Tag: inflation

Does the Fed Still Believe in the NAIRU?

(I write occasional opinion pieces for Barron’s. This one was published there in October 2024. My previous pieces are here.)

Not long ago, there was widespread agreement on how to think about monetary policy. When the Federal Reserve hikes, this story went, it makes credit more expensive, reducing spending on new housing and other forms of capital expenditure. Less spending means less demand for labor, which means higher unemployment. With unemployment higher, workers accept smaller wage gains, and slower wage growth is in turn passed on as slower growth in prices — that is, lower inflation. 

This story, which you still find in textbooks, has some strong implications. One is that there was a unique level of unemployment consistent with stable 2% inflation — what is often called the “nonaccelerating inflation rate of unemployment,” or NAIRU. 

The textbook story also assumes that  wage- and price-setting depend on expectations of future prices. So it’s critical for central banks to stabilize not only current inflation but beliefs about future inflation; this implies a commitment to head off any inflationary pressures even before prices accelerate. On the other hand, if there is a unique unemployment rate consistent with stable inflation, then the Fed’s mandate is dual only in name. In practice, full employment and price stability come to the same thing.

In the early 21st century, all this seemed sufficiently settled that fundamental debates over monetary policy could be treated as a question for history, not present-day economics.

The worldwide financial crisis of 2007-2009 unsettled the conversation. The crisis, and, even more, the glacial recovery that followed it, opened the door to alternative perspectives on monetary policy and inflation. Jerome Powell, who took office as Federal Open Market Committee chair in 2018, was more open than his predecessors to a broader vision of both the Fed’s goals and the means of achieving them. In the decade after the crisis, the idea of a unique, fundamentals-determined NAIRU came to seem less plausible.

These concerns were crystallized in the strategic review process the Fed launched in 2019. That review resulted, among other things, in a commitment to allow future overshooting of the 2% inflation target to make up for falling short of it. The danger of undershooting seemed greater than in the past, the Fed acknowledged.

One might wonder how much this represents a fundamental shift in the Fed’s thinking, and how much it was simply a response to the new circumstances of the 2010s. Had Fed decision-makers really changed how they thought about the economy?

Many of us try to answer these questions by parsing the publications and public statements of Fed officials. 

A fascinating recent paper by three European political scientists takes this approach and carries it to a new level. The authors—Tobias Arbogast, Hielke Van Doorslaer and Mattias Vermeiern—take 120 speeches by FOMC members from 2012 through 2022, and systematically quantify the use of language associated with defense of the NAIRU perspective, and with various degrees of skepticism toward it. Their work allows us to put numbers on the shift in Fed thinking over the decade. 

The paper substantiates the impression of a move away from the NAIRU framework in the decade after the financial crisis. By 2019-2020, references to the natural rate or to the need to preempt inflation had almost disappeared from the public statements of FOMC members, while expressions of uncertainty about the natural rate, of a wait-and-see attitude toward inflation, and concern about hysteresis (long-term effects of demand shortfalls) had become more common. The mantra of “data dependence,” so often invoked by Powell and others, is also part of the shift away from the NAIRU framework, since it implies less reliance on unobservable parameters of economic models. 

Just as interesting as the paper’s confirmation of a shift in Fed language, is what it says about how the shift took place. It was only in small part the result of changes in the language used by individual FOMC members. A much larger part of the shift is explained by the changing composition of the FOMC, with members more committed to the NAIRU gradually replaced by members more open to alternative perspectives. 

The contrast between 2014-2018 Chair Janet Yellen and Powell is particularly noteworthy in this respect. Yellen, by the paper’s metric, was among the most conservative members of the FOMC, most committed to the idea of a fixed NAIRU and the need to preemptively raise rates in response to a strong labor market. Powell is at the opposite extreme — along with former Vice Chair Lael Brainard, he is the member who has most directly rejected the NAIRU framework, and who is most open to the idea that tight labor markets have long-term benefits for income distribution and productivity growth. The paper’s authors suggest, plausibly, that Powell’s professional training as a lawyer rather than an economist means that he is less influenced by economic models; in any case, the contrast shows how insulated the politics of the Fed are from the larger partisan divide.

Does the difference in conceptual frameworks really matter? The article’s authors argue that it does, and I agree. FOMC members may sincerely believe that they are nonideological technicians, pragmatically responding to the latest data in the interests of society as a whole. But data and interests are always assessed through the lens of some particular worldview. 

To take one important example: In the NAIRU framework, the economy’s productive potential is independent of monetary policy, while inflation expectations are unstable. This implies that missing the full employment target has at worst short-term effects, while missing the inflation target grows more costly over time. NAIRU, in other words, makes a preemptive strike on any sign of inflation seem reasonable. 

On the other hand, if you think that hysteresis is real and important, and that inflation is at least sometimes a question of supply disruptions rather than unanchored expectations, then it may be the other way round. Falling short of the employment target may be the error with more lasting consequences. This is a perspective that some FOMC members, particularly Powell and Brainard, were becoming open to prior to the pandemic.

Perhaps even more consequential: if there is a well-defined NAIRU and we have at least a rough idea of what it is, then it makes sense to raise rates in response to a tight labor market, even if there is no sign, yet, of rising inflation. But if we don’t believe in the NAIRU, or at least don’t feel any confidence about its level, then it makes more sense to focus more on actual inflation, and less on the state of the labor market.

By the close of the 2010s, the Fed seemed to be well along the road away from the NAIRU framework. What about today? Was heterodox language on inflation merely a response to the decade of weak demand following the financial crisis, or did it represent a more lasting shift in how the Fed thinks about its mission?

On this question, the evidence is mixed. After inflation picked up in 2022, we did see some shift back to the older language at the Fed. You will not find, in Powell’s recent press conferences, any mention of the longer-term benefits of a tight labor market that he pointed to a few years ago. Hysteresis seems to have vanished from the lexicon. 

On the other hand, the past few years have also not been kind to those who see a tight link between the unemployment rate and inflation. When inflation began rising at the start of 2021, unemployment was still over 6%; two years later, when high inflation was essentially over, unemployment was below 4%. If the Fed had focused on the unemployment rate, it would have gotten inflation wrong both coming and going.

This is reflected in the language of Powell and other FOMC members. One change in central-bank thinking that seems likely to last, is a move away from the headline unemployment rate as a measure of slack. The core of the NAIRU framework is a tight link between labor-market conditions and inflation. But even if one accepts that link conceptually, there’s no reason to think that the official unemployment rate is the best measure of those conditions. In the future, we are likely to see discussion of a broader set of labor-market indicators.

The bigger question is whether the Fed will return to its old worldview where tight labor markets are seen as in themselves an inflationary threat. Or will it stick with its newer, agnostic and data-driven approach, and remain open to the possibility that labor markets can stay much stronger than we are used to, without triggering rising inflation? Will it return to a single-minded focus on inflation, or has there been a permanent shift to giving more independent weight on the full employment target? As we watch the Fed’s actions in coming months, it will be important to pay attention not just to what they do, but to why they say they are doing it.

 

FURTHER THOUGHTS: I really liked the Arbogast et al. paper, for reasons I couldn’t fully do justice to in the space of a column like this.

First of all, in addition to the new empirical stuff, it does an outstanding job laying out the intellectual framework within which the Fed operates. For better or worse, monetary policy is probably more reliant than most things that government does on a consciously  held set of theories.

Second, it highlights — in a way I have also tried to — the ways that hysteresis is not just a secondary detail, but fundamentally undermines the conceptual foundation on which conventional macroeconomic policy operates. The idea that potential output and long-run growth (two sides of the same coin) are determined prior to, and independent of, current (demand-determined) output, is what allows a basically Keynesian short-run framework to coexist with the the long-run growth models that are the core of modern macro. If demand has lasting effects on the laborforce, productivity growth and potential output, then that separation becomes untenable, and the whole Solow apparatus floats off into the ether. In a world of hysteresis, we no longer have a nice hierarchy of “fast” and “slow” variables; arguably there’s no economically meaningful long run at all.1

Arbogast and co don’t put it exactly like this, but they do emphasize that the existence of hysteresis (and even more reverse hysteresis, where an “overheating” economy permanently raises potential) fundamentally undermine the conventional distinction between the short run and the long run.

This leads to one of the central points of the paper, which I wish I’d been able to highlight more: the difference between what they call “epistemological problematization” of the NAIRU, that is doubts about how precisely we can know it and related “natural” parameters; and “ontological problematization,” or doubts that it is a relevant concept for policy at all. At a day to day operational level, the difference may not always be that great; but I think — as do the authors — that it matters a lot for the evolution of policy over longer horizons or in new conditions.

The difference is also important for those of us thinking and writing about the economy. The idea of some kind of “natural” or “structural” parameters, of a deeper model that abstracts from demand and money, deviations from which are both normatively bad and important only in the short term — this is an incubus that we need to dislodge if we want to move toward any realistic theorizing about capitalist economies. It substitutes an imaginary world with none of the properties of the world that matter for most of the questions we are interested — a toy train set to play with instead of trying to solve the very real engineering problems we face.

I appreciate the paper’s concluding agnosticism about how far the Fed has actually moved away form this framework. As I mentioned in the piece, I was struck by their finding that among the past decade’s FOMC members, Powell has moved the furthest away from NAIRU and the rest of it. If nothing else, it vindicates some of my own kind words about him in the runup to his reappointment.2

This is also, finally, an example of what empirical work in economics ought to look like.3 First, it’s frankly descriptive. Second, it asks a question which has a quantitative answer, with substantively interesting variation (across both time and FOMC members, in this case.) As Deirdre McCloskey stressed in her wonderful pamphlet The Secret Sins of Economics, the difference between answers with quantitative and qualitative answers is the difference between progressive social science and … whatever economics is.

What kind of theory would actually contribute to an … inquiry into the world? Obviously, it would be the kind of theory for which actual numbers can conceivably be assigned. If Force equals Mass times Acceleration then you have a potentially quantitative insight into the flight of cannon balls, say. But the qualitative theorems (explicitly advocated in Samuelson’s great work of 1947, and thenceforth proliferating endlessly in the professional journals of academic economics) don’t have any place for actual numbers.

