Supply-Side Inflation And Its Cures
The Federal Reserve failed to anticipate the worst inflation since the 1970s and is now administering medicine that will sicken rather than cure the patient. As Fed Chair Jerome Powell said recently: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions.”
This is entirely misguided: unlike the 1970s, today’s inflation is the result of too little labor and too little capital investment – in manufacturing as well as energy. To a great extent, it is a supply-side problem. Discouraging employment and investment by raising interest rates will only make things worse. What the United States requires, rather, is incentives for investment and employment in manufacturing and construction.
The impulse from inflation came from a fiscal shock in the form of federal transfer payments in response to the COVID-19 pandemic.
With a lag of zero to six quarters, transfer payments show a high correlation with year-on-year changes in the Consumer Price Index, as in the cross-correlogram above. A predictive equation that relates year-on-year changes in CPI with lagged values of transfer payments explains most of the change in CPI.
That is a basic difference between the present inflation and the inflation of the 1970s. Transfer payments were not an important factor in the last bout of high inflation.
The inflation of the 1970s, by contrast, occurred during a period of extremely rapid credit expansion.
During the period 1977–1979, the total loans and leases of U.S. commercial banks grew by a record 35%. During 2019–2021, by contrast, bank credit grew by less than 10%.
Extremely high credit growth as a driver of inflation implies deeply entrenched inflationary expectations. During the 1970s, market participants from homebuyers to corporations sought to buy real assets with debt, in the expectation that real assets would appreciate while the real cost of debt service would fall due to inflation. Paul Volcker’s Federal Reserve responded by drastically increasing the cost of credit in order to persuade investors to change their behavior.
Today’s inflation, by contrast, began with two fiscal shocks, in 2020 and 2021, respectively. It was not accompanied by rapid credit growth. On the contrary, credit outstanding at commercial banks fell during the first year of the pandemic, as the chart above makes clear. The demand-side inflationary shock from fiscal policy ran headlong into a supply-side barrier. U.S. industrial capacity could not meet the demand surge. The rise in transfer payments, meanwhile, discouraged labor force participation. A demand shock in the presence of capital and labor shortages was the cause of the present crisis.
The Federal Reserve’s response to inflation – namely, tightening credit conditions – is doubly wrong: it does not attack the source of inflation, and it discourages the capital investment required to solve the supply-side constraints.
In 1979, the Federal Reserve’s monetary tightening addressed the manifest problem of excess credit creation driven by inflation expectations. But the Volcker monetary tightening was only one half of a successful policy combination inspired by Robert Mundell: tight money to reduce inflation and deep tax cuts to promote growth. The 1981 Kemp-Roth tax cut reduced the U.S. top marginal personal rate to 40% from 70% and drew out reserves of labor and entrepreneurship.
The Supply-Side Constraints
The United States cannot marshal enough capital and labor to meet demand. Contrary to what we learn in Economics 101, demand curves in the U.S. seem to be sloping upward. Despite an unprecedented increase in the prices of homes and autos – the two largest items in the household budget for goods – supply has declined. Making sense of that anomaly is a precondition for effective policy.
Used car prices on the Manheim Index have risen 35% since 2019, while home prices are up more than 40%, according to the S&P Case-Shiller National Home Price Index.
Remarkably, the supply of new cars and new homes has declined despite the unprecedented rise in prices.
Manufacturers and builders can’t find workers. Job openings in both construction and manufacturing stand at the highest levels since data were compiled.
Labor force participation, meanwhile, is at a historic low for men and a generational low for women. Without question, fiscal support for incomes is a major cause of low labor force participation. As Goldman Sachs economists led by Jan Hatzius wrote in December 2021: “We attribute about one-half of the U.S. labor force participation rate shortfall to generous fiscal support, which likely discouraged labor supply. . . . Second, we attribute about a third of the U.S. participation shortfall to the form in which fiscal support was delivered, through generous unemployment benefits instead of job retention schemes. Such schemes kept workers attached to their employers in most of the OECD despite similarly large declines in hours worked. Finally, we estimate that the remaining one-sixth of the U.S. participation rate shortfall reflects the labor market response to virus fears, which have likely discouraged people from returning to work.”
Another factor affecting labor force participation is declining real compensation. The recent sharp decline in real median weekly earnings reported by the Bureau of Labor Statistics is as steep as during the 1980 recession. For low-income workers, the impact of inflation is worse due to bracket creep.
