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Those who warned that current macroeconomic policies risk sustained higher inflation were tempted to turn to victory this week. Both the United States and the United Kingdom published very high inflation figures: in just one month, the British consumer price index rose 1.1 percent, the American consumer price index rose 0.9 percent and the harmonized consumer price index of the euro zone rose 0.7 percent (the last two were both seasonally adjusted). If such price changes continued for over a year, we would see annualized inflation of over 10 percent.
Keyword Lawrence Summers, calling on “Team Transitory” to “step down”, Martin Wolf channeled the 1970s and my Swamp Notes colleagues agree that “Summers was right”. The implication of these views is that the US Federal Reserve should curb its monetary stimulus, a policy conclusion that Jason Furman presented at length in a recent speech.
These are sharp commentators, well aware of the uncertainty surrounding their judgments. But there is a consensus in the broader, more lazy public debate that it has now become somewhat ridiculous to refer to this level of inflation as “temporary”. The implication is that those who want macroeconomic policies to continue to stimulate the economy are guilty of a grave mistake. Sustained demand impulses risk sustained higher inflation or a recession caused by the need to raise interest rates much more drastically after exiting too late.
What can Team Transitory that I’m proud of answer? The honest thing is to reconsider what we’ve said in the past to see if the current surge in inflation proves us wrong. In my case, my most relevant post was in April 2020. I wrote at the time that we had to expect an increase in inflation and that this would be a good thing:
“We shouldn’t be too concerned about this suppressed inflation. To the extent that reduced production catches up with sustained demand later on, inflationary pressures will be removed – and it is precisely by maintaining nominal incomes that we have the best chance of maintaining production capacity through the crisis. In fact, we should hope that once the pent-up demand is released from its effective rationing, demand pressures will boost production beyond normal capacity, as businesses and people may be willing to put in extra efforts to make up for lost time.
Against this background, we should view the acceleration of the standard inflation indicators as a triumph. That would mean that we do not let demand fall below the economy’s amputated supply capacity; in other words, that we maximized the chance for a quick recovery after the crisis ended. Conversely, if inflation is too low, we should be concerned, as that would mean that we are causing demand to fall even more than supply. “
It may be too early to claim my triumph, but I certainly don’t mind the latest inflation figures. I am also not embarrassed about another relevant article in which I pointed out that inflation has actually been falling on both sides of the Atlantic for the past two months. That remains correct – the increases in October followed months of declining inflation. I wrote at the time that “inflation could still be resolved”. But the fact that the slowdown in inflation then didn’t prevent it from rising today should tell us that a month’s increase doesn’t have to mean that inflation cannot slow down again anytime soon.
The reason for thinking it could be is what I referred to as the “ketchup-bottle economy” in May. Many of the obvious causes of the current high inflation – extraordinary fiscal stimulus and constraints in manufacturing supply chains – are very likely to be reversed. This has not changed.
But on the contrary; The ketchup bottle argument is reinforced when we discover that both bottlenecks and inflation are predominantly in the production of goods and not in service production. (The UK is a little different, probably because of the trade disputes it has imposed on itself by leaving the EU.) A new, short article in the Bank for International Settlements bulletin underscores this point (see also the excellent Twitter thread by BIS research director Hyun Song Shin). It indicates that the pandemic is the composition demand for services to goods and that the production of goods is more vulnerable to bottlenecks and the “bullwhip” effect, where producers throughout the supply chain hoard inventory to avoid bottlenecks. However, when demand shifts back to services, the opposite mechanisms come into effect:
“Some price trends could even be reversed if bottlenecks and preventive hoarding behavior abate. The mechanical effect on the CPI could very well become disinflationary in this second phase. “
Look at the magnitude of this effect in the United States. Here is the evolution of personal consumer spending on goods and services.
Notice two things about this diagram. People were able to keep consumption going – while the graph shows nominal consumer spending, inflation-adjusted private consumer spending has also increased by 3.5 percent since the beginning of the pandemic. That alone is a political victory to be celebrated in the worst economic disruption in a century. Second, the shift in consumption towards goods is enormous. The share of services in private consumer spending has fallen from 69 to 65 percent since February 2020. The growth in nominal demand for goods of around 22 percent during this period is much stronger than the fiscal stimulus that the economy as a whole.
So it’s no wonder that goods prices are soaring. As a result, inflation is in large part a product of shifts in the composition of demand, rather than the total amount of demand. Take a look at the table below and write to me if you can see any acceleration in service prices. All of the rise in US inflation is due to commodity prices.
The single most important question for the inflation debate should therefore be whether the demand patterns will shift back towards services. There are signs of this: spending on durable goods has fallen 8 percent since April.
What about politics? Those warning of inflation consider it a policy mistake to wait to tighten. In the spirit of our responsibility, let me share what I wrote to a colleague who is on the other side of the inflation debate:
“I would like to admit that I was wrong about the following circumstances: a) In early 2023 inflation was consistently above 5%; b) the Fed tightened its monetary policy significantly in 2022; c) Employment has stagnated and even declined, and there is little sign of inflation subsiding. ”That is, inflation does not go away on its own and the Fed is causing damage by acting too late.
The inflation worries want the Fed to avoid this now through preventive tightening. But let’s be clear what that means. Monetary policy reduces inflationary pressures by reducing activity in the economy. Hawkish calls for the recommendation that the U.S. economy – still below the pre-pandemic trend and with millions less people in work – should have less consumption or investment (or both) than people are currently enjoying.
This looks like a much worse mistake to me. It ignores the very likely possibility of a ketchup bottle dynamic. It fails to recognize that less consumption and less investment mean less economic well-being. Above all, it seems to be blind to the fact that the high demand is having its desired effect on the increase in supply. Despite the talk of bottlenecks, people are actually managing to consume significantly more goods than would be the case with the pre-pandemic trends. The BIS points out that semiconductor exports from East Asia are higher than in 2019. In short, capitalist globalization is working!
The supply grows because the demand is there. If producers expect demand to stay hot, they will invest in larger capacity. If, on the other hand, they are taught – again – that informed policy will curb demand as soon as demand exceeds supply, the growth incentive disappears. That’s the mistake we’ve made over the past 30 years. It would be a tragedy to come back to this when we learn that we can actually do better.
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