A reasonable measure of long-term expected inflation is the ten-year break-even inflation rate, which equals the difference in yield between conventional and inflation-indexed ten-year US Treasuries. In January-February 2020, this rate equaled 1.7% per year, so that long-term expected inflation coincided with recent actual inflation. Then, the severe recession that started in March 2020 generated a short-term fall in the price level, leaving inflation temporarily in negative territory (‑4% per year from March to May). At the same time, long-term expected inflation fell to around 1% per year.
But the inflation rate soon ticked up—averaging 3% per year from May 2020 to January 2021—and long-term expected inflation increased substantially from 1% per year in March-May 2020 to 2.2% by February 2021. This change reflected partly an increase in the conventional Treasury yield, from 0.7% to 1.2%, and partly a decrease in the indexed-bond yield, from -0.3% to -1%.
The upshot, according to the financial markets, is that the higher inflation experienced since last May will not be temporary. Bond yields are signaling long-term inflation above 2% per year. On the bright side, this is still well below the 6% of the 1970s.
Again, the Fed, particularly Chair Jerome Powell, seems highly confident that it can keep a lid on inflation by eventually raising short-term nominal interest rates if necessary. The problem is that hiking short-term rates will have little impact on inflation once high long-term expected inflation has taken root.
The only way to keep the genie in the bottle is with the “whatever-it-takes” philosophy that Volcker pioneered in the early 1980s. Financial markets, businesses, and households would have to believe that the Fed, in cooperation with the Treasury, would maintain high interest rates as needed even in the face of recession.
Powell should be emphasizing the perils of high inflation, as befits a central bank chief. And Secretary of the Treasury Janet Yellen—herself a former Fed chair—should be stressing fiscal discipline, rather than favoring a “go big” approach that pays little attention to unrestrained public debt.
To ensure that inflation will not reemerge, we need policymakers to fashion themselves in the mold of a Volcker or a Draghi. But my fear is that weak policymakers, incapable of serious commitments, will squander the reputational capital that was created at high cost by Volcker more than 30 years ago.
Robert J. Barro, professor of economics at Harvard, is a visiting scholar at the American Enterprise Institute and a research associate of the National Bureau of Economic Research.