If you are looking for a simple answer – and a simple solution – to why we have a distressingly high and sustained inflation rate, I need to warn you that you will be greatly disappointed. The press has obsessed over increasing inflation rates for the past few months but without considering in detail the underlying reasons for inflation. The recent focus has been primarily on expansionary monetary policy by the Federal Reserve and expansionary fiscal policy but has not put those policies in a broader context.
To understand how we got to our current inflation predicament, we need to review recent economic history and keep these three things in mind. First, is the saying that inflation results from too much money chasing too few goods. Alternately phrased, we have general excess demand. Second is Milton Friedman’s famous line “Inflation is everywhere and always a monetary phenomenon” which is a statement about the long run. And third is that Keynesian economic models focus on aggregate demand rather than supply, and there have been obvious and appreciable shocks to global supply over the past couple of years.
Why do Keynesian models focus on demand? Because most business cycles revolve around changes in aggregate demand rather than aggregate supply. In no way does this minimize the importance of supply shocks; it simply reflects that demand has been more variable than supply. Since the late 1940s and the start of a consistent series for Gross Domestic Product (GDP), there have been 12 recessions. Of those, only two can be attributed to a shock to aggregate supply, the 1974-75 recession brought on by the oil crisis and the 2020 pandemic-induced shutdown and recession. But recently we have had three important supply shocks.
First, in terms of recent supply shocks, since March 2020 we have seen Covid shut down large parts of virtually every economy in the world. The result was a direct reduction in aggregate supply worldwide, coming with the side effect of disrupting supply chains worldwide. The impact of the shutdown was sudden and dramatic but relatively short-lived. The reactions to the shutdown, however, had much more durable impacts. Without a clear perspective on when, if ever, business would return to the old normal, many industries dramatically reduced their production levels, including the termination of many critically skilled workers. Airlines are a good example. The extreme drop in bookings led airlines to substantially reduce the number of highly skilled personnel like pilots and mechanics. Cutting back was relatively easy. Resuming pre-pandemic operations is proving challenging and is leading to price increases and inflation.
Second, some components of the supply shock associated with the pandemic have been gradually reduced or eliminated. For example, transportation difficulties in particular with shipping have been substantially reduced and, in some cases, eliminated. But a new one has emerged. China’s zero-Covid policy has greatly slowed its economy. Couple the drop in inexpensive production from China with a deliberate shift to reduce the length and complexity of supply chains, and the result is an increase in the costs of production generating a further cause for inflation.
And third, Russia’s attack on Ukraine has greatly stressed the global economy, in particular in the areas of energy and basic foods. The resulting sanctions on Russian energy and the implicit cooperation of OPEC in raising energy prices is a supply shock, and recent actions by OPEC suggest that this shock likely will not readily subside. Looking at core inflation rather than overall inflation removes some but not all of the measured impact of higher energy prices. For example, higher energy prices means higher transportation costs which in turn gets embedded in virtually all prices.
Russia’s aggression also has had a major impact on basic food prices worldwide. To some extent the U.S. is insulated from that but on a global inflation scale, it is a critical consideration. Food staples like wheat have very inelastic demand curves. Everyone needs a basic number of calories whether food prices are high or low. Historically, supply and demand have been roughly equal from a worldwide perspective, and we haven’t seen worldwide famines – or worldwide surpluses. With no excess production, however, even a 3 percent reduction in supply will generate a huge spike in food costs as competition for limited food resources heats up.
It is currently impossible to estimate how much supply shocks have contributed to U.S. inflation, but the magnitude is definitely not trivial. That the EU now has higher inflation rates than the U.S. likely reflects its proximity to the third of the three supply shocks.
Turning to U.S. economic policies, both fiscal and monetary policy were aggressively used to minimize the economic effect of the shutdown. The federal government initiated multiple huge fiscal policy stimuli to keep the economy from a complete meltdown. Those actions were largely successful, although in the second quarter of 2020 GDP did fall by 8.9%. And the impacts of those actions generally were intended to be short-lived and to replace or supplement demand from other sectors. In addition, the Federal Reserve undertook a very expansionary policy, both by dropping interest rates to near zero and by aggressively increasing the monetary base.
