The inflation story


March 2022

Q: There are a lot of economists skeptical that you can reduce inflation as much as you’ve penciled in without raising the unemployment rate. And I’m just wondering what are the mechanisms you see in reducing demand, outside of housing and autos, how do higher Fed rates reduce consumer demand, unless it’s through higher unemployment?

POWELL: If you take a look at today’s labor market, what you have is 1.7+ job openings for every unemployed person. So that’s a very, very tight labor market, tight to an unhealthy level I would say. So, in principle, let’s say that our tools work as you describe, and the idea is that we’re trying to better align demand and supply, let’s just say in the labor market. So if you were just moving down the number of job openings so they were more like 1 to 1, you would have less upward pressure on wages. You would have a lot less of a labor shortage, which is going on, pretty much across the economy, we’re hearing from companies that they can’t hire enough people, they’re having a hard time hiring. That’s really the thinking there, these are fairly well-understood channels, interest-sensitive and basically across the entire economy we would like to slow demand so that it’s better aligned with supply, give supply, at the same time, time to recover, and do a better alignment of supply and demand, and that, over time, should bring inflation down.

November 2022

Q: Do you see wages being a significant driver of inflation?

POWELL: You know, I think wages have an affect on inflation and inflation has an affect on wages. That’s always been the case. The question is, is that really elevated right now? I don’t think so. I don’t think wages are the principal story of why prices are going up. I don’t think that. I also don’t think we see a wage price spiral. But, again, it’s not something you can — once you see it, you’re in trouble. We don’t want to see it. We want wages to go up. We want them to go up at a level that’s sustainable and consistent with 2% inflation. We do think that given the data that we have this labor market can soften without having to soften as much as history would indicate through the unemployment channel. It can soften through job openings declining. We think there’s room for that. We won’t know that. That will be discovered empirically.

Q: If I could follow up on that. Thank you. The Fed has acknowledged in the past that the tools that you have don’t affect things like energy and food prices that stem from some of those conflicts overseas. And they’re some of the biggest pain points for consumer. As you pursue the current path you’ve outlined, is there a risk that some of those prices simply don’t come down?

POWELL: We don’t directly affect, for the most part, the food and energy prices, but it affects them at the margin. The thing about the United States is we also have strong — in many other jurisdictions, the principal problem really is energy. In the United States we have a demand issue. We have an imbalance between demand and supply in many parts of the economy. Our tools are well suited to work on that problem. That’s what we’re doing. You’re right. The price of oil is set globally. It’s not something we can affect. I think by the actions that we take, though, we help keep longer-term inflation expectations anchored and keep the public believing in 2% inflation by the things we do even at times when energy is part of the story of why inflation is high.

There are two separate but related stories that the Fed is telling of why inflation is high.

The first is that the labor market is out of balance. Job openings are too high relative to the number of job seekers; the labor market is “tight” to an “unhealthy level”; “companies can’t hire enough people”. At the same time, though, Chairman of the Fed Jay Powell claims he doesn’t “think wages are the principal story of why prices are going up”. The latter fact seems to be well-supported by empirical evidence, since wage growth is significantly lower than price growth (inflation), or, in other words, wages in real, as opposed to nominal, terms, are declining on average.

The second story is that aggregate demand exceeds aggregate supply. Driven by government spending (like the February 2021 American Rescue Plan), household savings ballooned. Consumers felt (and were) wealthier, and wanted to spend that money on more things. Simultaneously, the ability of the economy to supply goods was impaired by supply chain snafus, increases in energy prices, and labor market disruptions stemming from the pandemic. The cure for inflation, in this story, is to curb consumer demand. If households are too wealthy, that wealth needs to be drained, for instance by causing asset prices to fall (like stocks and housing). If consumers overall are able to afford too much, some of them must be fired so that demand overall decreases. (To quote Larry Summers, “We are unlikely to achieve inflation stability without a recession of a magnitude that would take unemployment towards the 6% range”)

One basic problem with these stories is that, as much as Powell drones on about “supply and demand”, inflation operates on a basket of goods and services, and each of these has its own supply and demand story. J.W. Mason, an economics professor at John Jay College, has written eloquently about this topic:

Rents are rising rapidly right now — at an annual rate of about 6 percent as measured by the CPI. And there is reason to think that this number understates the increase in market rents and will go up rather than down over the coming year. This is one factor in the acceleration of inflation compared with 2020, when rents in most of the country were flat or falling. (Rents fell almost 10 percent in NYC during 2020, per Zillow.) The shift from falling to rising rents is an important fact about the current situation. But rents were also rising well above 2 percent annually prior to the pandemic. The reason that rents (and housing prices generally) rise faster than most other prices generally, is that we don’t build enough housing. We don’t build enough housing for poor people because it’s not profitable to do so; we don’t build enough housing for anyone in major cities because land-use rules prevent it.

Rising rents are not an inflation problem, they are a housing problem. The only way to deal with them is some mix of public money for lower-income housing, land-use reform, and rent regulations to protect tenants in the meantime. Higher interest rates will not help at all — except insofar as, eventually, they make people too poor to afford homes.

