A big question for monetary policy today is whether the current bout of “inflation” is “transitory” – or “structural.”
It is now pretty clear that the wave of price increases that swept through the economy in 2022 was indeed…“transitory.” Even the mainstream media and some of the more prominent pundits now admit as much.
- “It turns out… that Team Transitory’s central idea may be vindicated.” – Alan Blinder (former Vice-Chair of the Federal Reserve), writing in the Wall Street Journal (July 2023)
- “Inflation appears to have been transitory after all…just as the U.S. got used to thinking high inflation could be here to stay, signs are emerging that most of the surge through 2021 and the first half of 2022 was actually transitory.” – The Wall Street Journal (Jan 2023)
- “Gotta say it: the original Team Transitory proposition was that inflation would subside without the need for a big rise in unemployment. Not looking so wrong now….Actually, at this point inflation is looking somewhat transitory,” – Paul Krugman on Twitter and in The New York Times (Jan 13, July 12, 2023),
- “[Larry] Summers emphasizes that it was always the case that transitory factors pushed inflation up…” – reported in The Washington Post (Aug 13, 2023)
- “Conclusion: Turns out, Jay [i.e., Chairman Powell], that when you and your colleagues said inflation is transitory, you were correct.” – BusinessWeek (August 2023)
It is also becoming clear that the post-pandemic inflationary spasm is now quite over (see my previous column).
- “The inflation performance at this point is better than I think many standard models would have predicted.” – Larry Summers (August 2023)
[Note: Indeed. It was not long ago that Mr. Summers was predicting that it would take “five years of unemployment above 5%” to contain inflation.]
- “The notion [behind “transitory”] was that most of the rising inflation wasn’t due to an overheated economy fueled by monetary and fiscal policy, but rather to several “special factors” that would disappear on their own…. What matters for policy makers is that… inflation is falling.” – Alan Blinder (July 2023)
[For a sampler of bad calls by prominent figures, see this piece in Barron’s from August. As well, some at the Federal Reserve are still “Disinflation-Deny-ers” – see my previous column on inflation and the Consumer Price Index.]
All that said, it may be a good moment to consider Transitory’s more dangerous cousin: “Structural” Inflation. What is it, exactly? and why is it so frightening?
First, What Is Transitory Inflation?
Since we will be differentiating “structural” from “transitory” it may be a good idea first to be clear about just what “transitory inflation” really is, and is not. The term is widely misconstrued.
1. “Transitory Inflation” is not defined by a specific time-frame.
“Transitory” does not mean “short-term.” It is not a question of whether the cycle takes two quarters or two years. “Transitory” is about causes, solutions, and outcomes.
2. It’s About Supply and Demand (But Usually Supply)
Transitory inflation is the result of a disequilibrium in the market, caused by one of two things: an unexpected shortage (supply), or an unexpected surge in demand. In economist-speak, it is either a supply shock or a demand shock. My view is that in most cases it is a supply shock, like OPEC’s oil embargo in the 1970s.
3. “Transitory Inflation” cures itself
“Transitory inflation” refers to price increases that are caused by factors in the economic system which create an imbalance between supply and demand – which are self-correcting as the market mechanism goes to work to find a new equilibrium. When the balance is restored, prices level off – and may even go into reverse. The initial imbalance and the resulting price increases may arise either from a surge in demand which catches the supply-side off guard, or a sudden constraint or bottleneck in the supply chain which creates a shortage.
The Demand-Driven Case
For example, if the cause of a price increase is “excess demand” resulting from, say, lavish stimulus measures in response to Covid which put extra money in consumers’ hands (a favorite if inaccurate explanation for the recent inflationary trend), then the extra spending will chase prices up until they reach the point where demand throttles down again, and a new balance is achieved – at which point prices will stabilize. As the saying goes, the cure for high prices is… high prices.
There is truth to that. The trajectory of Used Car prices – a major driver of inflation in 2020 through 2022 – shows this sort of pattern. In the wake of the pandemic shock, demand for used cars rose nearly 50%.
- “With a lack of new cars from auto plants able to hit dealer lots, and consumers more cautious about spending on big items, used car sales boomed….demand is driving up prices…. ‘We’re selling higher units today than we were pre-Covid.’[said one industry CEO] ” – CNBC (Oct 15, 2020)
High demand drove higher prices, which in turn moderated demand and prices stabilized. Used Car inflation turned into disinflation, and then deflation.