The Fed’s playbook from early 2020 through 2021 was essentially a rerun of its actions in dealing with the financial crisis and the Great Recession of 2008-2009 – dropping interest rates to zero and then undertaking Quantitative Easing (QE) to maintain liquidity in the financial system. The Fed’s actions then were largely successful in stimulating the economy and not generating additional inflation. With QE, the monetary base (MB) increased from under $1 trillion pre-crisis to over $4 trillion by 2014. With a potentially huge increase in the money supply, we saw no increase in inflation. Given Friedman’s quote, the obvious question is why didn’t we see inflation? The answer is equally simple. While the Fed was increasing liquidity with the increase in the monetary base, the demand for liquidity was also increasing as asset holders were uncertain about the direction of the economy. By mid-2014, that uncertainty was decreasing, and the Fed gradually began to unwind its holdings and reduce the MB, actions that continued until late 2019 when the economy began to slow down.
When Covid struck, the MB had been reduced from $4 trillion to $3.4 trillion, and the Fed changed gears to assist in keeping the economy afloat. Within the course of a few months, it increased the monetary base to $5.1 trillion and continued to increase the monetary base until December 2021 when it topped out at $6.4 trillion. This increase in the MB with Covid was almost identical to the MB increase with the financial crisis, albeit over a two-year window rather than a six-year window.
So why inflation this time and not after the Great Recession? The best answer is that the Great Recession was a demand-induced shock while the Covid-based recession was a supply-induced shock, and monetary policy is better equipped to address a demand shock than a supply shock. With a demand shock, reducing interest rates and providing additional liquidity should prompt consumers and investors to increase spending because the costs of doing so are lower. With a supply shock, reducing interest rates and providing additional liquidity does not address the underlying issue of needing to increase aggregate supply. Potentially, the increase in the monetary base would increase demand and exacerbate any potential inflation problem, although this effect would likely be at least partially offset by an increase in demand for liquidity, exactly as it was after the financial crisis.
Expansionary fiscal policy has also been accused of being the underlying cause of inflation. The underlying argument is at best very weak. Fiscal policy was most expansionary in 2020 when the economy was operating well below full employment. Without excess demand, we shouldn’t expect higher inflation without other factors in play. By the end of 2021, fiscal policy was no longer expansionary when we consider appropriate metrics like government expenditures as a percent of GDP or the government deficit as a percent of GDP.
So, what underlies our higher inflation rates? The first appreciable increase occurred in March/April 2021. Those are best viewed as statistical artifacts. That is, looking at year-over-year price changes, inflation appeared to increase not because of prices going up more in 2021 but because of prices in 2020, at the heart of the pandemic, were relatively low. By mid-2021, however, there was a non-artifact increase in inflation as measured by the Consumer Price Index (CPI). That increase was largely a result of supply shortages and supply chain issues, a residual of the U.S. economy and other economies, in particular, China shutting down. In addition, many industries had dramatically reduced their capacity with computer chips, used vehicles, airlines, and construction materials all having serious supply shortages.
Moving into 2022, some supply shortages remained. Any items dependent on components from China had potential issues as did industries that cut back dramatically during the pandemic. Adding to this mix is Russia’s attack on Ukraine. While Putin claims his actions have virtually no impact on western inflation or third-world food shortages, his understanding of basic economics appears limited – or he is lying. Two items with some of the most dramatic price increases are oil and basic agricultural commodities. One contributes to higher food prices, the other contributes directly to higher gasoline prices, and indirectly to anything that needs to be shipped. Putin contends, for example, that Ukraine’s wheat is only a small fraction of world production and should have minimal impact on world prices. However, when starting from a position of the quantity supplied roughly equal to the quantity demanded, even a minuscule reduction in supply can substantially increase the price when demand is inelastic, that is when the demand curve is near vertical. Families around the world cannot simply stop eating or switch to cheaper alternatives when they are already at or near subsistence levels of consumption.
From an inflation perspective then, our current levels are likely due in part to aggressive monetary policy, continuing supply shortages generated by the pandemic, and China’s war on Covid plus Russia’s war on Ukraine. The implication is that it is likely that we are at or near peak inflation and that inflation should begin to decline relatively shortly, albeit perhaps excruciatingly slowly. The Russian/Ukraine war has contributed to higher oil prices, for example. But while oil prices have spiked, with the assistance of OPEC, it appears unlikely that oil prices will continue to increase. OPEC may celebrate higher prices, but to the extent those prices may contribute to a worldwide recession, that would limit their ability and willingness to maintain those higher prices. Supply shortages have been with us since the start of the pandemic and are not likely to be eliminated in the near future. But the key to future inflation likely lies in the conduct of monetary policy.
