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KC Fed economist: Inflation could become embedded if rate remains high

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Joe Mueller

(The Center Square) – The longer inflation remains above the Federal Reserve’s annual target of 2 percent, the harder it will be to reduce, according to an economist with the Federal Reserve Bank of Kansas City.

“It is widely believed that the longer inflation remains elevated, the greater the risk that high inflation will become self-reinforcing and thus embedded in the economy,” Amaze Lusompa wrote in the bank’s Economic Bulletin. “For example, workers experiencing high inflation are more likely to demand higher wages to compensate for rising costs. These higher wage costs, together with other increasing input costs, can cause firms to increase their prices to protect profit margins. In economic theory, this phenomenon is described as a wage-price spiral.”

Lusompa stated a key statistic in determining persistent price increases will be underlying inflation.

“Underlying inflation is the rate of inflation that would be expected to eventually prevail in the absence of economic slack, supply shocks, idiosyncratic relative price changes, or other disturbances,” Jeremy Rudd wrote in FEDS Notes in 2020. “Underlying inflation is a useful benchmark for monetary policy in that it provides an idea of the rate of price change that would be expected to obtain under ‘normal’ circumstances in an economy where the level of resource utilization is putting neither upward nor downward pressure on inflation.”

Lusompa used inflation projections from the Survey of Professional Forecasters and a slightly higher projection than the organization to chart two hypothetical paths. The first projection had inflation at 2 percent in 2024 and the higher projection at the level in 2025.

“The slow pace at which inflation declines under this assumption is comparable to the unwinding of the high-inflation episodes of the 1970s and 1980s,” Lusompa wrote.

However, if overall inflation increases it would increase underlying inflation.

“We also show that if inflation surprises to the upside and decays more slowly, underlying inflation could converge to approximately 3 percent and risk becoming embedded in the economy,” Lusompa wrote. “Therefore, the longer inflation stays elevated, the more difficult it may be for the Federal Reserve to reach its mandate of price stability.”

The Federal Reserve Bank of Kansas City covers western Missouri, Colorado, Kansas, Nebraska, northern New Mexico, Oklahoma and Wyoming.