A qualitative question, in empirical work, is a question of the form “are these statistical results consistent or inconsistent with this theoretical claim?” The answer is yes, or no. The specific numbers — coefficients, p-values, and of course the tables of descriptive statistics people rush through on their way to the good stuff — are not important or even meaningful. All that matters is whether the null has been rejected.

McCloskey, insists, correctly in my view, that this kind of work adds nothing to the stock of human knowledge. And I am sorry to say that it is just as common in heterodox work as in the mainstream.

To add to our knowledge of the world, empirical work must, to begin with, tell you something you didn’t know before you did it. “Successfully” confirming your hypothesis obviously fails this test. You already believed it! It also must yield particular factual claims that other people can make use of. In general, this means some number — it means answer a “how much” question and not jsut a “yes or no” question. And it needs to reveal variation in those quantities along some interesting dimension. Since there are no universal constants to uncover in social science, interesting results will always be about how something is bigger, or more important in one time, one country, one industry, etc. than in another. Which means, of course, that the object of any kind of empirical work should be a concrete historical development, something that happened at a specific time and place.

One sign of good empirical work is that there are lots of incidental facts that are revealed along the way, besides the central claim. As Andrew Gelman observed somewhere, in a good visualization, the observations that depart from the relationship you’re illustrating should be as informative as the ones that fit it.

This paper delivers that. Along with the big question of a long term shift, or not, in the Fed’s thinking, you can see other variation that may or may be relevant to the larger question but are interesting facts about the world in their own right. If, for example, you look at the specific examples of language they coded in each category, then a figure like shows lots of interesting fine-grained variation over time.

Also, in passing, I appreciate the fact that they coded the terms themselves and didn’t outsource the job to ChatGPT. I’ve seen a couple papers doing quantitative analysis of text, that use chatbots to classify it. I really hope that does not become the norm!

Anyway, it’s a great paper, which I highly recommend, both for its content and as a model for what useful empirical work in economics should look like.

 

In Praise of Profiteering

Of the usefulness of the concept, that is.4

 In my comments on inflation, I’ve emphasized supply disruptions more than market power. But as I’ll explain in this post, I think the market power or profiteering frame is also a valid and useful one.

Thanks in large part to Lindsay Owens and her team at the Groundwork Collaborative, the idea that corporate profiteering is an important part of today’s inflation is getting a surprising amount of traction, including from the administration. So it’s no surprise that it’s attracted some hostile pushback. This sneering piece by Catherine Rampell in the Washington Post is typical, so let’s start from there.

For critics like Rampell, the profiteering claim isn’t just wrong, but “conspiracy theory”, vacuous and incoherent:

The theory goes something like this: The reason prices are up so much is that companies have gotten “greedy” and are conspiring to “pad their profits,” “profiteer” and “price-gouge.” No one has managed to define “profiteering” and “price-gouging” more specifically than “raising prices more than I’d like.” 

The problem with this narrative is that it’s just a pejorative tautology. Yes, prices are going up because companies are raising prices. Okay. This is the economic equivalent of saying “It’s raining because water is falling from the sky.” 

The interesting thing about the profiteering story, to me, is precisely that it’s not a tautology. As a matter of logic, one might just as easily say “prices are going up because consumers are paying more.” It is not an axiomatic truth that businesses are who decide on prices. It is not a feature of textbook economics (where firms are price takers) nor is it an empirically true of all markets. As for profiteering, there is a straightforward definition — price increases that don’t reflect any change in the costs of production. Both economically and in the common-sense morality that terms like “price gouging” appeal to, there’s a distinction between price increases that reflect higher costs and ones that do not. And there’s nothing novel or strange about policies to limit the latter.

These two points are related. If prices were set straightforwardly as a markup over marginal costs, it wouldn’t make sense to say that “companies are raising prices.” And there wouldn’t be any question of price-gouging. The starting point here is, that’s not necessarily how prices are set. And once we agree that prices are a decision variable for firms, rather than an automatic market outcome, it’s not obvious why there shouldn’t be a public interest in how that decision gets made.

Think about water. It’s a commonplace that big increases in the price of bottled water in a disaster zone should not be allowed. The marginal cost of selling a bottle of water already on the shelf is no higher than in normal times. Nor are high prices for bottled water serving a function as signals — the premise is precisely that the quantity available is temporarily fixed. And everyone agrees that in these settings, willingness to pay is not a good measure of need. 

What about water in normal times? In most of the United States, piped water is provided by local government. But in some places, it is provided by private water companies. And in those cases, invariably, its price is tightly regulated by a public utility commission, with price increases limited to cases where an increase in costs has been established. According to this recent GAO report, states with private water utilities all “rely on the same standard formula … to set private for-profit water rates. The formula relies on the actual costs of the utility …. including capital invested in its facilities, operations and maintenance costs, taxes, and other adjustments.” 

The principle in these types of regulations — which, again, are ubiquitous and uncontroversial — is that in the real world prices may or may not track costs of production. Price increases that reflect higher costs are legitimate, and should be permitted; ones that do not are not, and should not.

Rent control is very controversial, both among economists and the general public. But I have never heard “water rate control” brought up as an example of an illegitimate government interference in the market, or seen a study of how much more water would be provided if utilities could charge what the market would bear. (Maybe some enterprising young economist will take that on.)

The same goes for many other public utilities — electricity, gas, and so on. Here in New York, a utility that wants to raise its electricity rates has to submit a filing to the Public Service Commission documenting the its operating and capital costs; if the proposed increase doesn’t reflect the company’s costs, it is not allowed. Obviously this isn’t so simple in practice, and the system certainly has its critics. But the point is, no one thinks that electricity — an industry that combines very high fixed costs, concentration and very inelastic demand, and which is an essential input to all kinds of other activity — is something where prices can be left to the market.

So the the question is not: Should prices be regulated or controlled? Nor is it whether some price increases are unreasonable. The answers to those questions are obviously, uncontroversially Yes. The question is whether the price regulation of utilities, and the economic analysis behind it, should be extended to other areas, or to prices in general.

*

People like Rampell are not thinking in terms of our world of production by large organizations using specialized tools and techniques. They are imagining an Econ 101 world where there is a fixed stock of stuff, and the market price is the one where people just want to buy that much. There are, to be sure, cases where this is a reasonable first approximation — used car dealers, say. But it is not a good description of most of the economy. Markets are not allocating a given stock of stuff, but guiding production. This production is carried out by large enterprises with substantial market power. They are not price takers. For most goods and services, price is a decision variable for producers, involving tradeoffs on a number of margins.5 

In the models taught in introductory microeconomics, producers are price takers; they choose a quantity of output which they will sell at the going price. Given rising marginal costs — each additional unit of output costs more to produce than the last one — firms will carry out production just to the point where marginal cost equals the market price. This model is in principle consistent with the existence of fixed as well as marginal costs: Free entry and exit ensures that revenue at the market price just covers fixed costs, plus the normal profit (whatever that is). 

The usual situation in a modern economy, however, is flat or declining marginal costs. Non-increasing marginal costs, nonzero fixed costs, and competitive pricing cannot coexist: In the absence of increasing marginal costs, a price equal to marginal cost leaves nothing to cover fixed costs. Modern industries, which invariably involve substantial fixed costs and flat or declining marginal costs at normal levels of output, require some degree of monopoly power in order to survive. This is the economic logic behind patents and copyrights — developing a new idea is costly, but disseminating it is cheap. So if we are relying on private businesses for this, they must be granted some degree of monopoly.6

The problem is, once we agree that some degree of market power is necessary in order for industries without declining returns to cover their fixed costs, how do we know how much market power is enough? Too much market power, and firms can make super-normal profits by holding prices above the level required to cover their costs, reducing access to whatever social useful thing they supply. Too little market power, and competing firms will be inefficiently small, drive each other to bankruptcy, or simply decline to enter, depriving society of the useful thing entirely. Returning to the IP example: To the extent that copyrights and patents serve an economic function, it is possible for them to be either too long or too short.

The problem gets worse when we think about what fixed costs men concretely. On the one hand, the decision to pay for a particular long-lived means of production is irreversible and taken in historical time; producers don’t know in advance whether their margins over costs of production will be enough to recoup the outlay. But on the other hand, the form these costs take is financial: A company has, typically, borrowed to pay for its plant, equipment and intellectual property; the concrete ongoing costs it faces are debt service payments.  These may change after the fact, by, for example, being discharged in bankruptcy — which does not in general prevent the firm from continuing to operate. So there may be a very wide space between a price high enough to induce new firms to enter and a price low enough to induce existing firms to exit.

In addition, concerns over market share, public opinion, financing constraints,  strategic interaction with competitors and other considerations mean that the price chosen within this space will not necessarily be the one that maximizes short-term profits (to the extent that this can even be known.) A lower price might allow a firm to gain market share, but risk retaliation from competitors. A higher price might allow for increased payments to shareholders, but risk a backlash from regulators or bad press. Narrowly economic factors may set some broad limits to pricing, but within them there is a broad range for strategic choices by sellers.

*

These issues were central to economic debates around the turn of the last century, particularly in the context of railroads. In the second half of the 19th century, railroads were the overwhelmingly dominant industrial businesses. And they clearly did not fit the models of competitive producers pricing according to marginal cost that the economics profession was then developing.

Railroads provided an essential function, for which there were no good alternatives. A single line on a given route had an effective monopoly, while two lines in parallel were almost perfect substitutes. The largest part of costs were fixed. But on the other hand, a firm that failed to meet its fixed costs would see its debt discharged in bankruptcy and then continue operating under new ownership. The result was cycles of price gouging and ruinous competition, in which farmers and small businesses could (much of the time) reasonably complain that they were being crushed by rapacious railroad owners, and railroads could (some of the time) reasonably complain they were being driven to the wall by cutthroat competition. Or as Alfred Chandler puts it,

Railroad competition presented an entirely new business phenomenon. Never before had a very small number of very large enterprises competed for the same business. And never before had competitors been saddled with such high fixed costs. In the 1880s fixed costs…averaged two-thirds of total cost. The relentless pressure of such costs quickly convinced railroad managers that uncontrolled competition of through traffic would be “ruinous”. As long as a road had cars available to carry freight, the temptation to attract traffic by reducing rates was always there. … To both the railroad managers and investors, the logic of such competition would be bankruptcy for all.7

As Michael Perelman explains in his excellent books The End of Economics and Railroading Economics (from which the following quotes are drawn), the problem of the railroads was the problem for the first generation of American professional economists. As these economists were developing models in which prices set in competitive markets would guarantee both a rational allocation of society’s resources and a normatively fair distribution of incomes, it was clear that in the era’s dominant industry, market prices did not work at all.

