Is the US Economy in Danger of Reheating?


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It seems like only yesterday that the inflation debate was all about “Team Permanent” vs. “Team Transitory.” But after several months of low inflation data, a kind of consensus has arisen: Inflation has revealed itself to be transitory.

This is only a temporary (or should I say transitory?) consensus. There are signs that some economies, including that of the US, may experience a phenomenon known as “reheating”: a rapid turnaround that causes inflationary pressures to re-emerge. Is such a phenomenon possible?

Consider a simple scenario involving output and money, much of which takes the form of credit expansion by banks and other intermediaries. In a well-functioning economy, money and output grow at roughly the same rate.

When economies experience turnarounds, however, conditions on the ground can change rapidly. In such circumstances, the growth of the money supply might outpace the growth in output — even if the central bank does not intend such a result. The reason is that output can take a while to grow. Businesses might have to expand capacity or hire more workers, and right now there is still a labor shortage. Even when an economy is functioning well and business conditions are good, output often grows with a lag.

The money supply, however, need not suffer from a lag. Banks, for instance, can extend credit quickly if they foresee that a recovery is stronger than expected. Even if a bank is in the midst of processing a loan, it can simply lend out more than it was planning.

Thus there can be periods when, for entirely natural reasons, the money supply is rising faster than output. That situation requires only a sudden burst of good news. And indeed there has been exactly that with the recent favorable inflation reports and the surprisingly good recent GDP report. The irony is that a positive market response to low inflation and strong growth cheers up market participants and could lead to … a new dose of inflation.

Another possible pathway for these scenarios involves interest rates. During a normal disinflation, the Federal Reserve raises rates and keeps them high for a long period of time while the economy adjusts slowly — often passing through recession. But inflation has fallen more rapidly than expected, and so the market may expect the Fed to lower interest rates sooner than planned. And an expected cut in interest rates can encourage expansionary pressures just as much as an actual cut in interest rates.

It is a funny world in which slow inflation can cause faster inflation. It’s the logic of expectations that makes it possible, albeit far from certain.

So what is the evidence for reheating? Some commentators suggest that the housing market has already found its bottom. In addition, lumber prices are rebounding. Labor markets remain tight, and may be even tighter than they look. My Bloomberg Opinion colleague Conor Sen has been predicting an economic rebound rather than recession for some while now, and so far things have been going his way. The Cleveland Fed’s “nowcasts” for inflation data for January are not entirely reassuring and raise the possibility of an inflation rebound.

Outside the US, both core and headline inflation have spiked in Spain, during a time when inflationary pressures are supposed to be moderating.

Those scattered data points don’t amount to a dispositive case for an inflationary reheating. But if the data over the last few years have shown anything, it is that this is an era of surprises. Perhaps those surprises are not yet over.

I still think the chances of an episode of inflationary reheating are less than 50%. But good investing and decision-making are not just about pinpointing the most likely scenarios — they are also about identifying nascent risks.

The good news is that an inflationary reheating would be partly caused by the prospect and expectation of a boom. The bad news is that this makes the Fed’s current job harder, as inflation risks remain. The Fed’s uncertainty could induce it to make mistakes, or to radiate uncertainty to the broader market.

No one ever said monetary economics was easy. It would be a mistake to take the recent good news about inflation for granted.

More From Bloomberg Opinion:

• Team Transitory vs. Team Structural, the Rematch: John Authers

• The Federal Reserve Should Pause Right Now: Karl Smith

• Inflation Finally Drives a Stake Through ‘Transitory’: Jonathan Levin

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. He is coauthor of “Talent: How to Identify Energizers, Creatives, and Winners Around the World.”

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