Manufacturing investment in real terms remains well below levels of a few years ago. Shown below are the projected capital expenditures for the 80 companies in the S&P 500 Industrial Sub-Index, deflated by the PPI for private investment goods.
Energy is a significant contributor to inflation. U.S. oil production remains below pre-pandemic levels due in large part to the Biden administration’s hostility to carbon fuel development, including a suspension of oil and gas leasing on public lands.
Capital Investment Remains Depressed
By another gauge – deflated orders for nondefense capital goods by U.S. manufacturers – most categories of capital goods are below their 2006 peak.
With domestic production constrained, American consumers bought a record amount of foreign products, and the U.S. trade balance reached an all-time low of $127 billion in March 2022, or more than $1.5 trillion annualized.
Conclusion
Tightening credit conditions is not a remedy for the present wave of inflation. It does not address the causes of inflation, and it will make inflation worse by constraining investment. The Federal Reserve should end its tightening cycle immediately. The United States urgently requires policy measures to increase supply. The Kemp-Roth tax cuts were an effective solution forty years ago, but conditions are different today. We need to revive investment in manufacturing, mining, and energy extraction, and we must encourage Americans to return to work.
Supply-side solutions to inflation should include:
1) Restoring incentives for U.S. oil and gas production
2) Revision of the corporate tax code to favor capital-intensive manufacturing investment (including full first-year tax deduction of capital investment)
3) An end to loopholes that permit Big Tech to shift intellectual property to low-tax countries overseas
4) Encourage firms to buy back their stock rather than invest in new capacity
5) Indexing of tax brackets for inflation and lowering of marginal tax rates for low- and middle-income workers at the federal and state level
6) Public-private partnerships for training skilled workers.
David P. Goldman is deputy editor of Asia Times, a Washington fellow of the Claremont Institute, and a senior writer for Law & Liberty.
Dampening Demand Necessary To Get Economy Moving
David Goldman makes a number of valid points that policymakers – fiscal and monetary – should consider as they work to restore price stability. First, that current inflation reflects an imbalance of supply and demand, in which supply constraints played a major role; second, that a key constraint was the decline in labor force participation; and third, that it would be much better for growth to rebalance the economy by increasing supply than by dampening demand.
Where we differ is in his belief that the Federal Reserve should not be trying to rebalance the economy and restore price stability by restraining demand through higher interest rates. I see no alternative that would reduce inflation sufficiently and soon enough to forestall having higher inflation perpetuate itself by becoming embedded in inflationary expectations.
To be sure, the transfer payments and accompanying expansionary fiscal policy contributed to the supply/demand imbalance. Goldman argues that’s because the transfer payments discouraged people from supplying labor; in my view, the causation ran importantly to the demand side – the payments t boosted spending. After all, the transfer payments have dropped back – no checks in the mail since spring 2021, and supplemental unemployment insurance ran out in September 2021. But labor force participation remains stuck about a percentage point below its level of early 2020. Interestingly, the labor force participation of prime-age workers (between 25 and 55) has almost recovered its pre-pandemic level; the shortfall remains concentrated in the over-55s, who retired in size much earlier than anticipated and haven’t come back. That could have reflected in some small part the transfers they received, reinforced by a rapid rebound in wealth as the economy rallied in 2020 and 2021, but it is not likely to be reversed any time soon. The economy will need to find a sustainable equilibrium without this source of labor supply.
Monetary policy contributed to the supply-demand imbalance with a highly expansionary policy held for too long in the mistaken belief that the price effects of the supply restraints from Covid would be short-lived. In addition, the Fed misjudged the degree of tightness in labor markets. The central bank was utilizing the time-honored metrics of the unemployment rate and labor force participation, expecting the latter to normalize to take pressure off the labor market. But as we see, that isn’t happening. Employers are bidding against one another for scarce labor, elevating wage gains to levels inconsistent with the Fed’s 2 percent inflation target. We can see the tightness in the number of job vacancies being advertised – down recently, but still extremely high – the reluctance of businesses to lay people off as demand weakens, and the elevated willingness of employees to quit for better or more lucrative work.
The interest rate increases that we have seen to date have been taking way the monetary over-stimulus left in place for too long. But getting rates up to “neutral” and raising the unemployment rate only a little is not likely to be enough in these circumstances. Because of the Fed’s actions and rhetoric, longer-term inflation expectations have remained reasonably well anchored around the Fed’s 2 percent target. But as high inflation persists and spreads widely through the economy, dampening demand and taking pressure off the labor market seems the only assured way to price stability.
