Global inflation has shot up in the past year to multi-decade highs. But why has this happened and where do we go from here? To answer the first question, we have to start with the basics of Econ 101: supply and demand.
The laws of supply and demand dictate that higher prices will cause producers to increase supply, while consumers will subsequently scale back demand. This dynamic leads markets to clear at a price at which supply equals demand. This price mechanism, that Adam Smith termed “the invisible hand,” allocates resources without overt coercion.
While demand and supply changes are typically relatively slow and predictable, shocks do occasionally occur, most often on the supply side. A prominent example of a supply shock is the OPEC embargo of 1973/74, which led to the quadrupling of oil prices. And small supply shocks, often driven by weather events that curtail or expand supply, happen routinely. Demand shocks, on the other hand, are less frequent. An interesting, but perhaps little-known demand shock, took place in the mid-1930s when Clark Gable took off his button-down shirt and appeared bare-chested in a scene of It happened One Night, wowing movie-goers. Legend has it that undershirt sales, driven almost entirely by women, plummeted overnight as wives longing for their husbands to look like Clark Gable took matters into their own hands.
The examples I cite above are for individual products and services. What happens when prices in general go up or down, leading to inflation or deflation? Classic economic theory stipulates that changes in the relative price for a single or set of items, like energy, should not influence the general price level. Look at it this way: if the price of gasoline goes up, it eats up a bigger share of income so consumers have less to spend on other things, thereby imparting downward pressure on the prices of all goods.
I take a contrarian view about the link between relative price shocks and the general price level, as I argued in my MIT Master’s thesis about inflation during the 1970s. Relative prices matter because relative incomes matter for both individuals and businesses. A large exogenous shock that sends energy prices higher results in a big shift of income from energy consumers to energy producers. Rather than simply accepting that their absolute and relative standards of living have fallen, economic actors fight to restore the status quo ante. That might involve an energy cost surcharge for certain businesses such as shipping companies. For individuals that might mean demands for higher wages. The classical economic model where a shock causes some relative price to rise and therefore other prices must fall ignores human nature. People fight to keep their income and standard of living relative to peers. Inflation is the process through which relative prices and incomes adjust to shocks.
I’ve mentioned that supply/demand shocks can impact price levels, but what else can drive inflation? A shocking example of inflation was the post-WWI scenario in Germany. The Weimar Republic, bound by the terms of the Versailles Treaty to pay reparations to the Allies, began to print vast sums of money, eventually leading to hyperinflation and the collapse of the currency (and the rise of the Nazi party).
As painful as inflation can be, deflation can also have terrible consequences. As consumers defer purchases under the assumption that prices will be lower in the future, economic activity slows. This was the backdrop that led to the Great Depression and the current situation in Japan. Today, central banks target a low, but positive rate of inflation at 2%. (The reason for this, however, isn’t econometric). Low but positive inflation has other benefits besides avoiding deflation. It makes relative price and wage adjustments more palatable, serving as a social and economic lubricant, and leads to fewer constraints on the economy allowing for faster growth. But why has the job of creating conditions that lead to slow but low inflation fallen on the central bank and not on the government using fiscal policy to raise taxes or cut spending? Statute directs the Fed to have a dual mandate of promoting price stability and maximum employment. And importantly, politicians worried about facing an angry electorate are happy to let the Fed handle tough and unpopular inflation-fighting measures. So, when bringing down high inflation comes at the terrible cost of crushing the economy, as happened during Paul Volker’s reign at the Fed in the 1980s, there’s no doubt that the Fed can take the unpalatable but necessary steps.
Let’s return to today. Chairman Powell says the Fed is shooting for a soft landing but historically this has been very tough to do with inflation at its current level. The key to understanding where we are and where we are going is to ask why, after decades of low inflation, is inflation so high?
Part of the answer can be attributed to two policy mistakes. The $1.9 trillion American Rescue plan pushed through in early 2021 to stimulate economic activity squelched by the pandemic was too big, especially given that the economy was already recovering. Larry Summers, former Secretary of the Treasury, notes that the Federal government replaced every dollar of lost income from the pandemic with $3. Although highly successful at ameliorating economic and individual pain, the $7 trillion total pandemic relief expenditure contributed 3% to inflation in 2021 according to Fed researchers. But the Fed, by maintaining easy monetary policy and near-zero interest rates since the Great Financial Crisis - long past needed - also bears some responsibility. Still, despite these stimulative measures, inflation stayed mostly below the Fed’s 2% target. So, what’s changed in the last 15 months and why did the Fed get it wrong?
In my view, the biggest causes of current inflation are the unprecedent supply and demand shocks attributed to the pandemic and the war in Ukraine. For the five years from 2015-early 2020, goods demand rose at a modest yet steady pace. This predictable pattern meant companies and employees could plan efficiently. But amid pandemic-related restrictions imposed in March of 2020, goods demand plummeted by about 20%, almost overnight. Over the course of the next year, demand soared 50% from the low, hitting almost 20% above the pre-pandemic trend. It remains elevated at about 10% above trend. Services spending also fell by about 20% at the height of restrictions. Although it has rebounded, it remains about 5% below the trend line and slightly below pre-pandemic levels.