Inflation’s New Normal Will Be 4%. Get Used to It.

Now that inflation is back, it's not going away anytime soon. The Federal Reserve expects it to fall below 3% next year and eventually go back to 2%. But there are reasons to think that’s far too optimistic. We are living in a new world. Even after things get back to normal that could mean inflation averages 4% or even 5% for the foreseeable future.

The Fed can almost be forgiven for its optimism. The idea that inflation was no longer a concern had become conventional wisdom before the pandemic. Many articles were written explaining why. Pension funds pulled back on their promises to increase benefits with inflation, and hardly anyone noticed.

But now inflation is up to 8.5% and, between lockdowns in China and the war in Ukraine, it could go even higher this year. At some point, we hope, the world will fully open and some of the pressure will lessen. But these times could leave lasting scars on the economy and we may have seen the last of 2% inflation for a while. Americans used to live in a world where 4% or 5% inflation was the norm, and that could be where it settles in the future.

There are many reasons why inflation became so low and stable in the last 30 years. One popular explanation is after years of missteps, the Fed finally figured out what worked. During the last serious bout of price increases in the 1970s, Fed Chair Paul Volker raised interest rates high enough to cause a recession. This created confidence that the Fed would do what it takes to keep inflation in check and that credibility helped keep inflation low, because today’s economy is largely driven by expectations about what future inflation will be.