This inflation defies the old models


Last April, economists thought inflation would be around 2.5% right now. Instead, it’s over 6%. Even by indulgent standards of economic forecasting, it’s a lack of epic proportions.

The explanations come in two schools. The Demand School accuses President Biden and the Federal Reserve of administering too many stimulus packages.

The supply school blames bottlenecks and supply chains linked to the pandemic.

In fact, it becomes clear that neither demand nor supply per se is to blame. On the contrary, this inflation was only made possible by a strong demand in interaction with a restricted supply. The United States has seen nothing like it except, perhaps, in the aftermath of World War II. Then, Biden’s Council of Economic Advisers noted, pent-up demand coincided with war-induced shortages. That makes the solution elusive: Fixing the offer is well beyond the means of the White House and the Fed, but treating the problem as one of the only needs could hurt the economy.

Consider the demand first. Federal spending and falling interest rates indirectly influence inflation, by strengthening aggregate demand which lowers unemployment. As the labor market tightens and available capacity shrinks, firms gain pricing power and workers earn higher wages. This inverse relationship between unemployment and inflation, known as the Phillips curve, was factored into economists’ spring forecasts which revealed that Mr Biden’s $ 1.9 billion stimulus package, enacted in March , would have only a slight impact on inflation. David Mericle, chief US economist at Goldman Sachs, puts the impact at 0.1 to 0.2 percentage point at most. Joel Prakken, Chief US Economist at IHS Markit,

said: “The current inflation rate can in no way be explained by the impact of fiscal stimulus through the usual channels of the Phillips curve.”

Federal Reserve Chairman Jerome Powell discussed at a Senate hearing the factors behind continued inflation and the risk the Omicron variant poses to the economy. Photo: Al Drago / Bloomberg News

What about the supply side? Global developments that have pushed up oil and gas prices partly explain the rise in inflation; core inflation, which excludes energy and food, was 4.6% in October. Core inflation has been heavily influenced by shortages of inputs, such as semiconductors for automobiles, and bottlenecks such as for ocean freight. Yet most other advanced economies suffered similar disruptions and their inflation rose less than that of the United States.

What sets the United States apart is the combination of tight supply in many sectors and demand inflated by stimulus measures. Normally, an industry responds to higher demand primarily by increasing production and only partially by increasing prices. (Economists would say the supply curve is going up). Sometimes, however, the supply is fixed (the supply curve is vertical). This is what characterizes the oil market. In 2008, demand from China surged as producers had little spare capacity. Oil prices have reached record highs, raising inflation around the world.

The auto market this year is similar to the oil market in 2008. Normally, auto manufacturers can easily meet increased demand. But this year, as low interest rates and pandemic-triggered needs drove demand higher, supply was corrected due to a lack of semiconductor chips. The result: a huge jump in prices that IHS Markit says explains about a third of the rise in the Federal Reserve’s preferred core inflation measure.

Many economists note that the inflation surge is concentrated in goods. This is because the pandemic has diverted consumer spending from services such as restaurant meals to products such as groceries. However, the unusual dynamic also extends to services.

The Covid-19 pandemic has diverted consumer spending from services such as restaurant meals to products such as groceries.


Jeenah Moon / Bloomberg News

The cost of housing, for example, is heavily dependent on house prices, which have risen 14% since the start of the year, according to Freddie Mac. Don’t blame the Fed: Lower mortgage rates since 2019 can explain at most 5 percentage points of the increase, concludes a review of various studies by the Federal Reserve Bank of New York. Don’t blame investors or speculators, either: Cash buyers’ share of home buying is normal, according to Freddie Mac.

Prices have gone up so much because demand is channeled into a few segments of the market. Demand has been particularly strong for existing entry-level homes in smaller domestic markets with limited inventory such as Idaho, while the “gateway” markets of New York, Los Angeles and San Francisco, Boston, Washington, DC and Miami are experiencing emigration, according to Freddie Mac. The resulting price dynamics can be “explosive,” said Sam Khater, Freddie’s chief economist.

Even the labor market has growing demand and a fixed supply. Demand for workers has surged as businesses reopen and consumers spend stimulus checks and stock market wealth. But supply has failed to respond, especially from the lowest paid workers on whom many service industries depend. In the hotel and restaurant industry, although demand and employment have not yet recovered to pre-pandemic levels, a severe shortage of workers has caused vacancies to double from their previous levels. pre-pandemic level. As a result, wages and prices in the sector are increasing rapidly.

The unusual origins of this inflation mean that the solution is not easy. Ideally, it will go away painlessly, as demand and supply distortions will correct themselves. The increased production of semiconductors will eventually alleviate the shortage of cars. A shrinking virus and less generous federal relief should prompt some workers to fill vacant positions. Households can have all the furniture, exercise equipment and pizza they want.

But this process could take some time; at the same time, higher inflation could be self-sustaining through pricing and wage fixing behavior. Then the solution to this unknown inflation becomes painfully familiar: higher interest rates and perhaps a recession.

Write to Greg Ip at [email protected]

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