Already in the 1870s, Charles Francis Adams could observe:

The traditions of political economy,…notwithstanding, there are functions of modern life, the number of which is also continually increasing, which necessarily partake in their essence of the character of monopolies…. Now it is found that, whenever this characteristic exists, the effect of competition is not to regulate cost or equalize production, but under a greater or less degree of friction to bring about combination and a closer monopoly. This law is invariable. It knows no exceptions. 

Arthur Hadley, an early president of the American Economic Association, made a similar argument. Where railroads competed, prices fell to a level that was too low to recover fixed costs, eventually sending one or both lines into bankruptcy. In the absence of competition, railroads could charge monopoly prices, which might be much higher than fixed costs. Equating prices to marginal costs made sense in an economy of small farmers or artisans. But in industries where most costs took the form of large, irreversible investments in fixed capital, there was no automatic process that would bring prices in line with costs. In Perelman’s summary:

 In order to attract new capital into the business, rates must be high enough to pay not merely operating expenses, but fixed charges on both old and new capital. But, when capital is once invested, it can afford to make rates hardly above the level of operating expenses rather than lose a given piece of business. This “fighting rate” may be only one-half or one-third of a rate which would pay fixed charges. Based on his knowledge of the railroads, [Hadley] concluded that “survival of the fittest is only possible when the unfittest can be physically removed—a thing which is impossible in the case of an unfit trunk line.”

Perelman continues:

The root of the problem, for Hadley, was that to build a new line, owners had to expect rates high enough to cover not only the costs of operating it but the costs of constructing it, the financing charges, and a premium for risk; while to continue running an existing line, rates only had to cover operating costs. And these costs were essentially invariant to the volume of traffic on the line. 

Or as John Bates Clark  put it in 1901: “There is often a considerable range within which trusts can control prices without calling potential competition into positive activity.”

These were some of the leading figures in the economics profession around the turn of the century, so it’s striking how unambiguously they rejected the  Marshallian orthodoxy of equilibrium prices. When the American Economics Association met for the first time, its proposed statement of principles included the line: “While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals.” Politically, they were not socialists or radicals. They rejected competitive markets, but not private ownership. That however left the question, how should prices be regulated? 

For a conservative economist like Hadley, the answer was social norms:

This power [of the trusts] is so great that it can only be controlled by public opinion—not by statute…. There are means enough. Don’t let him come to your house. Disqualify him socially. You may say that it is not an operative remedy. This is a mistake. Whenever it is understood that certain practices are so clearly against public need and public necessity that the man who perpetrates them is not allowed to associate on even terms with his fellow men, you have in your hands an all-powerful remedy.

Unfortunately, in practice, the withholding of dinner party invitations is not always an operative remedy.

In principle, there are many other ways to solve the problem. Intellectually, one can assume it away by simply insisting on declining returns to scale; or one can allow constant returns but have firms rent the services of undifferentiated capital, so there are no fixed costs. If the problem is not assumed away — a more practical option for theorists than for policymakers — it could in principle be solved by somehow ensuring that producers enjoy just the right degree of monopoly. This is what patents and copyrights are presumably supposed to do. Another possible answer is to say that where competition is not possible, that is an activity that should be carried out by the public. That was, of course, where urban rail systems ended up. For someone like Oskar Lange, it was a decisive argument for socializing production more broadly.8

Alternatively, one can accept cartels or monopolies (perhaps under the tutelage of dominant banks) in the hopes that social pressure or norms will limit prices, or on the grounds that a useful service provided at monopoly prices is still better than it not being provided at all. This was, broadly, the view of figures like Hadley, Ely and Clark, and arguably a big part of how things worked out. 

But the main resolution to the problem, at least in the case of railroads, came from the increasing public pressure to regulate prices. The Interstate Commerce Commission was established to regulate railroad rates in 1887; its authority was initially limited, and it faced challenges from hostile Gilded-Age courts. But it was strengthened over the ensuing decades. The guiding principle was that rates should be high enough to cover a railroad’s full costs and a reasonable return, but no higher. This required railroads, among other things, to adopt more systematic and consistent accounting for capital costs.

Indeed, there’s a sense in which the logic of Langean socialism describes much of the evolution of private markets over the 20th century. The spread of cost-based price regulation forced firms to systematically measure and account for marginal  costs in a way they might not have done otherwise. Mark Wilson, in his fascinating Destructive Creation, describes how the use of cost-plus contracts during World War II rationalized accounting in a broad range of industries. Systems of railroad-like rate regulation were applied to a number of more or less utility-like businesses both before and after the war, imposing from above the rational relationship between costs and prices that the market could not. Many of these regulations have been rolled back since the 1970s, but as noted earlier, many others remain in place. 

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Late 19th-century debates over railroad regulation might not be the most obvious place to look for guidance to today’s inflation debates. But as Axel Leijonhufvud points out in a beautiful essay on “The Uses of the Past,” economics is not progressive in the way that physical sciences are — we can’t assume that the useful contributions of the past are all incorporated into today’s thought. Economists’ thinking often changes for reasons of politics or fashion, while the questions posed by reality are changing as well as well, often in quite different ways. Older ideas may be more relevant to new problems than the current state of the art. History of economic thought becomes useful, Leijonhufvud writes,

when the road that took you to the ‘frontier of the field’ ends in a swamp or blind alley. A lot of them do. … Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time.

The road I want to take from those earlier debates is that in a setting of high fixed costs and pervasive market power, how businesses set prices is a legitimate question, both as an object of inquiry and target for policy. One of the central insights of the railroad economists is that in modern capital-intensive industries, there is a wide range over which prices are, in an economic sense, indeterminate. Depending on competitive conditions and the strategic choices of firms, prices can be persistently too high or too low relative to costs. This indeterminacy means that pricing decisions are, at least potentially, a political question. 

It’s worth emphasizing here that in empirical studies of how firms actually set prices — which admittedly are rather rare in the economics literature — an important factor in these decisions often seems to be norms around price-setting. In a classic paper on sticky prices, Alan Blinder surveyed business decision-makers on why they don’t change prices more frequently. The most common answer was, “it would antagonize customers.” In a recent ECB survey, one of the top two answers to the same question from businesses selling to the public was, similarly, that “customers expect prices to remain roughly the same.” (The other one was fear that competitors would not follow suit.)

This kind of survey data supports the idea, relied on by the Groundwork team, that businesses with substantial market power might be reluctant to use it in normal times. Those inhibitions would be lifted in an environment like that of the pandemic recovery, where individual price hikes are less likely to be seen as norm violations, or to be noticed at all. (And are more likely to be matched by competitors.)

Even more: It suggests that the moralizing language that critics like Rampell object to can, itself, be a form of inflation control. If fear of antagonizing customers is normally an important restraint on price increases then maybe we need to stoke up that antagonism! The language of “greedflation,” which I admit I didn’t originally care for, can be seen as an updated version of Arthur Hadley’s proposal to “disqualify socially” any business owner who raised prices too much. It is also, of course, useful in the fight for more direct price regulation, which is unlikely to get far on the basis of dispassionate analysis alone.

And this, I think, is a big source of the hostility toward Groundwork and toward others making the greedflation argument, like Isabella Weber.9 They are taking something that has been understood as a neutral, objective market outcome and reframing it as a moral and political question. This is, in Keynes’ terms, a question about the line between the Agenda and the Non-Agenda of political debates; and these are often more acrimonious than disputes where the legitimacy of the question itself is accepted by everyone, however much they may disagree on the answer.

By the same token, I think this line-shifting is a central contribution of the profiteering work. The 2022-23 inflation seems on its way to coming to an end on its own as supply disruptions gradually revolve themselves, just as (albeit more slowly than) Team Transitory always predicted. But even if the aggregate price level is behaving itself, rising prices can remain burdensome and economically costly in all kinds of areas (as can ruinous competition and underinvestment in others). Prices will remain an important political question, even if inflation is not.

My neighbor Stephanie Luce, who spent many years working in the Living Wage movement, often points out that the direct impact of those measures was in general quite small. But that does not mean that all the hard work and organizing that went into them was wasted. A more important contribution, she argues, is that they establish a moral vision and language around wages. Beyond their direct effects, living wage campaigns help shift discussions of wage-setting from economic criteria to questions of fairness and justice. In the same way, establishing price setting as a legitimate part of the political agenda is a step forward that will have lasting value even after the current bout of inflation is long over.

 

Inflation Came Down, and Team Transitory Was Right

Line goes down, and up. Last week, I wrote out a post arguing that the inflation problem is largely over, and the Fed had little to do with it. Yesterday, the new CPI numbers were released and they showed a sharp rise in inflation — a 4 percent rate over the past three months, compared with 2 percent when I wrote the piece.

Obviously, I’m not thrilled about this. It would be easier to make the arguments I would like to make if inflation were still coming down. But it doesn’t really change the story. Given that the spike last month is entirely energy, with growth in other prices continuing to slow, almost everyone seems to agree that it has nothing to do with demand conditions in the US, or anything the Fed has been doing or ought to do.

Here is an updated version of the main figure from the piece. You can see the spike at the far right – that’s the numbers released yesterday. You can also see that it is all energy costs (the pink bar). Everything else is still coming down.

Here is a table presenting the same data, but now comparing the high inflation of June 2021-June2022 with the lower inflation of the past yer. The last column shows how much each category has contributed to the change in inflation between the two periods. As you can see, the fall in inflation is all about goods, especially energy and cars. Services, which is where you’d expect to see any effects of a softening labor market, have not so far contributed to disinflation.

One thing the figure brings out is that we have not simply had a rise and then fall in inflation over the past couple of years. We’ve had several distinct episodes of rising prices. The first, in the second half of 2020, was clearly driven by reopening and pandemic-related shifts in spending. (One point Arjun and I make in our supply-constraints article is that big shifts in the composition of spending lead to higher prices on average.) The next episode, in the second half of 2021, was all about motor vehicles. The third episode, in the first half of 2022, was energy and food prices, presumably connected to the war in Ukraine. Finally, in later 2022 and early this year, measured inflation was all driven by rising housing costs.