In the projections of the Federal Open Market Committee in September, Fed policymakers saw the funds rate needing to get to a moderately restrictive level and the unemployment rate needing to rise a little – by 1/2 a percentage point – over its longer-run sustainable level to restore price stability in the next few years. I don’t know whether the exact numbers the committee projected are right, but the general proposition is sound. History demonstrates unequivocally that high-enough interest rates restrain inflation, and stable prices are the environment that businesses need to plan and execute capital decisions that will enhance the supply side of the economy.
At the same time the Fed is dampening demand, the fiscal and regulatory authorities should be trying to expand supply to ease and speed the return to price stability. Without commenting on the specifics of the list of suggested actions, they don’t seem sure enough or fast-acting enough to reduce inflation in the next few years. (An increase in immigration, expanding the labor force, might have quicker effects, but that option wasn’t on the list.)
Unfortunately, dampening demand – inflicting some pain, as Jay Powell has remarked – seems necessary to put the economy and prices on a more sustainable path, setting the stage for sustained expansion and the increased investment it will bring.
Donald Kohn holds the Robert V. Roosa Chair in International Economics and is a senior fellow in the Economic Studies program at the Brookings Institution.
Congress, Not The Fed, Will Have To Cure Bidenflation
David Goldman did a terrific job explaining the factors that are inhibiting economic growth and fueling inflation. He’s right that The Federal Reserve Board (and the White House) has been wrong at every turn on the inflation crisis. It isn’t temporary/transitory; it isn’t “a high-class problem;” and it isn’t going away on its own.
But Fed chairman Jerome Powell can’t solve this problem on his own by simply raising interest rates as he did for the fourth time this year last week. More rate hike runs like this risks crushing private sector and household demand. This is the austerity solution. The flattening of the economy is as likely to create stagflation (lower output and still-high prices) as it is to tame our 40-year high in inflation.
To bring inflation down, we need to fully understand what started the forest fire of rising prices in the first place.
The culprit is what I call the globe’s new deadly virus, and I’m not talking about the latest strain of Covid. No, this virus is multitrillions of dollars of government spending and debt, unprecedented in modern times. In the U.S., we added $2 trillion of debt during the early days of Covid and the catastrophic lockdowns of businesses in 2020. Then Biden came into office and poured kerosene on the fire with $4 trillion more in debt spending. We should have been cutting spending in 2021 and 2022, but we did the opposite.
Add this Mount Everest of government all together and we have spent more than we did adjusted for inflation to win World War II. What have we gotten in return for all that money spent – especially on welfare benefits? Windmills, unemployment benefits, student loan bailouts, and the like. In other words, zero-return investments.
Biden is partially right that the inflation is global, though five major countries – including Japan, at 3% – with lower inflation rates than we have in the U.S.
But the global inflation, especially in Europe and the U.K., has been caused by exactly the same fiscal blunders made in America. The governments and central banks of advanced economies have spent and borrowed more than $22 trillion since 2020. The balance sheets (debt purchases) of the ECB, the Federal Reserve Board, and the Bank of England have all expanded by trillions of dollars, pounds, and euros. And voila: we have raging inflation, now exceeding 11% in Europe and Britain.
All this means that it’s time for massive and immediate cutbacks in government spending. I have called for at least a $1 trillion package of cuts immediately from Congress. Europe and Britain should do the same. These will boost growth by lowering government debt which is only crowding out private investment.
The spending cuts shouldn’t be difficult. The plan should start by dramatically cutting welfare benefits for employable adults – and requiring work for those who do get benefits. These programs, which have been expanded by trillions of dollars, are a double whammy in the fight against inflation: they increase consumer demand with government money, while reducing the supply of goods and services by reducing productive work.
This doesn’t mean slashing the social safety net. In many states, according to a study by University of Chicago economist Casey Mulligan, a family of four can still receive more than $80,000 a year in benefits with neither parent working a single hour. This is a major reason Americans aren’t going back to work despite more than eight million job openings. Getting Americans back on the job is a critical component of an anti-inflation strategy.
Congress must also investigate and pursue the criminal scamsters who ripped off more than $200 billion in welfare and unemployment payments. Another high priority must be to end the $300 billion green-energy slush fund that Biden passed. That money should never get spent. The last thing we need from Washington is more Solyndras – the solar company that was given hundreds of millions of taxpayer dollars and went belly up.