The rise in Used Car prices was clearly demand-driven, and the market mechanism responded as one would expect, to bring down the rate of price increases and bring inflation in this sector under control.
The Supply-Driven Case
If the problem is inadequate supply, rising prices will incentivize producers to raise their output, unlocking bottlenecks, expanding operations.
The price of eggs offers a good example. Over the past 10 years, two outbreaks of avian flu have decimated the population of egg-laying hens (in 2015 and 2022). Egg prices soared – and then plummeted as poultry producers rebuilt their flocks. (I have written about the eggflation episode in several columns earlier this year.)
Once again, the market mechanism worked as expected, restoring the supply-demand balance, and ending eggflation. The price increases were transitory, and in this case, even reversible.
4. Monetary Policy has little or no effect on “Transitory Inflation.”
Episodes of transitory inflation are not affected by or responsive to monetary policy initiatives such as interest rate increases (within the normal range). The Federal Reserve can do nothing to bring down the price of eggs or used cars or natural gas or any other commodity price. Again, as Krugman muses:
- “Fed did raise rates a lot, although it’s fairly unclear how that reduced inflation.”
Transitory, In Sum
Transitory inflation responds to initiatives taken in the private sector, by producers and consumers, to react to higher prices by either reducing or delaying demand, or by increasing supply. That is what the price signal should do: it moves the market back towards equilibrium. When avian flu swept through the poultry industry, producers took measures to combat the disease and to rebuild their flocks. This brought prices down. When used car prices became exorbitant, buyers were able to delay their purchases, wait until prices moderated – which they did. Monetary policy played no role in these adjustments.
Those are the signature facts about transitory inflation: (1) it is created by temporary imbalances in supply and/or demand; (2) it is self-correcting through the working of the normal market mechanism; and (3) it is largely impervious to monetary policy countermeasures.
So, What Is Structural Inflation?
Non-transitory inflation can carry a number of labels, including “built-in inflation,” “systemic inflation, “systemically significant inflation,” “sustained inflation,” “persistent inflation,” “underlying inflation,” “deeply entrenched inflation,” and – the term I will use – structural inflation. The central idea in all cases can be described as follows.
First of all, structural inflation is not temporary. It is a long-term, open-ended phenomenon.
Second, it is not self-correcting, and may in fact be self-reinforcing.
Third, and fundamentally, it is created and driven by significant changes in the structure of the economy, which alter the basic relationships between supply and demand in a more or less permanent (or at least long-lasting) way, or which distort the pricing mechanism so that the market can no longer find its equilibrium.
The best way to grasp this idea is with an example.
Structural Inflation in Higher Education
College tuition offers a classic case of structural inflation. In the last 20 years, college costs have grown much faster than overall inflation. It is widely seen as a crisis of “affordability.”
- “The significant increase in the cost of college has outpaced both inflation and — even more starkly — family income over recent decades.” – CNBC (March 2021)
Tuition inflation is clearly persistent. It is also “entrenched” in the sense that it hardly shows any impact of the business cycle. College costs have gone up through good times and bad, powering through every downturn in the economy, including the 2008 financial crisis and the Great Recession and 10% unemployment, rising right on through the era of quantitative easing and near-zero interest rates, up and up through the Covid pandemic, up further as the Fed raised rates 500 basis points at the fastest pace in history. Tuition costs have kept rising even as demand for the product (indicated by the annual number of Fall enrollments – which is closest to the point where a “decision to purchase” occurs, where consideration of the cost of tuition is most explicit) has leveled off since 2009, and started to decline.
This is an inflation that seems impervious to macro-economic conditions, monetary policy, plague, politics and geopolitics. Prices keep rising even as demand softens. The market mechanism is not functioning properly.
The causes of tuition inflation are many, including the growing overburden of administrative costs (so-called “administrative bloat” – administrative costs per student growing much faster than other expense categories), and expensive campus renovations. But it is also clear that the cause is not to be found in the traditional theories of inflation which blame excess demand or a shortage of supply.
Tuition Cost Increases Are Not Demand-Driven: Demand is Dropping
As shown above, the rise in tuition prices has not been caused by “increased demand.” Higher education is now experiencing a long-term decline in enrollment.