Even though they may all show up as increases in the CPI, these are really four distinct phenomena. And none of them looks like the kind of inflation the Fed claims to be fighting. Energy prices may continue to rise, or they may not — I really have no idea.  But either way, that’s not a sign of an overheated economy.

It’s the supply side. Of course I am not the only one making this point. Andrew Elrod had a nice piece in Jacobin recently, making many of the same arguments. I especially like his conclusion, which emphasizes that this is not just a debate about inflation and monetary policy. If you accept the premise that spending in the economy has been too high, and workers have too much bargaining power, that rules out vast swathes of the progressive political program. This is something I also have written about.

Mike Konczal makes a similar argument in a new issue brief, “Inflation is Down. It’s a Supply-Side Story.” He looks at two pieces of evidence on this: different regression estimates of the Phillips curve relationship between unemployment and inflation, and second, expenditure and price changes across various categories of spending. I admit I don’t find the regression analysis very compelling. What it says is that a model that used past inflation to predict future inflation fit the data pretty well for 2020-2022, but over predicted inflation this year. I’m not sure this tells us much except that inflation was rising in the first period and falling in the second.

The more interesting part, to me, is the figure below. This shows quantities and prices for a bunch of different categories of spending. What’s striking about this is the negative relationship for goods (which, remember, is where the disinflation has come from.)

It is literally economics 101 that when prices and quantities move together, that implies a shift in demand; when they move in opposite directions, that implies a shift in supply. To put it more simply, if auto prices are falling even while people are buying more automobiles, as they have been, then reduced demand cannot be the reason for the price fall.

Larry Summers, in a different time, called this an “elementary signal identification point”: the sign the price increases are driven by demand is that “output and inflation together are above” their trend or previous levels. (My emphasis.) Summers’ point in that 2012 article (coauthored with Brad DeLong) was that lower output could not, in itself, be taken as a sign of a fall in potential. But the exact same logic says that a rise in prices cannot, by itself, be attributed to faster demand growth. The demand story requires that rising prices be accompanied by rising spending. As Mike shows, the opposite is the case.

In principle, one might think that the effect of monetary policy on inflation would come through the exchange rate. In this story, higher interest rates make a country’s assets more attractive to foreign investors, who bid up the price of its currency. A stronger currency makes import prices cheaper in terms of the domestic currency, and this will lower measured inflation. This is not a crazy story in principle, and it does fit a pattern of disinflation concentrated in traded goods rather than services. As Rémi Darfeuil points out in comments, some people have been crediting the Fed with US disinflation via this channel. The problem for this story is that the dollar is up only about 4 percent since the Fed started hiking — hardly enough to explain the scale of disinflation. The deceleration in import prices is clearly a matter of global supply conditions — it is also seen in countries whose currencies have gotten weaker (as the linked figure itself shows).

Roaring out of recession. I’ve given a couple video presentations on these questions recently. One, last Friday, was for Senate staffers. Amusingly —to me anyway — the person they had to speak on this topic  last year was Jason Furman. Who I imagine had a rather different take. The on Monday I was on a panel organized by the Groundwork Collaborative, comparing the economic response to the pandemic to the response to the financial crisis a decade ago. That one is available on zoom, if you are interested. The first part is a presenation by Heather Boushey of the Council of Economic Advisors (and an old acquaintance of mine from grad school). The panel itself begins about half an hour in, though Heather’s presentation is of course also worth listening to.

 

[Thanks to Caleb Crain for pointing out a mistake in an earlier version of this post.]

At Barron’s: Inflation Is Falling. Don’t Thank the Fed

(I write a monthly opinion piece for Barron’s. This one was published there in September. My previous pieces are here.)

You wouldn’t necessarily guess it from the headlines, but we may soon be talking about inflation in the past tense. After peaking at close to 10% in the summer of 2022, inflation has fallen even faster than it rose. Over the past three months inflation, as measured by the CPI, has been slightly below the Federal Reserve’s 2% target. Nearly every other measure tells a similar story.

Predicting the future is always risky. But right now, it seems like the conversation about how to fix the inflation problem is nearing its end. Soon, we’ll be having a new debate: Who, or what, should get credit for solving it?

The Fed is the most obvious candidate. Plenty of commentators are already giving it at least tentative credit for delivering that elusive soft landing. And why not? Inflation goes up. The central bank raises interest rates. Inflation goes back down. Isn’t that how it’s supposed to work? 

The problem is, monetary policy does not work through magic. The Fed doesn’t simply tell private businesses how much to charge. Higher interest rates lead to lower prices only by reducing demand. And so far, that doesn’t seem to have happened – certainly not on a scale that could explain how much inflation has come down.  

In the textbook story, interest rates affect prices via labor costs. The idea is that businesses normally set prices as a markup over production costs, which consist primarily of wages. When the Fed raises rates, it discourages investment spending — home construction and business spending on plant and equipment — which is normally financed with credit. Less investment means less demand for labor, which means higher unemployment and more labor market slack generally. As unemployment rises, workers, with less bargaining power vis-a-vis employers, must accept lower wages. And those lower wages get passed on to prices.

Of course this is not the only possible story. Another point of view is that tighter credit affects prices through the demand side. In this story, rather than businesses producing as much as they can sell at given costs, there is a maximum amount they can produce, often described as potential output. When demand rises above this ceiling, that’s when prices rise. 

Either way, the key point — which should be obvious, but somehow gets lost in macro debates — is that prices are determined by real conditions in individual markets. The only way for higher rates to slow down rising prices, is if they curtail someone’s spending, and thereby production and employment. No business — whether it’s selling semiconductors or hamburgers — says “interest rates are going up, so I guess I’ll charge less.” If interest rates change their pricing decisions, it has to be through some combination of fall in demand for their product, or in the wages they pay.

Over the past 18 months, the Fed has overseen one of the fast increases in short-term interest rates on record. We might expect that to lead to much weaker demand and labor markets, which would explain the fall in inflation. But has it?

The Fed’s rate increases have likely had some effect. In a world where the Federal Funds rate was still at zero, employment and output might well be somewhat higher than they are in reality. Believers in monetary-policy orthodoxy can certainly find signs of a gently slowing economy to credit the Fed with. The moderately weaker employment and wage growth of recent months is, from this point of view, evidence that the Fed is succeeding.

One problem with pointing to weaker labor markets as a success story, is that workers’ bargaining power matters for more than wages and prices. As I’ve noted before, when workers have relatively more freedom to pick and choose between jobs, that affects everything from employment discrimination to productivity growth. The same tight labor markets that have delivered rapid wage growth, have also, for example, encouraged employers to offer flexible hours and other accommodations to working parents — which has in turn contributed to women’s rapid post-pandemic return to the workplace. 

A more basic problem is that, whether or not you think a weaker labor market would be a good thing on balance, the labor market has not, in fact, gotten much weaker.

At 3.8%, the unemployment rate is essentially unchanged from where it was when at the peak of the inflation in June 2022. It’s well below where it was when inflation started to rise in late 2020. It’s true that quits and job vacancy rates, which many people look to as alternative measures of labor-market conditions, have come down a bit over the past year. But they still are extremely high by historical standards. The prime-age employment-population ratio, another popular measure of labor-market conditions, has continued to rise over the past year, and is now at its highest level in more than 20 years. 

Overall, if the labor market looks a bit softer compared with a year ago, it remains extremely tight by any other comparison. Certainly there is nothing in these indicators to explain why prices were rising at an annual rate of over 10% in mid-2022, compared with just 2% today.

On the demand side, the case is, if anything, even weaker. As Employ America notes in its excellent overview, real gross domestic product growth has accelerated during the same period that inflation has come down. The Bureau of Economic Analysis’s measure of the output gap similarly shows that spending has risen relative to potential output over the past year. For the demand story to work, it should have fallen. It’s hard to see how rate hikes could be responsible for lower inflation during a period in which people’s spending has actually picked up. 

It is true that higher rates do seem to have discouraged new housing construction. But even here, the pace of new housing starts today remains higher than at any time between 2007 and the pandemic. 

Business investment, meanwhile, is surging. Growth in nonresidential investment has accelerated steadily over the past year and a half, even as inflation has fallen. The U.S. is currently seeing a historic factory boom — spending on new manufacturing construction has nearly doubled over the past year, with electric vehicles, solar panels and semiconductors leading the way. That this is happening while interest rates are rising sharply should raise doubts, again, about how important rates really are for business investment. In any case, no story about interest rates that depends on their effects on investment spending can explain the recent fall in inflation. 

A more disaggregated look at inflation confirms this impression. If we look at price increases over the past three months compared with the period of high inflation in 2021-2022, we see that inflation has slowed across most of the economy, but much more so in some areas than others.

Of the seven-point fall in inflation, nearly half is accounted for by energy, which makes up less than a tenth of the consumption basket. Most of the rest of the fall is from manufactured goods. Non-energy services, meanwhile, saw only a very modest slowing of prices; while they account for about 60% of the consumption basket, they contributed only about a tenth of the fall in inflation. Housing costs are notoriously tricky; but as measured by the shelter component of the Bureau of Labor Statistics, they are rising as fast now as when inflation was at its peak.

Most services are not traded, and are relatively labor-intensive; those should be the prices most sensitive to conditions in U.S. product and labor markets. Manufactured goods and especially energy, on the other hand, trade in very internationalized markets and have been subject to well-publicized supply disruptions. These are exactly the prices we might expect to fall for reasons having nothing to do with the Fed. The distribution of price changes, in other words, suggests that slowing inflation has little to do with macroeconomic conditions within the US, whether due to Fed action or otherwise.

If the Fed didn’t bring down inflation, what did? The biggest factor may be the fall in energy prices. It’s presumably not a coincidence that global oil prices peaked simultaneously with U.S. inflation. Durable-goods prices have also fallen, probably reflecting the gradual healing of pandemic-disrupted supply chains. A harder question is whether the supply-side measures of the past few years played a role. The IRA and CHIPS Act have certainly contributed to the boom in manufacturing investment, which will raise productive capacity in the future. It’s less clear, at least to me, how much policy contributed to the recovery in supply that has brought inflation down.

