The administration of President Joe Biden has repeatedly assured Americans that the sharp uptick in inflation they are experiencing is temporary—in the language of economists, transitory. Surveys suggest that public is less than convinced, but consumer expectations of inflation are notoriously fickle.
All of this has economists and central bankers dutifully poring over data for signs of when or whether inflation, currently just under 4%, will drift back toward the Federal Reserve’s target of 2%. Instead, they should be considering a more fundamental question: whether the Fed should strive to make 4% inflation permanent.
To be clear, there is no doubt that the recent rise in price growth has been an unpleasant shock. That’s partly because it is so uneven. Prices on commodities such as gasoline and lumber, along with a few select goods such as used cars, have risen by double-digit rates.
A sharp increase in the price of even a small set of products creates far more pain than a rise the overall rate of inflation, which is averaged across thousands of products. But narrow inflation is also the type of inflation that’s most likely to reverse itself, since it reflects supply-chain disruptions that will eventually be relieved.
Analysts are concerned that the rise in inflation may be persistent because they see hints of a broader, gentler rise in prices across a range of goods—and, crucially, in the wages of the workers who produce those products.
This increase in both wages and prices can lead to the dreaded wage-price spiral. Yet because it is shared by both households and businesses, the pain is muted. Indeed, a higher rate of inflation, and correspondingly higher wage growth, could be a net positive for the economy.
There are two main reasons. The first is debt dynamics. Higher rates of inflation make debt more expensive, but easier to manage.
A permanent increase in inflation from 2% (its average over the last decade) to 4% would cause interest rates to rise by roughly 2% as well, as lenders sought to protect themselves from rising prices. Economists describe this as a rise in nominal rates, because the net return from lending—the real interest rate after accounting for inflation—remains the same.
One way to see how this would play out is to consider the mortgage market. Higher nominal interest rates would mean a higher monthly payment for any given loan. That might seem to make houses even less affordable. But what’s been clear over the last two decades—and what economic theory predicts—is that housing prices in the most desirable urban areas are determined by the maximum mortgage an affluent urban family can afford.
Buyers in those markets bid against each other for a relatively fixed stock of housing. Over the last decade, as nominal interest rates fell, families could afford to take out larger mortgages, and so maximum bids rose. Overall, buyers ended up with roughly the same monthly payment.