- The percentage of 18-24 year olds enrolled in college declined from 41% to 38% from 2010 to 2021
- The percentage of high school graduates enrolling in college fell from 70% in 2009 to 61% in 2021
- The total number of college students (different from Fall enrollments) fell by 15% (2.6 million) between 2010 and 2021
- US News & World Report cites a study forecasting a further 15% drop in enrollment between 2025 and 2029
This decline in demand for higher education is driven in part by “a looming demographic storm”: a decrease in the size of the college-age cohort. There are simply fewer students graduating from high school, fewer potential customers for a college education. This demographic shift is itself a “structural” factor, projecting a long-term and persistent downward trend in demand. But this would be a force of structural deflation, not inflation. (We will look at the phenomenon of structural deflation in a forthcoming column.) If the pricing mechanism were functioning properly, prices should moderate. Instead, they have accelerated.
The supply side of this “education industry” is fairly stable in most respects. There is no scarcity of opportunities to obtain a college degree.
- The number of mainstream institutions that form the core of the higher education supply side – 4-year private nonprofit and 4-year public degree-granting colleges – increased by 4% from 2012 to 2021
- The number of 2-year degree-granting colleges (community colleges) declined by about 13%
- For-profit colleges, both 2-year and 4-year, have seen a larger decline numbers, but they account for only about 5% of the market
In short, there is no indication of a supply constraint. The modest reduction in some categories of higher education seems natural in light of the downward drift in demand cited above.
The Key Structural Driver: Student Loans
The main driver of college costs is the explosive growth of student loans. Beginning in about 1993, the Federal Government made it much easier for students to borrow to pay for their education. The market uptake of cheap and easy credit was phenomenal. From 2000 to 2020, overall inflation was up by a factor of 1.5, college tuition rose 2.2 times (private universities) and 2.8 times (public universities), while the volume of student loans grew by a factor of 25 times. Last year (2022) the loan balance reached $1.75 Trillion (92% of which was provided by the Federal government). The average college student graduated in 2023 with $37,718 in debt. Student loan debt accounted for 3.5% GDP in 2006. By 2020, it was up to 7.8% GDP.
This flood of cash mostly came from the government itself, which means that the normal discipline of the credit market did not apply. Today, almost anyone can obtain a government-backed student loan. The only requirements are (1) enrollment in college, (2) proof of citizenship or a greencard, and (3) a valid social security number. The Dept of Education website is clear: “You don’t need a credit check or a cosigner to get most federal student loans.”
For colleges, this new and market-discipline-free cash flow was a bonanza. By 2011, the annual value of new student loans surpassed 116% of the total annual tuition revenue of all public and private nonprofit colleges in the United States. By 2020, the student loan levels had declined (due at least in part to the moderation of loan demand from students burdened with so much debt already). But the value of the new loans that year still amounted to 68% of the total tuition revenue.
The mechanics are simple: If students can pay more – because they have access to easy credit – it means that colleges can charge more – without impacting the customers’ ability to pay. That is, they can raise prices without reducing demand. And so they have done so. Structural inflation, Q.E.D.
The federal student loan program structurally altered the market for higher education, stimulating and supporting the extraordinary tuition price increases shown here. Customers (students) with leverage had more money to spend (and repay later). Prices could rise without crimping the customer (at least in the front end where the payment for the attenuated transaction called a “getting a college degree” occurs – since no repayments are required until after graduation). College revenues meanwhile boomed, which allowed for the rapid expansion of expenses for non-teaching staff and infrastructure, and locked in the need for keeping the spigot open and flowing. That’s how this type of inflation can be “self-reinforcing” rather than self-correcting.
In short, the business model for higher education changed in a way that led to structural inflation. Tuition costs keep rising through good economic times and bad. They keep rising regardless of the direction of monetary policy. They keep rising even as fundamental demand softens, and the process appears to be self-reinforcing.
Summary
Some price trends are created by important changes in the structure of the economy, which alter the nature of supply and demand in ways that create inflation (or deflation) that is much more persistent and much harder to counteract than the “normal” form of inflation arising from transitory imbalances between supply and demand. The “affordability crisis” in higher education is an example of this type of inflation.
The scary part is the self-reinforcing character of structural inflation. It makes stopping it much harder, because there is no natural support from the market mechanism. Prices are disconnected from normal supply and demand, and the equilibrium-seeking tendency of the market cannot function.
College tuition only carries about a 1% weighting in the Consumer Price Index, and so contributes little to the broader inflationary trend. Yet there are other trends and factors which may create structural changes that are much broader, and may have macro-economic effects across the economy as a whole. In the next installment, we will consider a number of these potential sources of structural inflation on a larger scale.
For more on the topic of inflation, see also:
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