But that’s a topic for another time. For now it’s enough to say: Don’t thank the Fed.


(Note: Barron’s, like most publications I’ve worked with, prefers to use graphics produced by their own team. For this post, I’ve swapped out theirs for my original versions.)

At Barron’s: Who Is Winning the Inflation Debate?

(I write a monthly opinion piece for Barron’s. This one was published there in July. My previous pieces are here.)

Is inflation fundamentally a macroeconomic problem – a sign of an overheated economy, an excess of aggregate demand over supply? Or is it – at least sometimes – better understood in microeconomic terms, as the result of producers in various markets setting higher prices for their own reasons? 

Not long ago, almost all economists would have picked door No. 1. But in the postpandemic world the choice isn’t so clear.

The answer matters for policy. If the problem is too much spending, then the solution is to bring spending down — and it doesn’t matter which spending. This is what interest rate hikes are intended to do. And since wages are both the largest source of demand and the biggest single component of costs, bringing down spending entails higher unemployment and slower wage growth. Larry Summers – perhaps the most prominent spokesman for macroeconomic orthodoxy – predicted that it would take five years of above-5% unemployment to get inflation under control. He was widely criticized for it. But he was just giving the textbook view.

If inflation is driven by dynamics in particular markets, on the other hand, then an across-the-board reduction in demand isn’t necessary, and may not even be helpful. Better to address the specific factors driving price increases in those markets – ideally through relieving supply constraints, otherwise through targeted subsidies or administrative limits on price increases. The last option, though much maligned as “price controls,” can make sense in cases where supply or demand are particularly inelastic. If producers simply cannot increase output (think, automakers facing a critical chip shortage) then prices have little value as a signal, so there’s not much cost to controlling them.

The debate between these perspectives has been simmering for some time. But it’s reached a boil around Isabella Weber, a leading exponent of the microeconomic perspective. Her recent work explores the disproportionate importance of a few strategic sectors for inflation. Weber has probably done more than any other economist to bring price controls into the inflation-policy conversation.

A recent profile of Weber in the New Yorker describes how she has become a lightning rod for arguments about unconventional inflation policy, with some of her critics going well beyond the norms of scholarly debate.  

This backlash probably owes something to the fact that Weber is, biographically, a sort of anti-Summers. While he is a former Treasury secretary and Harvard president who comes from academic royalty (two of his uncles won economics Nobels), she is young, female, and teaches at the University of Massachusetts, Amherst, a department best-known for harboring heterodox, even radical, thinkers. (Full disclosure: I got my own economics doctorate there, though well before Weber was hired.) Some prominent economists embarrassed themselves in their rather obvious professional jealousy, as the New Yorker recounts.

But even more than jealousy, what may explain the ferocity of the response is the not unjustified sense that the heterodox side is winning.

Yes, central banks around the world are hiking interest rates – the textbook response to rising prices. But the debate about inflation policy is much broader than it used to be, in both the U.S. and Europe.

Weber herself served on the committee in Germany that devised the country’s “price brake” for natural gas, which is intended to shield consumers and the broader economy from rising energy prices while preserving incentives to reduce consumption. In the wake of the New Yorker piece, there was a furious but inconclusive debate about whether a “brake” is the same as a “control.” But this misses the point. The key thing is that policy is targeted at prices in a particular market rather than at demand in general.

Such targeted anti-inflation measures have been adopted throughout Europe. In France, after President Emmanuel Macron pledged to do “whatever it takes” to bring down inflation, the country effectively froze the energy prices facing households and businesses through a mix of direct controls and subsidies. Admittedly, such an approach is easier in France because a very large share of the energy sector is publicly owned. In effect, the French measures shifted the burden of higher energy costs from households and businesses to the government. The critical point, though, is that measures like this don’t make sense as inflation control unless you see rising prices as coming specifically from a specific sector (energy in this case), as opposed to an economy-wide excess of demand over supply. 

Even economists at the International Monetary Fund – historically the world’s biggest cheerleader for high rates and austerity in response to inflation – acknowledge that these unconventional policies appear to have significantly reduced inflation in Europe. This is so even though they have boosted fiscal deficits and GDP, which by orthodox logic should have had the opposite effect.

The poster child for the “whatever it takes” approach to inflation is probably Spain, which over the past two years has adopted a whole raft of unconventional measures to limit price increases. Since June 2022, there has been a hard cap on prices in the  wholesale electricity market; this “Iberian exception” effectively decouples electricity prices in Spain from the international gas market. Spain has also adopted limits on energy price increases to retail customers, increased electricity subsidies for low-income households, reduced the value-added tax for energy, and instituted a windfall profits tax on energy producers. While the focus has been on energy prices (not surprisingly, given the central role of energy in European inflation) they have also sought to protect households from broader price increases with measures like rent control and reduced transit fares. Free rail tickets aren’t the first thing that comes to mind when you think of anti-inflation policy, but it makes sense if the goal is to shift demand away from scarce fossil fuels.

This everything-plus-the-kitchen-sink approach to inflation is a vivid illustration of why it’s so unhelpful to frame the debate in terms of conventional policy versus price controls. While some of the Spanish measures clearly fit that description, many others do not. A more accurate, if clunkier, term might be “targeted price policy,” covering all kinds of measures that seek to influence prices in particular markets rather than the economy-wide balance of supply and demand.

More important than what we call it is the fact that it seems to be working. Through most of the postpandemic recovery, inflation in Spain was running somewhat above the euro-area average. But since summer 2022 – when the most stringent energy-price measures went into effect – it has been significantly below it. Last month, Spain saw inflation fall below 2%, the first major European country to do so.

Here in the U.S., direct limits on price rises are less common. But it’s not hard to find examples of targeted price policy. The more active use of the Strategic Petroleum Reserve, for example, is a step toward managing energy prices more directly, rather than via economy-wide spending. The Russian sanctions regime — though adopted, obviously, for other reasons — also has a significant element of price regulation. 

The Inflation Reduction Act is often lampooned as having nothing to do with its name, but that’s not quite right. Instead, it reflects a very different vision of inflation control than what you’d get from the textbooks. Rather than seeking to reduce aggregate demand through fiscal contraction, it envisions massive new public outlays to address problems on the supply side. It’s a sign of the times that a closely divided Congress could pass a vast expansion in federal spending as an anti-inflation measure. 

Meanwhile, there’s growing skepticism about how much rate hikes have actually achieved. Inflation has declined steeply without Summers’ prescribed three years of over-5% unemployment, or indeed any noticeable rise in unemployment at all. By connventional measures, demand is no weaker than it was a year ago. If it’s interest rates that brought down inflation, how exactly did they do so?

To be sure, hardly anyone in either camp correctly predicted the 2021 surge in inflation, or its equally dramatic decline over the past year. So it’s too soon to declare victory yet. But for the moment, it’s Team Weber and not Team Summers that seems to be gaining ground.

 

At Barron’s: The Fed’s View of the Economy Matters for More than Monetary Policy

(I write a monthly opinion piece for Barron’s. This is the most recent one; you can find earlier ones here.) 

Has the inflationary fever broken at last? The headline Consumer Price Index, which was rising at a 17 percent annual rate last June, actually fell in December. Other measures show a similar, if less dramatic, slowing of price growth. But before we all start congratulating the Federal Reserve, we should think carefully about what else we’re signing up for.

For Fed Chair Jerome Powell, it’s clear that slower price growth is not enough. Inflation may be coming down, but labor markets are still much too tight. “Nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time,” he said recently, so “another condition we are looking for is the restoration of balance between supply and demand in the labor market.” 

The model of the economy that the Fed is working with looks something like this: most prices are, at the end of the day, set as a markup over wages. Wage increases depend on the relative bargaining power of workers and employers, and that in turn depends on labor market tightness. Labor market tightness depends on aggregate demand, which the Fed can influence through interest rates. Yes, there are other influences on inflation; but it’s clear that for the Fed this story is central. Indeed, we might call it the Federal Reserve View.

Is this story a fair description of the real world? Yes and no.

A useful rule to remember is that the rise in average wages must equal the rise in the price of domestically-produced goods, plus productivity growth, plus the share of income going to workers. All else equal, higher wages mean higher prices. But all else is not always equal. It’s possible to have faster wage growth and stable inflation if profit margins are falling, or if productivity is rising, or if import prices are falling.

In the short run, these other factors can easily outweigh wage growth. Just look at the 10 years prior to the pandemic. Hourly wages grew almost twice as fast in the second half of the decade as in the first half — nearly 4 percent annually, versus 2 percent. Yet inflation as measured by the CPI was no higher over 2015-2019 than over 2010-2014. That was thanks to productivity growth, which accelerated significantly, and import prices, which declined. (Workers’ share of national income did not change significantly.)

On the other hand, there is a limit to how fast productivity can rise, or profit margins or import prices can fall. No one doubts that if wages were to rise by, say, 10 percent year after year, inflation would eventually rise.

Critics of the Fed have questioned whether these long-run relationships tell us much about the inflation we are seeing now. There are plenty of things that cannot go on forever but can, and should, go on for a while. Rapid wage gains might be one of them. While Powell clearly still sees wage growth as excessive, others might look at the latest Employment Cost Index—less than 1% growth, compared with 1.4% at the start of 2022—and see a problem taking care of itself.

The Fed’s current plan is to increase unemployment by 1 percent over the next year, throwing 1.6 million people out of work. If the link between labor market conditions and prices is not as tight as they think, that’s a lot of suffering being inflicted for no reason. 

But there’s an even bigger problem with the Federal Reserve View: what else follows once you accept it. If price stability requires a weaker labor market – one in which employers have an easier time finding workers, and workers have a harder time finding jobs – that has implications that go far beyond monetary policy.

Take the Fair Trade Commission’s recent ban on non-compete clauses in employment contracts. When President Biden issued the executive order that led to this action, he explicitly framed it as a way of shifting bargaining power to workers and allowing them to demand higher pay. “If your employer wants to keep you,” he said, “he or she should have to make it worth your while to stay.” 