Or energy costs. Energy today still mostly means fossil fuels, especially at the margin. Both supply and demand are inelastic, so prices are subject to large swings. It’s a global market, so there’s not much chance of insulating the US even if it is “energy independent” in net terms. The geopolitics of fossil fuels means that production is both vulnerable to interruption from unpredictable political developments, and subject to control by cartels.

The long run solution is, of course, to transition as quickly as possible away from fossil fuels. In the short run, we can’t do much to reduce the cost of gasoline (or home heating oil and so on), but we can shelter people from the impact, by reducing the costs of alternatives, like transit, or simply by sending them checks. (The California state legislature’s plan seems like a good model.) Free bus service will help both with the short-term effect on household budgets and to reduce energy demand in the long run. Raising interest rates won’t help at all — except insofar as, eventually, they make people too poor to buy gas.

It’s worth noting that Powell dodged questions related to this topic. In the excerpt quoted above, he acknowledged that energy prices are largely out of the Fed’s control, but indicated that this did not affect his thinking at all. On housing, there was this exchange.

Q: As you look around the economy, the clearest impact of your tightening so far has been on housing and maybe some tech companies. It’s lower in labor market a lot of sectors you don’t see a ton of effect. Is the pathway and channels changing? Is it narrower? In housing are you worried that your crimping housing supply that may be causing more problems down the road.

POWELL: I would say a big channel is the labor market and the labor is very, very strong. Households, of course, have strong balance sheets. We go into this with a strong labor market and excess demand in the labor market as you can see through many different things. Also with households who have strong spending power built up. So it may take time. It may take resolve and patience. It’s likely to get inflation down. I think you see from our forecasts and others, that it will take some time for inflation to come down. It will take time, we think.

Sorry, was I getting to your question there? The housing part of it. Yeah. So we look at housing — of course, housing is significantly affected by these higher rates, which are really back where they were before the global financial crisis. They’re not historically high, but they’re higher than they’ve been. You’re seeing housing activity decline. You’re seeing housing prices growing at a faster rate and in some parts of the country declining. The housing market was very overheated for a couple years after the pandemic as demand increased and rates were low. We all know the stories of how overheated the housing market was. Pricing going up, many, many bidders, no conditions. The housing market needs to get back into a balance between supply and demand. We’re well aware of what’s going on there.

Once again there is the tedious “balance between supply and demand” phrase bandied about, but nothing in Powell’s response indicates he truly grasps the problem that Mason outlines above. The Fed’s solution to the imbalance between housing supply and housing demand is to raise mortgage rates high enough that few homebuyers will be able to afford a mortgage. Mason’s solution is to, well, build more housing. One of these makes us worse off; the other makes us better off. So why should we believe the Fed is in the right here?

The story repeats across other sectors of the economy. The NYT had an interesting piece about food prices:

A year ago, a bag of potato chips at the grocery store cost an average of $5.05. These days, that bag costs $6.05. A dozen eggs that could have been picked up for $1.83 now average $2.90. A two-liter bottle of soda that cost $1.78 will now set you back $2.17.

Something else is also much higher: corporate profits.

In mid-October, PepsiCo, whose prices for its drinks and chips were up 17 percent in the latest quarter from year-earlier levels, reported that its third-quarter profit grew more than 20 percent. Likewise, Coca-Cola reported profit up 14 percent from a year earlier, thanks in large part to price increases.

Restaurants keep getting more expensive, too. Chipotle Mexican Grill, which said prices by the end of the year would be nearly 15 percent higher than a year earlier, reported $257.1 million in profit in the latest quarter, up nearly 26 percent from a year earlier.

Although food companies are prominent examples of how rapid inflation is being passed from producers to consumers, the trend is evident across a wide variety of industries. Executives from banks, airlines, hotels, consumer goods companies and other firms have said they are finding that customers have money to spend and can tolerate higher prices.

Now, it is certainly true that food prices would come down if we curbed “aggregate demand”, and if Larry Summers’s eagerly sought recession actually came to pass. But it is also true that food prices would come down if we attacked the kind of price gouging discussed above, or broke up corporations with monopolistic grips on the market, or went after corporate landlords or third parties (like Doordash) who indirectly increase costs for restaurants. Why is the Fed’s way better than the alternatives? Once again, if the Fed succeeds, it means that consumers are, in aggregate, poorer and worse off. That is not necessarily the case with the alternatives.

The Fed’s inflation story describes the things we thought were good about the economy — high household savings and healthy balance sheets, wage growth, low unemployment rate, competition by businesses for workers — and recasts them as bad things. What does it say about the economic system if its stability is incompatible with workers and consumers being well off? According to Powell, if consumers have the savings with which to spend more, then corporate profits will increase to capture those savings. And if workers have the bargaining power to demand higher wages, then prices will increase to nullify or even reverse those gains, in real terms. In this story, any effort to make workers better off makes them worse off. Heads, corporations win, tails, workers lose. If the story of inflation is that it happens when we are doing too well, then the conclusion seems to be that we should never do well at all.


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