Two Kinds of Transitory Inflation

Now that Nobel laureate Joseph Stiglitz has declared victory for Team Transitory, it’s worth delving into the causes of our recent inflation woes once again. Price hikes have indeed slowed, with the Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCEPI) declining from peaks at 8.93 and 7.11 percent respectively in June 2022 to 3.12 and 2.64 percent respectively in November 2023. Insofar as “transitory” means “not forever,” inflation certainly appears transitory. 

Of course, this isn’t what Team Transitory meant. But what did they mean?

At the time, Team Transitory argued the uptick in inflation beginning in Spring 2021 was primarily due to supply-side factors. Lingering pandemic bottlenecks increased the cost of producing and distributing goods in general. Since these bottlenecks would soon ease, members of Team Transitory assured us, inflation would be short-lived.

It is important to note both points: Team Transitory offered not only a timeline for elevated inflation, but a cause. Indeed, Team Transitory was almost synonymous with temporary supply-side inflation. It would be difficult (though not impossible) to find those who endorsed Team Transitory’s view about the source of inflation but not the timeline, or vice versa. Aren’t you saying it wouldn’t be difficult? The source is supply bottlenecks and they endorsed this. But it turns out it wasn’t true. It was a monetary phenomenon.

At this point, I have a hard time seeing how the original Team Transitory argument can be correct. Inflation reached levels they swore we’d never see. It has since fallen, but the price level has not. This is important because the supply-side inflation theory does predict a declining price level. If bottlenecks were the cause of inflation, eased bottlenecks should have brought prices back down to where they would have been had the bottlenecks never occurred. To the contrary, the price level remains permanently elevated.

There’s another kind of transitory inflation, although it’s very different from what Team Transitory posited. Consider the effects of a massive monetary injection that occurs just once. The public would have much more cash and other liquid assets on hand than they’d like, so they reallocate their portfolios by spending down their excess money balances. This will boost demand for just about everything. Prices should grow more quickly than before. But eventually the price level will rise enough that the public will stop decreasing its stock of liquid assets. The higher prices are in general, the more money you need on-hand to make regular purchases. Here ends the inflationary episode. In the language of monetary economics, we transitioned from one price level growth path to another. The steps between the two growth paths contained elevated inflation. Since we transitioned from one equilibrium to another, the behavior of the economy over that interval might rightly be classified as transitory.

This is standard demand-side macroeconomics. There’s nothing wrong with the above story, as far as it goes. But we should explicitly recognize two points. First, since this is a demand story, it is categorically different from the original Team Transitory argument. Second, it doesn’t take into account the major policy interventions we had since inflation started rising, especially since Winter 2022. The Federal Reserve has majorly tightened since then, hiking interest rates from 0.25 percent to 5.5 percent and engaging in quantitative tightening. The resulting financial disintermediation (e.g., banks calling in loans and not making new ones) even caused the money supply to fall, which is very rare.

It’s clearly nonsensical for Team Transitory to point to declining inflation after two-plus years as somehow conforming their story. Think about what their paradigm implies about past inflations. Starting in early 1973, PCEPI inflation started ratcheting up to a peak of 11.57 percent in late 1974. Thereafter it fell, bottoming out at just above 5 percent in December 1976. Then it rose again, reaching an apex of 11.6 percent in March 1980, before gradually declining into the beginning years of the Great Moderation. Was this decade-long inflationary event transitory? It came to an end, after all. And there were plenty of supply shocks during that period. It checks Team Transitory’s boxes. Yet this stretches the meaning of “transitory” so far it becomes a useless descriptor. 

Team Transitory’s narrative just doesn’t cohere. Whether we’re trying to explain the Great Inflation of the 1970s and early 1980s, or the inflation of the past two years, we need to rely on demand-side mechanisms. Both disinflations involved significant monetary tightening. Supply problems can make inflation worse, but bottlenecks or growth slowdowns are not the main culprits. Both of those proposed causes come with major social-scientific baggage in the form of falsified predictions. Ultimately, once we think in terms of causes and timeframes, it is clear that Team Transitory was wrong from the beginning.