This sounds like good news for workers. But here’s the problem: from the Fed’s point of view, businesses are already paying too much to hold onto their employees. As Powell has said repeatedly over the past year, there is currently a “real imbalance in wage negotiating” in favor of workers. He wants to make it harder for people to switch jobs, not easier. So if the non-compete ban delivers what the President promised, that will just mean that rates have to go up by more.

Or think about minimum wage laws. Thanks to widespread indexing, nearly half the states saw significant increases in their minimum wages at the start of this year. Others, like New York, are moving in this direction. For many people the case for indexing is obvious: It makes sure that the incomes of low-wage workers in retail, fast food and other services keep pace with rising prices. But for the Fed, these are exactly the wages that are already rising too fast. Higher minimum wages, from the Fed’s point of view, call for higher interest rates and unemployment.

There’s nothing new or secret about this. In a typical macroeconomics textbook, the first example of something that raises the “natural rate” of unemployment (the one the central bank targets) is more generous unemployment benefits, which encourage workers to hold out for higher wages.

Publicly, the Fed disavows any responsibility for labor market policy. But obviously, if your goal is to maintain a certain balance of power between workers and employers, anything that shifts that balance is going to concern you.

This problem had dropped from view in recent years, when the Fed was struggling to get inflation up to its target. But historically, there’s been a clear conflict between protecting workers and keeping unemployment low. Under Alan Greenspan, Fed officials often worried that any revival of organized labor could make the job of inflation control harder. Treasury Secretary Yellen made a version of this argument early on in her career at the Fed, observing that “lower unemployment benefits or decreased unionization could … result in a decline in workers’ bargaining power.” This, she explained, could be a positive development, since it would imply “a permanent reduction in the natural rate of unemployment.”

Unfortunately, the same logic works the other way too. Stronger unions, higher minimum wages, and other protections for workers must, if you accept the Federal Reserve View, result in a higher natural rate of unemployment — which means more restrictive monetary policy to bring it about.

It’s easy to understand why administration officials would say they trust the Fed to manage inflation, while they focus on being the most-pro-labor administration in history. Unfortunately, dividing things up this way may not be as simple as it sounds. If that’s what they think their job is, they may have to challenge how the Fed thinks about its own.

What Does It Mean to Say that Inflation Is Caused by Demand?

There has been a lot of debate about whether the high inflation of 2021-2022 has been due mainly to supply or demand factors. Joe Stiglitz and Ira Regmi have a new paper from Roosevelt making the case for supply disruptions as the decisive factor. It’s the most thorough version of that case that I’ve seen, and I agree with almost all of it. I highly recommend reading it. 

What I want to do in this post is something different. I want to clarify what it would mean, if inflation were in fact driven by demand. Because there are two quite distinct stories here that I think tend to get mixed up.

In the textbook story, production takes place with constant returns to scale and labor as the only input. (We could introduce other inputs like land or imports without affecting the logic.) Firms have market power, so price are set as a positive markup over unit costs. The markup depends on various things (regulations, market structure, etc.) but not on the current level of output. With constant output per worker, this means that the real wage and wage share are also constant. 

The nominal wage, however, depends on the state of the labor market. The lower the unemployment rate, and the more bargaining power workers have, the higher the wage they will be in a position to demand. (We can think of this as an expected real wage, or as a rate of change from current wages.) When unemployment falls, workers command higher wages; but given markup pricing, these higher wages are simply passed on to higher prices. If we think of wages as a decreasing function of unemployment, there will be a unique level of unemployment where wage growth is equal to productivity growth plus the target inflation rate.

The conventional story of demand and inflation, from Blanchard. With constant returns to scale and a fixed markup, the real wage is unaffected by short-run changes in output and employment.

You can change this in various ways without losing the fundamental logic. If there are non-labor costs, then rising nominal wages can be passed less than one for one, and tight labor markets may result in faster real wage growth along with higher inflation. But there will still be a unique level of wage growth, and underlying labor-market conditions, that is consistent with the central bank’s target.  This is the so-called NAIRU or natural rate of unemployment. You don’t hear that term as much as you used to, but the logic is very present in modern textbooks and the Fed’s communications.

There’s a different way of thinking about demand and inflation, though, that you hear a lot in popular discussions — variations on “too much money chasing too few goods.” In this story, rather than production being perfectly elastic at a given cost, production is perfectly inelastic — the amount of output is treated as fixed. (That’s what it means to talk about “too few goods”.) In this case, there is no relationship between costs of production and prices. Instead, the price ends up at  the level where demand is just equal to the fixed quantity of goods.

In this story, there is no relationship between wages and prices — or at least, the former has no influence on the latter. Profit maximizing businesses will set their price as high as they can and still sell their available stocks, regardless of what it cost to produce them. 

In the first story, the fundamental scarcity is inputs, meaning basically labor. In the second, what is scarce is final goods. Both of these are stories about how an increase in the flow of spending can cause prices to rise. But the mechanism is different. In the first case, transmission happens through the labor market. In the second, labor market conditions are at best an indicator of broader scarcities. In the first story, the inflation barrier is mediated by all sorts of institutional factors that can change the market power of businesses and the bargaining power of workers. In the second story it comes straightforwardly from the quantity of stuff available for purchase. 

Once concrete difference between the stories is that only in the first one is there a tight quantitive relationship between wages and prices. When you say “wage growth consistent with price stability,” as Powell has in almost all of his recent press conferences, you are evidently thinking of wages as a cost. If we are thinking of wages as a source of demand, or an indicator of broader supply constraints, we might expect a positive relationship between wages and inflation but not the sort of exact quantitive relationship that this kind of language implies.

in any case, what we don’t want to do at this point is to say that one of these stories is right and the other is wrong. Our goal is simply to clarify what people are saying. Substantively, both could be wrong.

Or, both could be right, but in different contexts. 

If we imagine cost curves as highly convex, it’s very natural to think of these two cases as describing two different situations or regimes or time scales in the same economy.10 Imagine something like the figure below. At a point like c, marginal costs are basically constant, and shifts in demand simply result in changes in output. At a point like b, on the other hand, output is very inelastic, and shifts in demand result almost entirely in changes in price.

convex cost (or supply) curve

Note that we can still have price equal to marginal cost, or a fixed markup to it, in both cases. It’s just that in the steeply upward-sloping section, price determines cost rather than vice versa.

Another point here is that once we are facing quantity constraints, the markup over average cost (which is all that we can normally observe) is going to rise. But this doesn’t necessarily reflect an increase in the  markup over (unobservable) marginal cost, or any change in producers’ market power or pricing decisions.

We might think of this at the level of a firm, an industry or the economy as a whole. Normally, production is at a point like a — capitalists will invest to the point where capacity is a bit greater than normal levels of output. As long as production is taking place within the normal level of utilization, marginal costs are constant. But once normal capacity is exceeded by more than some reasonable margin, costs rise rapidly. 

This framework does a couple of things. First, it clarifies that demand can lead to higher prices in two different ways. First, it shifts the demand curve (not shown here, but you can imagine a downward-sloping diagonal line) up and to the right. Second, insofar as it raises wages, it shifts the cost curve upward. The first effect does not matter for prices as long production is within normal capacity limits. The second effect does not matter once production has exceeded those limits. 

Second, it helps explain why shifts in the composition of output led to a rise in the overall price level. Imagine a situation where most industries were at a position like a, operating at normal capacity levels. A big change in the mix of demand would shift some to b and others to c. The first would see lower output at their old prices, while the latter would see little increase in output but a big rise in prices. This has nothing to do with price stickiness or anything like that. It simply reflects the fact that it’s easy to produce at less than full capacity and very hard to produce much above it.

ETA: One of the striking features of the current disinflation is that it is happening without any noticeable weakening of the labor market. We could see that as just one more piece of evidence for the Stiglitz-Regmi position that it was transitory supply problems all along. But if you really want to credit the Fed, you could use the framework here to do it. Something like this:

In a sustained situation of strong demand, businesses will expect to be able to sell more in the future, and will invest enough to raise capacity in line with output. So the cost curve will shift outward as demand rises, and production will remain In the normal capacity, constant marginal cost range. In this situation, the way that demand is raising prices is via wages. (Unlike business capacity, the labor force does not, in this story, respond to demand.) Rising wages raise costs even at normal utilization levels, so the only way that policy can slow process growth is via weaker labor markets that reduce wage growth. But, when demand rises rapidly and unexpectedly, capacity will not be able to keep up in the short run, and we’ll end up on the righthand, steeply upward sloping part of the cost curve. At this point, price increases are not coming from wages or the cost side in general. Businesses cannot meaningful increase output in the short run, so prices are determined from the demand side rather than as a markup. In this context, price stability calls for policy to reduce desired purchases to what business can currently produce (presumably by reducing aggregate income). In principle this can happen without higher unemployment or slower wage growth.

I personally am not inclined to credit the Fed with a soft landing, even if all the inflation news is good from here on out. But if you do want to tell that story, convex supply curves are something you might like to have in your toolkit.

At Barron’s: Rate Hikes Are the Wrong Cure for Rising Housing Costs

(I write a monthly opinion piece for Barron’s. This is my contribution for November 2022.)

How much of our inflation problem is really a housing-cost problem?

During the first half of 2021, vehicle prices accounted for almost the whole rise in inflation. For much of this year, it was mostly energy prices.

But today, the prices of automobiles and other manufactured goods have stabilized, while energy prices are falling. It is rents that are rising rapidly. Over the past three months, housing costs accounted for a full two-thirds of the inflation in excess of the Federal Reserve’s 2% target.

Since most Americans don’t rent their homes, the main way that rents enter the inflation statistics is through owners’ equivalent rent—the government’s estimate of how much owner-occupied homes would rent for. The big cost that homeowners actually pay is debt service on their mortgage, which the Fed is currently pushing up. There is something perverse about responding to an increase in a hypothetical price of housing by making actual housing more expensive.

Still, the housing cost problem is real. Market rents are up by over 10% in the past year, according to Zillow. While homeownership rates have recovered somewhat, they are still well below where they were in the mid-2000s. And with vacancy rates for both rental and owner-occupied homes at their lowest levels in 40 years, the housing shortage is likely to get worse.

Housing is unlike most other goods in the economy because it is tied to a specific long-lived asset. The supply of haircuts or child care depends on how much of society’s resources we can devote to producing them today. The supply of housing depends on how much of it we built in the past.