Finally, the U.S. is losing $100 billion a year in domestic energy output due to Biden’s war on fossil fuels. This has raised the price of energy, which has reverberated throughout all sectors of the economy in the form of higher prices. More American energy means lower prices.
The Fed wants to fight inflation with private sector austerity. The have it reversed. We need government austerity coupled with strategies to expand private sector business and household income growth. The lesson of the last three years is that our progressive experiments in universal national income and Modern Monetary Theory have been colossal failures. They’ve steamrollered the middle class with $4,000 of real declines in income and multiple times more in lost savings.
Inflation of 8 to 9 percent is a prosperity killer. The Fed does need to restrain the growth of the money supply, but it’s much more urgent that Congress cut the overgrowth of its own spending. That might take a chainsaw. If Congress and the president pass a credible package of spending and debt reductions, inflation will subside – and to quote my favorite economist, Chauncy Gardener, in the spring there will be growth.
Stephen Moore is a senior economist with Freedom Works and a distinguished fellow at the Heritage Foundation.
Inflation Then Versus Inflation Now
Donald Kohn and Stephen Moore are distinguished practitioners in monetary economics, and I am grateful for and honored by their comments. I have read Dr. Kohn’s work avidly for three decades and learned a great deal from him. I am disappointed, though, that he did not address a key issue raised in my essay: a radical difference between inflation now and in the 1970s is credit expansion. Bank credit growth clearly led inflation forty years ago, but during the past two years, credit expansion has lagged inflation. That much is clear visually from the chart below.
Paul Volcker’s Federal Reserve was correct to tighten credit in 1979. In tandem with Ronald Reagan’s supply-side tax cuts, tight monetary policy achieved disinflation and growth. In the present environment, higher interest rates have not deterred households and businesses from borrowing. On the contrary, the Fed’s efforts to tighten credit conditions may have created a perverse effect, leading to preemptive borrowing to lock in credit before rates rise further.
With wages rising at 6.2% per year as of September according to the Atlanta Federal Reserve, and CPI rising at 8.2% per year, real wages are falling. Meanwhile, BB-rated speculative grade borrowers can borrow at 7.7%, below the inflation rate. Businesses continue to borrow and hire as long as real rates are negative and real wages are falling. The evidence is not yet in, but the Jerome Powell Fed may have set in motion a perverse response that perpetuates rather than suppresses inflation.
It is certainly true, as Dr. Kohn observes, that easy credit conditions contributed to some part of inflation, notably in the housing sector (although the shelter component of CPI began to rise only during the last two months, due to lags in translating rent increases into reported inflation). But that does not explain why housing supply hasn’t responded to higher prices. There were 422,000 job openings in construction in September, nearly double the pre-COVID level. That is a supply constraint, not a credit-related phenomenon.
I am grateful for Stephen Moore’s kind words and reciprocate by seconding his recommendations for fiscal policy. The demand shock that hit the U.S. and most other advanced economies was fiscal rather than monetary, and spending restraint is essential. In effect, the Federal Reserve has been asked to put its thumb over the mouth of a bottle of soda that was first shaken by the Treasury. As Moore explains with great clarity, federal handouts for employable adults explain why we have 11 million job openings today compared to 7 million before COVID.
I concur with Moore that barriers to domestic hydrocarbon production are a big contributor to inflation. Our manufacturing capital stock has also shrunk, in part because the federal tax code is biased against capital-intensive investment. The 2017 corporate tax cut reduced the headline tax rate but also reduced depreciation allowances. The Tax Foundation argues sensibly that businesses should be able to deduct 100% of capital investments in the year they are made. Supply-side incentives are required as much for capital as they are for labor.
An underappreciated element of the Reagan policy mix was a robust commitment to high-tech R&D, motivated by our Cold War defense requirements. The federal development budget in the late 1970s and 1980s stood at about 1% of GDP, or about $230 billion in today’s dollars, versus just 0.30% of GDP today. Public-private partnerships, in which federal funding defrays the cost of basic research while private capital bears the risk of commercialization, contributed to high productivity growth in the past. Sluggish productivity growth is an important contributor to inflation; reviving the public-private partnerships that drove high-tech industry in the Reagan era could contribute to a productivity revival.
David P. Goldman is deputy editor of Asia Times, a Washington fellow of the Claremont Institute, and a senior writer for Law & Liberty.