Inflation is muted, but not for long. Inflation is coming in the next two years, then will be followed by a boom/bust business cycle, or maybe two.

Over the past 12 months, consumer prices excluding food and energy have increased 1.5%, right in line with the average since the last recession. Including food and energy produces a slightly lower figure. We economists like to exclude food and energy because they cycle up and down separately from the overall inflation trend. These short-term changes usually reverse themselves in a year or two.

Individual prices also change a great deal more than the average, reflecting supply-demand imbalances in specific parts of the economy. These eventually work themselves out and do not change the overall inflation rate.

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The inflation that is dangerous is broad-based and long-lasting. It robs people of value. They may have as many dollars as before, but the dollars are worthless. Inflation also biases decisions as consumers and businesses adjust their affairs to reduce their damage. Inflation can cause businesses to show fake profits that would be subject to taxation. For example, a retailer usually earns a markup, the difference between the wholesale price and retail price. With inflation, the retailer also collects the amount by which prices rose while the product was on the shelf. But this is fake profit because when the product is sold, the retailer will have to replace it at a high price. This fake profit is fully taxable. Businesses can mitigate this damage, but that involves doing things that otherwise would be unprofitable. The overall economy is damaged.

Similarly, investors may sell an asset at a dollar profit but not an economic profit. If prices rise 10%, and my investment goes up 13%, then I’m only up 3% in purchasing power. The government, though, will tax me on my entire 13% profit, leaving me with less purchasing power than I had started with.

Persistent high inflation also correlates with a more volatile economy, with more recessions and rebounds than during eras of low inflation. This result is not inevitable, but it’s common. The period from 1965 through 1985 illustrates the phenomenon. The episode began with Presidents Kennedy and Johnson spending more on the Vietnam War and on Great Society social programs here at home. The Federal Reserve accommodated fiscal policy by increasing the money supply rapidly.

Then the Fed tightened sharply in 1970, triggering a recession. To get out of that recession, they pushed the money supply up sharply. As inflation rose, the Fed tightened again, causing the 1973-75 recession. Then more easing and another round of tightening that sent the economy into the very severe double-dip recession of 1980-82. Something like this could be our future.

The monetary base, which is the raw material from which dollars are made, has jumped over 50% in the past 12 months. The actual stock of money, counting paper currency and balances in bank deposit accounts, has increased 26%. Usually the relationship is one-to-one, but much of the monetary base is sitting idle as reserves that commercial banks hold at their Federal Reserve Bank. The extra monetary base is dry tinder or a ticking time bomb, choose your own metaphor.

The increased money supply has not yet triggered inflation, largely because the money’s owners have chosen not to spend. Consumers have used their stimulus checks and extra unemployment insurance largely to pay down debt and to build up their checking accounts. Similarly, many businesses took Paycheck Protection Program loans not because they needed the money immediately, but as a buffer in case, things got worse. Outside of leisure and hospitality, things didn’t get much worse. With the loans being forgiven now, the cash in sitting in the business checking accounts.

Having money that does not get spent is unusual. As a joke, I sometimes say it’s un-American. But large cash deposits, along with much credit card debt having been paid down, is dry tinder or a ticking time bomb, again choose your metaphor. Bank loans to consumers have dropped 5.0% in the past 12 months. Bank lending often drops in recessions, because banks are more cautious and also because consumers are more cautious. The lower debt burden enables consumers to ramp up their spending when their jobs and confidence improve. The composition of debt has also moved in a dry tinder direction. Credit card balances have dropped, while automobile lending has increased. With those car loans mostly at low fixed interest rates, consumers enjoy low payments and are protected from rising interest costs.

At some point, probably late in 2021, consumers will feel more confident about their finances, and they will resume spending growth. They will have substantially more resources to do that. Businesses will see their customers spending more and will invest in equipment, computers and real estate to serve them. Both consumers and businesses have now, and will have even more in the future, the capacity to spend.

The traditional formula for inflation is too many dollars chasing too few goods and services. The extra spending that will come would be fine if the country’s productive capacity increased proportionately. That has not been the case, however. Our productive capacity is, at first approximation, based on the available labor force and on productive equipment, machinery and computers. Retirements surged in 2020, running twice the growth as in recent years. Many parents left the workforce when schools closed or went virtual, but most parents will return to work when the schools normalize in September. Still, the extra retirements will reduce our productive capacity.

Investment in capital equipment for nonresidential use dropped in 2020, both for structures and for equipment. We don’t yet have estimates of depreciation, so we don’t know if the total productive capacity grew or shrunk, but it certainly did not grow as fast as it had in recent years, The Federal Reserve estimates a small loss of industrial capacity over the 12 months ending January 2021, though their data sources are still incomplete. Production capacity certainly did not grow so fast that we kept up with potential consumer spending. Much of the business spending that did occur was for goods not previously needed, but necessary in a pandemic: laptop computers, webcams and audio gear. Throw in some partitions and other social distancing tools, and companies spent more just to do the same old things.

Inflation will result from the upcoming expansive spending amidst limited increases in the production of goods and services. There is no avoiding it unless the Federal Reserves begins sopping up excess liquidity in mass amounts.

That won’t happen, because the Fed changed its approach to monetary policy last year by focusing on “outcomes-based policy.” For example, their latest statement includes this:  “With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well-anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.”

In plain English, the Fed wants to get inflation above two percent for a while. Then they will think about whether inflation has been too high for too long, compared with an average of two percent over a long period. Inflation in 2018 was just a hair above target, then we had two years well below target. That would easily justify continued easy money policy through the end of 2022 and well into 2023. Monetary policy operates with long time lags, though, so inflation would likely continue to accelerate through 2024 and into 2025. At that point, if my forecast is correct, they would feel the need to tighten sharply. The odds of the Fed getting their tightening exactly right in both timing and magnitude are very low. The next recession is too far away to predict exactly when it will begin, or how harsh it will be, but a recession is almost inevitable given the existing stimulus and the Fed’s new policy.

Those who worried about inflation a decade ago have been proved wrong. But that does not mean the invulnerability of our economy to inflation. With all of the stimulus being poured in, inflation is inevitable, and boom bust cycles will likely follow the rising inflation.