This means that conventional monetary policy is ill-suited to tackle rising housing prices. Because the housing stock adjusts slowly, housing costs may rise even when there is substantial slack in the economy. And because production of housing is dependent on credit, that’s where higher interest rates have their biggest effects. Housing starts are already down 20% since the start of this year. This will have only a modest effect on current demand, but a big effect on the supply of housing in future years. Economics 101 should tell you that if efforts to reduce demand are also reducing supply, prices won’t come down much. They might even rise.

What should we be doing instead?

First, we need to address the constraints on new housing construction. In a number of metropolitan areas, home values may be double the cost of construction. When something is worth more than it costs to produce, normally we make more of it. So, if the value of a property comes mostly from the land under it, that’s a sign that construction is falling far short of demand. The problem we need to solve isn’t that people will pay so much to live in New York or Los Angeles or Boston or Boulder, Colo. It’s that it is so difficult to add housing there.

Land-use rules are set by thousands of jurisdictions. Changing them will not happen overnight. But there are steps that can be taken now. For example, the federal government could tie transportation funding to allowing higher-density development near transit.

Second, we need more public investment. Government support—whether through direct ownership or subsidies—is critical for affordable housing, which markets won’t deliver even with relaxed land-use rules. But government’s role needn’t be limited to the low-income segment. The public sector, with its long time horizons, low borrowing costs, and ability to internalize externalities, has major advantages in building and financing middle-class housing as well.

If we look around the world, it isn’t hard to find examples of governments successfully taking a central role in housing development. In Singapore, which is hardly hostile to private business, the majority of new housing is built by the public Housing Development Board. The apartment buildings built by Vienna’s government between the world wars still provide a large share of the city’s housing. Before the privatizations under Prime Minister Margaret Thatcher, some 30% of English families lived in publicly owned housing.

In the U.S., public housing has fallen out of favor. But governments at all levels continue to support the construction of affordable housing through subsidies and incentives. Some public developers, like the Housing Production Fund of Montgomery County, Md., are finding that with cheap financing and no need to deliver returns to investors, they can compete with private developers for mixed-income housing as well. The important thing is to channel new public money to development, rather than vouchers for tenants. The latter may just bid up the price of existing housing.

Third, we should revisit rent regulation. The argument against rent control is supposed to be that it discourages new construction. But empirical studies have repeatedly failed to find any such effect. This shouldn’t be surprising. The high-rent areas where controls get adopted are precisely those where new housing construction is already tightly constrained. If not much is getting built in any case, rent regulation merely prevents the owners of existing housing from claiming windfall gains from surging demand.

No, rent control won’t boost the supply of housing. But it can limit the rise in prices until new supply comes on-line. And it’s a much bettertargeted response to rising housing costs than the policy-induced recession we are currently headed for.

At Barron’s: What We Don’t Talk About When We Talk About Inflation

(I am now writing a monthly opinion piece for Barron’s. This one was published there in July.)

To listen to economic policy debates today, you would think the U.S. economy has just one problem: inflation. When Federal Reserve Chairman Jerome Powell was asked at his last press conference if there was a danger in going too far in the fight against inflation, his answer was unequivocal: “The worst mistake we could make is to fail—it’s not an option. We have to restore price stability…because [it’s] everything, it’s the bedrock of the economy. If you don’t have price stability, the economy’s really not going to work.”

Few would dispute that rising prices are a serious problem. But are they everything?

The exclusive focus on inflation acts like a lens on our view of the economy—sharpening our attention on some parts of the picture, but blurring, distorting, and hiding from view many others.

In the wake of the Great Recession, there was a broadening of macroeconomic debates. Economists and policy makers shifted away from textbook truisms toward a more nuanced and realistic view of the economy. Today, this wide-ranging conversation has given way to panic over rising prices. But the realities that prompted those debates have not gone away.

In the clamor over inflation, we’re losing sight of at least four big macroeconomic questions.

First, does the familiar distinction between supply and demand really make sense at the level of the economy as a whole? In the textbooks, supply means the maximum level of production in the economy, labeled “full employment” or “potential output,” while demand means total spending. The two are supposed to be independent—changes in spending don’t affect how much the economy can produce, and vice versa. This is why we are used to thinking of business cycles and growth as two separate problems.

But in the real world, supply often responds to demand—more spending calls forth more investment and draws people into the labor force. This phenomenon, known by the unlovely name “hysteresis,” was clearly visible in the slowdown of labor force and productivity growth after the Great Recession, and their recovery when demand picked up in the years before the pandemic. The key lesson of this experience—in danger of being forgotten in today’s inflation panic—was that downturns are even more costly than we thought, since they not only imply lost output today but reduced capacity in the future.

Hysteresis is usually discussed at the level of the economy as a whole, but it also exists in individual markets and industries. For example, one reason airfares are high today is that airlines, anticipating a more sustained fall in demand for air travel, offered early retirement to thousands of senior pilots in the early stages of the pandemic. Recruiting and training new pilots is a slow process, one airlines will avoid unless it’s clear that strong demand is here to stay. So while conventional wisdom says that rising prices mean that we have too much spending and have to reduce it, in a world with hysteresis a better solution may be to maintain strong demand, so that supply can rise to meet it. In the textbook, we can restore price stability via lower demand with no long-run costs to growth. But are we sure things work so nicely in the real world?

The second big question is about the labor market. Here the textbook view is that there is a unique level of unemployment that allows wages to grow in line with productivity. When unemployment is lower than this “natural rate,” faster wage growth will be passed on to rising prices, until policy makers take action to force unemployment back up. But in the years before the pandemic, it was becoming clear that this picture is too simplistic. Rising wages don’t have to be passed on to higher prices—they may also come at the expense of profits, or spur faster productivity growth. And not all wages are equally responsive to unemployment. Younger, less-educated, and lower-wage workers are more dependent on tight labor markets to find work and get raises, while the incomes of workers with experience and credentials rise more steadily regardless of macroeconomic conditions. This means that—as Powell has acknowledged—macroeconomic policy has unavoidable distributional consequences.

In his classic essay “Political Aspects of Full Employment,” the great Polish economist Michal Kalecki argued that even if it were economically feasible to eliminate unemployment, this would be unsustainable, since employers’ authority in the workplace depends on “the threat of the sack.” Similar arguments have been made by central bank chiefs such as Alan Greenspan, who suggested that low unemployment was sustainable in the 1990s only because workers had been traumatized by the deep recession of the decade before.

Some would argue that it’s unnecessarily wasteful and cruel to maintain labor discipline and price stability by denying millions of people the chance to do useful work—especially given that, prior to the pandemic, unemployment had fallen well below earlier estimates of the “natural rate” with no sign of accelerating inflation. But if we wish to have a permanent full-employment economy, we need to answer a difficult question: How should we manage distributional conflicts between workers and owners (and among workers), and motivate people to work when they have little to fear from losing their job?

A third set of questions concerns globalization. There are widespread fears that renewed Covid lockdowns in China may limit exports to the U.S. and elsewhere. Seen through the inflation lens, this looks like a source of rising prices and a further argument for monetary tightening. But if we take a step back, we might ask whether it is wise to organize the global economy in such a way that lockdowns in China, a war in Ukraine, or even a factory fire in Japan leave people all over the world unable to meet their basic needs. The deepening of trade and financial links across borders is sometimes presented as a fact of nature. But in reality it reflects policy choices that allowed global production of all kinds of goods—from semiconductors to Christmas decorations and latex gloves—to be concentrated in a handful of locations. In some cases, this concentration is motivated by genuine technical advantages of larger-scale production, in others by the pursuit of low wages. But either way, it reflects a prioritization of cost minimization over flexibility and resiliency. Whatever happens with inflation, this is a trade-off that will have to be revisited in coming years, as climate change makes further disruptions in global supply chains all but inevitable.

Then there is climate change. Here, the inflation lens doesn’t just recolor the picture but practically reverses it. Until recently, the conventional wisdom was that a carbon tax was the key policy tool for addressing climate. An Obama-era economist once quipped that the big question on climate was whether a carbon tax was 80% of the solution, or 100%. A carbon tax would increase the prices of energy, which still mainly comes from fossil fuels, and of travel by private car. As it happens, this is exactly what we have seen: Autos and energy have increased much faster than other prices, to the point that these two categories account for a majority of the excess inflation over the past year. In effect, we’ve seen something like a global carbon tax. But far from welcoming the disproportionate rise in the prices of carbon-intensive goods as a silver lining of inflation, both policy makers and the public see it as an urgent problem to be solved.

To be clear, people are not wrong to be unhappy at the rising cost of cars and energy. In the absence of practical alternatives, these high prices inflict real hardship without necessarily doing much to speed the transition from carbon. One reasonable lesson, then, is that a carbon tax high enough to substantially reduce emissions will be politically intolerable. And indeed, before the pandemic, many economists were already shifting away from a carbon-price-focused approach to climate policy toward an investment-centered approach.

Whether via carbon prices or investment, the only way to reduce carbon emissions is to leave fossil fuels in the ground. Yet an increasing swath of the policy conversation is focused on how to encourage more drilling by oil-and-gas companies, not just today but into the indefinite future. As a response to today’s rising energy prices, this is understandable, given the genuine limitations of renewable energy. But how can measures to boost the supply of fossil fuels be consistent with a longer-term program of decarbonization?

None of these questions have easy answers. But the danger of focusing too single-mindedly on inflation is that we may not even try to answer them.

Demand, Supply, Both, or Neither?

One way current debates over inflation sometimes get framed is whether it’s driven by supply or demand. Critics of the ARPA and other stimulus measures point to various lines of evidence to suggest that rising prices are coming from the demand side, not the supply side; and of course you can find the opposite arguments among its defenders. This sometimes gets conflated with the question of how persistent inflation is likely to be, with a preference for supply-side explanations putting you on “team transitory.”

In my opinion, the question in this form is not well specified. It makes no sense to ask if price rises are driven by supply or by demand. A mismatch between aggregate demand and aggregate supply is one explanation for inflation. To say “inflation would be lower if aggregate demand were lower” is exactly the same statement as “inflation would be lower  if aggregate supply were higher.” This story is about the difference between the two.

