What economists like me got wrong about inflation

If you are like most Americans, your number-one financial problem these days is runaway inflation. You’re desperate to know when inflation will peak, and when it will be back down to a level you can live with.

The economic pain and suffering caused by more than a year of spiking in inflation — which has dramatically raised prices on everyday goods and services — has been tough to bear. The typical family must shell out $460 more a month to buy the same items and services they bought a year ago — a huge bite out of that family’s $70,000 in annual income. For lower-income households living paycheck to paycheck, this is unmanageable.

Prices are up a lot for almost everything, but most disconcerting are the big price increases for basic staples. The nationwide cost of gasoline has soared to a record near $5 per gallon, nearly all items on grocery store shelves have suddenly become much more expensive, and rents are increasing at a double-digit pace.

Many of us have never seen this kind of inflation before, making it especially difficult to fathom. The last time inflation was so high was two generations ago when Ronald Reagan was president. And it comes on the heels of more than a decade of inflation so low that the Federal Reserve, whose job it is to manage inflation, worried it was too low for the economy’s own good.

Also irksome is how wrong the Fed, the Biden administration, and economists, including me, were in thinking that the high inflation would quickly recede. It hasn’t.

We were wrong about inflation because we were wrong about the COVID-19 pandemic. A year ago, in the wake of the vaccine rollout, the widespread expectation was that the pandemic was over. It wasn’t. Global supply chains were badly scrambled, and workers sick with the virus or nervous about getting sick remained off the job.

“We were wrong about inflation because we were wrong about the COVID-19 pandemic.”

Even today, the pandemic continues to create havoc in China, which is critical to many supply chains. It is tough to resolve supply chain bottlenecks when the biggest link has been all but broken. Meanwhile, many U.S. businesses in the construction, hospitality, manufacturing and retail industries continue to struggle with labor shortages and must amp up wages to attract and keep workers. That adds to their costs and pressures them to charge higher prices.

And the Russian war in Ukraine wasn’t even on the radar until a few months ago. Russia’s aggression and the sanctions we and others have imposed are behind those record gasoline prices. Particularly problematic was the European Union’s recent surprise decision to stop purchasing Russian oil, as the EU buys a lot of it, causing a massive shortfall in global oil supply.

Higher oil prices are especially pernicious. They boost inflation directly in higher pump prices, and indirectly in food and other prices due to the higher cost of diesel and jet fuel. Perhaps even more important is their impact on inflation expectations. If we all believe inflation will be high in the future, it likely will be. Workers will demand bigger raises to compensate for their higher commuting and other living costs, and businesses will be willing to pay it if they believe they can increase prices to make up for their higher labor costs. A vicious wage-price spiral kicks in.

If my diagnosis for why inflation is so high is roughly right, then I think the worst of the inflation is at hand, it will be retreating quickly by this time next year, and it will be back in its cage two years from now.

My sanguine forecast requires that the pandemic continues to wind down. There surely will be more waves of the virus, but each new wave is expected to be less disruptive to the economy than the one that preceded it. That is the pandemic’s MO: the virus is becoming less virulent, our vaccines and therapies are more effective, and our economy’s ability to manage around the virus is improving.

On the Russian war, the worst of its economic fallout also must be at hand. Any country that is going to sanction Russian oil has done so, and global oil producers have a strong profit motive to produce more, which they have announced they will do. Oil prices, and thus gasoline and diesel prices, should decline meaningfully by early next year.

Finally, the Fed must successfully calibrate monetary policy. That means it must increase rates fast enough and high enough to contain inflation expectations and slow the strongly growing economy so it does not blow past full employment and further fan inflation — but not so fast and high as to push us into recession.

This all seems doable, even more than likely. But of course I say this with significant trepidation.

We need a bit of luck on how the pandemic and Russian war unfold, along with some reasonably graceful policymaking by the Fed. If we get these breaks, the odds are good that inflation is peaking and soon will moderate to a level we can be comfortable with.

Mark Zandi is chief economist of Moody’s Analytics.