Why US Long-Term Inflation May Be Higher Than 2 Percent

Long-term US inflation may be closer to the ratio of the budget deficit to GDP—5% or more—than to the Fed’s 2% target, even if monetary policy is not expansionary.

Capital markets are currently struggling to account for the magnitude and duration of the Federal Reserve’s battle with the unexpected surge in inflation. Less has been written about the prospects for the long-term inflation rate if and when the current battle is successful. For the US economy, long-term inflation has not been a hot issue over the last two decades or more because of the low level and low variance of inflation. Assuming future inflation to be 2% was defensible from the 1990s to 2019. Beginning in 2021, however, there has been a major departure from this long-term stable rate. By the summer of 2022, year-over-year inflation measured by the CPI exceeded 8%, and the initial belief that the price increases were merely temporary effects of the pandemic gave way to the realization that US monetary policy would need to be brought to bear in a major way to bring inflation back down to the Fed’s 2% target. There is a major problem with achieving this 2% target. The Fed has far less control over the money supply and inflation than it did before 2008. The main drivers of inflation today are the liquidity in the banking system and the federal budget deficit.

John Hekman reviews the inflation experience of the 1970s and subsequent changes in monetary policy beginning in the 1980s; describes the changes to bank balance sheets since 2008 and the Fed’s consequent loss of control over monetary policy; and analyzes the current situation in light of the changes to monetary policy that came out of the 2008 crisis.