The Fed has been pummeled in some quarters for facilitating or enabling inflation to take hold. Whether you concur or disagree with that perspective, what is now clear is that the Fed has adopted a clearly anti-inflationary policy. The focus in the press has been on the Fed’s five recent rate increases, with the first a standard 25 basis point (bps) increase, the second a 50 bps increase, followed by three 75 bps increases, the largest increases since 1994. The general expectation is that the Fed will continue to aggressively increase interest rates through 2022 and into 2023 with a common forecast of a 4% federal funds rate by the end of the year.
In the interest rate targeting period beginning in 1982, the Fed has increased the funds rate by 50 bps or more in only five prior intervals, 1984, 1987, 1989, 1994-95, and 2000. Only in 1987 was this rate increase not at the end of a series of rate increases. The implication is that a series of additional rate increases, while certainly possible, is inconsistent with prior Fed behavior. It would be unwise to bet against further Fed rate increases, but it would also appear unwise to bet on a series of additional Fed rate increases. The Fed’s interest rate increases certainly signal that the Fed is very concerned about inflation and is working assiduously to bring the inflation rate down. But much of the Fed’s work is less obvious than a change in the funds rate.
The primary way the Fed has been pursuing an anti-inflationary policy has been through changes in the monetary base. The MB peaked at $6.4 trillion in December 2021 and was reduced to $5.6 trillion by August. Given the Fed’s actions after the financial crisis was over, it is reasonable to expect that the Fed will continue to reduce MB. And given the decline in MB from December to August, it is likely that the Fed will be much more aggressive in this reduction than it was after the financial crisis. Simply stated, the Fed does not need to increase interest rates to undertake contractionary monetary policy. Its reduction in the monetary base may be an even more effective tool to reduce inflationary pressures without having the potential side effect of increasing the probability of a recession.
The implication of monetary policy for deposit rates is straightforward. For most institutions, deposit rates are unlikely to increase substantially. To the extent that the Fed’s contractionary policy relies on decreasing the monetary base, further increases in the federal funds rate and other market rates may be smaller than many analysts are currently forecasting. To date, there has been little movement in deposit rates, with the exception of some CD rates, despite an increase in the funds rate of 3%. There is a lag in the adjustment of deposit rates as many institutions adopt a “wait and see” approach on whether they experience a large outflow of funds. But even if there were further increases in the funds rate, there is a strong case to be made that deposit rates might not increase appreciably.
Previously, when the Fed undertook contractionary monetary policy, deposit rates followed market rates up, albeit with a lag and only partially. But previously when the Fed undertook contractionary monetary policy, the number of reserves in the banking system was less than $50 billion versus the August 2022 value of $3.3 trillion. The Fed no longer publishes the number of excess reserves. The last published value for excess reserves was $208 billion in February 2020. That value suggests that current excess reserves exceed $3 trillion. With depository institutions sitting on this much excess reserves, the need to increase deposit rates to retain funds would appear to be very limited. From a simple supply and demand perspective, the supply of deposits appears to greatly outstrip the demand implying that the price – the deposit rate – is likely to remain relatively low.
Key Points:
- We are in the process of recovering from supply shocks rather than a demand shock and fiscal and monetary policies are better designed for dealing with a demand shock.
- Because of the Covid supply shock, an increase in inflation was likely, and that increase was likely exacerbated by expansionary monetary policy and a further supply shock generated by China’s zero-Covid policy and Russia’s war on Ukraine.
- Monetary policy has turned contractionary, more so than is commonly understood, because it includes not only aggressive increases in interest rates but also aggressive decreases in the monetary base.
- There is widespread and possibly misplaced concern that deposit rates will rise substantially over the next few months. While such an increase in deposit rates is possible, it should also be considered unlikely because market rates are unlikely to increase as much as is commonly being forecast and because the amount of excess reserves in the banking system dramatically exceeds the amount available in prior periods of rising rates.
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Written by Richard Sheehan, Ph.D.
About the Author
Dr. Sheehan has published in some of the leading journals in economics, including American Economic Review, Review of Economics and Statistics, Journal of Business and Economic Statistics, European Economic Review, Journal of Money, Credit and Banking, Economic Inquiry, and International Journal of Forecasting.
At MVRA his responsibility is to ensure that the analytical background of every deposit and loan study follows best practices both in terms of statistical analysis and economic theory. He also works in model validation services analyzing financial and statistical models for financial risk.