The first step, then, is to think about how we can reframe the question in a meaningful way. The issue of specific indicators is downstream from this, as is the question of how long one might expect higher inflation to last. 

Here are some quick thoughts on how we might clarify this debate. 

1. Insofar as we are explaining price changes in terms of aggregate demand and aggregate supply (or potential output) this is a story about an imbalance between the two of them. If we are using this framework, any change in inflation is fully explained by supply *and* fully explained by demand. To turn this into an either-or question, we have to pose an explicit counterfactual. For example, we might say that current spending levels would have led to no (or less) rise in inflation if it weren’t for pandemic. Or we might say that the disruptions of the pandemic would have led to no (or less) rise in inflation if it weren’t for the stimulus bills. The problem is, these aren’t alternatives — both  might very well be true!

2. If the question is specifically whether current aggregate demand in the US would be inflationary even without the pandemic and Ukraine war, it seems to me that the answer is unequivocally No. The fact that real GDP is no higher than trend is, to me, absolutely decisive here. Suppose we thought that two years from now, the economy operating at normal capacity will be capable of producing a certain quantity of cars, houses, tv shows, haircuts, etc. Now suppose two years pass, and we find that people are in fact buying exactly the quantity of cars, houses, tv shows, haircuts, etc. that we had predicted,. If inflation has nonetheless risen, the only possible explanation, within the supply-vs-demand framework, is that the productive capacity of the economy is less than we expected. If buying a certain quantity of stuff is not inflationary in one year, but is inflationary in a later year, then (within this framework) by definition that means that potential output is lower.

Of course it may be true in this scenario that the nominal value of spending will be higher. But this precisely because prices have risen. Suggesting that higher nominal expenditure explains higher inflation is arguing in a circle — it is using the rise in prices to explain that same rise in prices.

To put it another way, aggregate supply or potential output are describing the quantity of stuff we can produce. It makes no sense to say that the potential output of the US economy is $22 trillion dollars. People who look at nominal expenditure in this context are just confused.

(It’s also worth noting that nominal GDP was below pre-pandemic trend until the last quarter of 2021, at which point inflation had been above target and accelerating for a year already. So this story fails on the basis of timing as well as logic.)

So in this specific sense, I think the supply story is simply right, and the demand story is simply wrong. There is no reason to think that the aggregate quantity of goods and services people are trying to purchase today would be beyond normal capacity limits in the absence of the pandemic.

3. Again, though, it all depends on the counterfactual. It does not contradict the preceding point to say that if the ARPA had been smaller, inflation would be lower. Given a fall in the economy’s productive capacity, you are going to see some combination of lower output and income, and higher inflation, with the mix depending on the extent to which demand also falls. Again, demand and supply are two sides of the same story. It’s perfectly consistent to say that in the absence of the pandemic, today’s level of spending would not have caused any rise in inflation, and that if we had allowed spending to fall in line with the fall in potential, the supply disruptions would not have caused any rise in inflation. 

This means the question of whether ARPA was too big is not really a question about inflation as such. It is not going to resolved by any data on whether inflation is limited to a few sectors or is broader, or whether inflation peaked at the end of 2021 or at some later date. The answer to this question depends on how we weigh the relative costs of rising prices versus lost income and output. The more socially costly you think inflation is, the more you are going to think that ARPA was too big. The more socially costly you think unemployment and the associated loss of income is, the more you are going to think the ARPA was the right size, or too small. It seems to me that this is what a lot of the debate over “supply” versus “demand” stories of inflation are really about.

4. So far, I’ve been using an aggregate supply and aggregate demand framework, which is how people usually talk about inflation. But as readers of this blog will know, I am generally skeptical that rising prices are best thought of at the aggregate level. If we don’t like the aggregate framework, we might tell micro stories. There are several flavors of these, any or all of which which could be true. 

First, there is there’s a story about changes in the composition of demand. It’s easy for a business or industry produce less than it usually does, but hard to produce more — especially in a hurry. So sectors of the economy that face reduced demand are likely to respond with lower output, while sectors that face increased demand are likely to respond in some large part with higher prices, especially if the increase is large and rapid. That means we should expect rapid shifts in demand to be associated with higher inflation, even if the total volume of demand is unchanged. 

That’s one micro story. Another is that when certain sectors of the economy face supply constraints, it may be hard to substitute elsewhere. If demand for the sectors facing bottlenecks is very inelastic, and/or they are important inputs for other sectors, then the fall in capacity in those sectors may have a larger effect on prices than a similar across-the-board fall in productive capacity would.  

Another, simpler micro story is that there is no useful information in the aggregate price level at all. If prices are rising for particular goods and services, that is best understood in terms of production conditions and demand for those particular things.

What these stories suggest is that the aggregate supply/demand framework is less useful when there are large, rapid shifts in the composition of spending or production. That framework may be reasonable when we are talking about an economy undergoing steady growth and want to know if somewhat faster growth (spurred perhaps by across the board easier credit) would lead to higher inflation. But it’s not very useful when the economy is undergoing major qualitative changes. It’s not even clear how the concept of aggregate supply is defined when we are seeing big shifts in the composition of output. 

To be clear, none of these micro stories are necessarily arguments for a “supply side” explanation of inflation. Rather, they are reasons why the supply versus demand framework might not be helpful. 

5. Another story about inflation that often gets conflated with aggregate demand but should not be is the extent to which higher wages are driving inflation. In the standard textbook story, the mechanism by which higher demand raises prices is through higher wages. In the textbook story — this is totally mainstream — there are no constraints on the supply side except the supply of labor. The reason higher demand leads to higher inflation is that lower unemployment leads workers to obtain higher wages, which then get passed on to prices. We know this is the theory the Fed is working with. And people like Krugman are saying that there’s no way to have lower inflation without “getting wage growth down considerably.” 

But even though these two things are linked in the textbook story, they are logically distinct. When we talk about a demand-side story of inflation, we need to be clear whether and to what extent this is a story about wages specifically. And as Krugman emphasizes in the linked piece, the question of whether reducing inflation will require slower wage growth is logically independent of the question of whether higher wages are what has driven rising inflation so far.

6. So what is actually at stake here? Before we start talking about who is on what team, we should be sure we know what game they are playing, and where the goals are.

It seems to me that, operationally, the big question people are arguing about is: if real activity — and in particular the labor market — remains on its current trend, will inflation eventually come down on its own? Or if not, can interventions in specific sectors reduce it? Or is a significant slowing of activity across the board required? This forward-looking question is what the fighting is really about. 

There is some relationship between these questions and the causes of inflation, but they are not the same. For example, it is certainly more plausible that resolving a small number of bottlenecks would bring prices down when the price increases are concentrated in a few sectors. But one might also believe — as I and others have long argued — that we underestimate the flexibility of the supply side of the economy in general. If you believe in hysteresis, then even a general overheating might over time lead to faster growth of potential output, as more people are drawn into the labor force and businesses invest and raise productivity. So unless you start from the premise that potential output is normally fixed, “inflation is widespread, therefore we need less demand” is a non sequitur.

(In this light, it would be worth systematically revisiting the arguments about hysteresis made by Lawrence Summers and others during the 2010s.)

7. The question of whether reducing inflation requires lower demand and weaker labor markets is inextricable from your political program and broader worldview. At this moment, we are on the verge of seeing a major new public investment bill that is being presented as a way of bringing down inflation and creating good jobs. This is a huge vindication for arguments that progressives have been putting forward for years. It would be odd if we now turned around and said, “no no, investing in clean energy won’t help with inflation. And we don’t want more jobs, there’s too much demand in the economy already.” If you think that the clean energy investments in the IRA will in fact bring down prices over time, you need an understanding of inflation that’s consistent with that. And if your view of inflation implies that we would be better off not making those investments at this time, then you need to own that position.

(Some people will say the bill is anti-inflationary because it lowers the deficit. First of all, it seems unlikely that the specific tax increases in the IRA will have much if any dampening effect on demand, while the spending components certainly will boost it. Second, even if you thought the bill as a whole will reduce inflation, you still need to have a view on whether the energy provisions specifically will do so.)

I’m not saying you should just make the economic arguments that support your political program. It’s very important to only say things that are supported by logic and evidence! But presumably, you have the worldview you do because it captures important things you think are true about the world. If your analysis of inflation is not consistent with other things that you strongly believe, that suggests that there might be something wrong with your analysis. 

For example, you might believe that potential employment in the US is much higher than conventional estimates of unemployment or the labor force suggest. You could arrive at this belief on the basis of statistical evidence and also from other beliefs that you are strongly committed to — for example, that women and non-white people are just as capable of useful work as white men are. This argument runs directly against claims that the US is currently facing hard supply constraints, so that the only way the growth in wages and prices will moderate is via lower demand. If the conventional unemployment rate vastly understated the number of people available for work in 2015, presumably it still does today. You can’t just ignore those earlier arguments when talking about current inflation.

Similarly, you might believe that business investment and productivity growth depend on demand. Or you might think they depend on decisions made at the firm level — that corporations face a choice between long-term growth and short-term returns to shareholders, which they will make differently in different institutional and legal environments. These long-standing arguments are relevant to the question of whether it’s plausible that corporate profiteering is contributing to current price rises, and whether changes to taxes and regulation could bring down inflation without any need to reduce demand. They are also relevant to the question of whether given sustained strong demand, supply will eventually catch up, via higher investment and faster productivity growth. This Gavin Wright paper argues that scarce labor and rising wages drove the acceleration of productivity growth in the late 1990s. How convincing you find that argument should be relevant to your assessment of inflation today.

Or again, the question of whether conventional monetary policy should be the go-to response to inflation is not (only) a question about inflation. You could have a fully “demand side” account of rising rents — that they are entirely driven by rising incomes, and not by any change in the housing supply — and yet also believe that higher interest rates, by discouraging housing construction, will only make the problem worse. 

It’s a big mistake, in my opinion, to debate inflation in isolation, or to think that debates over inflation are going to be resolved with statistical tests. We first need to step back and think carefully about what question we are trying to answer, and about what account of inflation is consistent with our broader intellectual commitments. The reason I disagree with someone like Jason Furman about inflation isn’t because I have a different read on this or that data series. (I like his empirical work!) We see inflation differently because we have different ideas about how the world works.