supply shocks—at that time, to energy and food—and easy monetary policy. We've got all that today, and much more.

The clearest sign that we're at the very start of a wage-price spiral is that businesses have lost all fear of raising prices. The press is full of quotes from shop owners and executives announcing price increases and justifying them by saying that customers can afford it and everyone else is doing it, too. Widespread cost increases—especially wages—are giving companies ample cover for raising prices without fear of losing sales. Add a little Fed-induced monetary ease, so that nobody complains, and we're off to the races.

The Fed isn't worried about any of this, because it believes it has successfully anchored people's inflation expectations at about 2 percent. In their view, people will still believe inflation will be 2 percent even as it rises well above that rate and stays there, so they won't ask for higher wages or run out to buy things before prices rise even more. But a quick look at the underlying indicators, such as the five-year break-even rate on Treasury-Inflation Protected Securities (commonly known as "TIPS"), reveals that expected inflation has been rising steadily for over a year and is now at the highest level over the past five years: 2.7 percent, with no signs of leveling off.

What's even worse than turning your back to the ocean? Trusting lifeguards who overestimate kids' ability to swim.

Connel Fullenkamp is professor of the practice of economics at Duke University.

The views expressed in this article are the writer's own.