Is the US Economy in Danger of Reheating?


It seems like only yesterday that the inflation debate revolved around the “Standing Team” vs. “Transition Team”. However, after several months of low inflation data, a kind of consensus has emerged: inflation has turned out to be transitory.

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

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

But when economies experience a turnaround, conditions on the ground can change quickly. In such circumstances, the growth of the money supply can outpace the growth of output – even if the central bank does not intend such an outcome. This is because production growth can take time. Firms may need to expand capacity or hire more workers, and there is still a labor shortage right now. Even when the economy is doing well and business conditions are good, output growth often lags.

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However, the money supply does not have to suffer the delay. For example, banks may be quick to extend credit if they anticipate that the recovery is stronger than expected. Even if the bank is in the middle of processing the loan, it can simply lend more than it planned.

So there can be periods when, for completely natural reasons, the money supply grows faster than output. Such a situation only requires a sudden burst of good news. And indeed, that has been the case with the recent favorable inflation news and the surprisingly good recent GDP report. Ironically, a positive market reaction to low inflation and strong growth encourages market participants and may lead to … a fresh dose of inflation.

Another possible avenue for these scenarios is interest rates. During normal disinflation, the Federal Reserve raises rates and keeps them high for a long time while the economy adjusts slowly – often going through a recession. However, inflation has fallen faster than expected, so the market may expect the Fed to cut interest rates earlier than planned. And an expected cut in interest rates can support expansionary pressures as much as an actual cut in interest rates.

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It’s a funny world where slow inflation can cause faster inflation. It is the logic of expectations that makes this possible, although far from certain.

So what is the evidence for reheating? Some commentators suggest that the housing market has already bottomed out. In addition, lumber prices are rising. The job market remains tight and may be tighter than it seems. My colleague Conor Sen of Bloomberg has been predicting an economic recovery rather than a recession for some time, and so far things are going according to his vision. The Cleveland Fed’s “new news” on inflation data for January is not entirely reassuring and raises the possibility of a rebound in inflation.

Outside the US, both core and headline inflation rose sharply in Spain at a time when inflationary pressures are expected to ease.

These scattered data points do not make a dispositive case for inflationary overheating. But if the data over the past few years has shown anything, it’s that this is the era of surprises. Perhaps the surprises are not over yet.

I still think the chance of an inflationary overheating episode is less than 50%. However, good investing and decision-making are not only about determining the most likely scenarios – they are also about identifying emerging risks.

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The good news is that inflationary overheating would be partly due to the prospect and expectation of a boom. The bad news is that this makes the Fed’s current job more difficult as inflationary risks persist. Uncertainty at the Fed could prompt it to make mistakes or radiate uncertainty into the broader market.

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

More from Bloomberg:

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

• The Federal Reserve Should Be Suspended Right Now: Karl Smith

• Inflation Finally Drives Bet Through ‘Transitional’: Jonathan Levin

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

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

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