History Lessons: How “Transitory” Is Inflation?

Key Points

  • The US Federal Reserve Bank’s expectations for the speed of reverting to 2% inflation levels remains dangerously optimistic.

  • An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.

  • If inflation is cresting, inflation levels of 4 or 6% revert by half in about a year. If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years, threatening an extended period of high inflation.

  • Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.

"Those who cannot remember the past are condemned to repeat it."

-George Santayana

Bad news: History tells us that once the inflation genie is out of the bottle, it can take far longer to return to normal levels than most people realize. Indeed, when Federal Reserve Chair Paul Volker took office in 1979, he pushed the fed funds rate to an unprecedented 20%, 5% above the previous peak inflation rate, the equivalent of today’s Fed embracing double-digit rates. Even so, it took two more years for this extreme policy intervention to cut inflation to half its peak level (to 7%), and over six years to bring inflation to 2%. In a meta-analysis of 67 published studies on global inflation and monetary policy, Havranek and Ruskan (2013) found that across 198 instances of policy rate hikes of 1% or more, in developed economies the average lag until a 1% decrease in inflation was achieved was between roughly two and four years.

Those who expect inflation to fall rapidly in the coming year may well be correct. But, history suggests that’s a “best quintile” outcome. Few acknowledge the “worst quintile” possibility, in which inflation remains elevated for a decade. Our work suggests that both tails are equally likely, at about 20% odds for each.