Don't rely on supply-side policy to fight inflation

It's fine to make stuff cheaper. But that isn't really what inflation is about.

The debate over whether inflation is persistent or transitory continues. A lot of this debate revolves around whether the recent rise in the price level is a general rise (which many think would imply that the government is pumping too much money into the economy), or just a rise in a few things like cars and lumber (which would presumably imply that it’s just a bunch of post-pandemic supply bottlenecks). The stakes in this debate are potentially very high; if we’re in a 70’s-type situation, the Fed will need to raise interest rates and Congress will need to cut back on deficit spending, potentially spoiling the chance for a transformative Biden economic agenda. But if this inflation is just a blip, such cutbacks would be a huge mistake.

So is inflation accelerating, or not? Of course, if you strip out all the things whose prices are going up, like cars and computer chips and rent, you’ll be left with a price index that doesn’t show much “inflation”, but this is a little like saying “Other than that, Mrs. Lincoln, how did you like the play?”. So to be consistent, we should rely on the same indicators from month to month. And here we see a mixed picture.

And these numbers are “change relative to a year earlier”, measured relative to a very weird base year. So here’s what the recent numbers look like in terms of annualized month-to-month price changes:

Now it looks like the median is rising a bit while the other measures are falling!

So reading the tea leaves here is a bit tough. I still personally favor a transitory explanation, but I’m not strongly wedded to that; the people who are on “team transitory” should probably have a bit more uncertainty. I think we should wait a month or two, especially with the economic situation changing rapidly thanks to the Delta variant.

Also, it’s important to validate people’s real concerns about inflation, not least because those concerns have a good chance of showing up at the ballot box next year. Consumer sentiment is falling, and that may not be only because of Delta. People generally despise inflation, probably because they feel like their wages have trouble keeping up. And in fact they’re probably not wrong about that; even though labor demand is high and there’s talk of labor shortages throughout the whole economy and wages are going up strongly in dollar terms, after you adjust for inflation it turns out that real wages are going down:

That’s not good, and economists ought to be thinking much more about why nominal wages can’t seem to keep up when inflation spikes. But in the meantime, it means the Fed and the Biden administration need to be thinking about how to bring this period of rising prices to an end.

The Fed isn’t doing that yet. Powell & co. have stated that they still think what we’re seeing is a blip. And Biden is now trying to paint his economic policies as an inflation solution:

While he still maintains inflationary concerns are exaggerated and will be short-lived, Biden is taking pains to show he recognizes the public’s fears over rising prices while arguing his spending plans are best suited to combat them…

In a speech on Wednesday, Biden cast a wide range of his key economic policies — from breaking up monopolies to child-care subsidies to education funding — as part of an agenda to “bring down the biggest costs” for working-class families…

While the administration has always partially sold some of its economic plans as easing families’ financial burden, the change in emphasis to directly confront the inflation debate highlights how the administration has adjusted to the new political and economic realities.

White House officials have looked at polling data suggesting that rising prices could prove a political head wind for Democrats, particularly among older voters far more likely to be worried about inflation, according to two people aware of the matter who spoke on the condition of anonymity to reflect private conversations.

Now, it’s absolutely a good thing to bring down costs for American families! That’s a great thing to do. But in terms of inflation-fighting policy, it’s not good to rely on these sorts of measures. Because although many people think of inflation in terms of the cost of living, limiting inflation is not really about making things cheaper for consumers.

The really scary inflation — the out-of-control spirals that hit South American countries every once in a while, and which we were probably in the early days of back in the 70s — happens not because of the cost of cars or lumber, but because of expectations. The leading theory is that when businesses decide en masse that the Fed (and Congress) simply aren’t going to do much to fight inflation, they start raising prices to get ahead of the trend, and spiraling inflation becomes a self-fulfilling prophecy.

The problem is that thwacking inflation, as Volcker did in the early 80s, is extremely painful for the real economy, so governments understandably shy away from doing this. Instead, they often try to limit rising prices through price controls. Nixon did this, and it’s also something that a lot of Latin American leaders try. To make a long story short, this doesn’t work. If aggregate demand is too high, the overall price level will continue to find a way to rise, and if you keep doubling down with the price controls, you’ll eventually get nasty stuff like empty store shelves and black markets, and your real economy will collapse. Not worth it. Better to suffer the short-term pain of a Volcker recession than to suffer hyperinflation.

But having government foot the bill for part of Americans’ daily necessities isn’t going to tamp down inflation either. Reducing how much consumers pay out of pocket for stuff doesn’t actually translate into a reduction in the prices businesses get paid. Imagine that you pay $1000 for child care. Then the government gives you a child voucher for $500 a month, and child care businesses accordingly raise their price to $1200. Now you’re paying only $700 a month out of pocket (good!), but the price of child care has actually risen.

Government subsidies for consumer goods can ease the financial burden on families and raise living standards and reduce inequality. But when it comes to fighting inflation, they do nothing to allay businesses’ belief that the government is willing to tolerate spiraling prices. Indeed, government subsidies actually raise the prices that businesses see! Biden is, to be blunt, feeding us a line of B.S. here.

But supply-side policies that don’t raise the prices businesses see — slashing tariffs, ending single-family zoning, etc. — shouldn’t be considered front-line inflation-fighting policy. They may be good things on their own, in terms of boosting productivity. But they don’t help to convince businesses that the political leadership is willing to curb demand if necessary.

If businesses decide that the Biden administration, Congress, and the Powell Fed are politically unwilling to fight inflation, that could spark a regime change in expectations that really would take us back to the 70s. If that happens, arguments about whether inflation is just about cars or computer chips would become moot. Republicans would come back to power (though a newly reinstalled President Trump would probably make the situation worse, appointing a Fed chair who would keep interest rates low and trying to fight inflation with price controls like a Latin American strongman). The U.S. economy would hit the skids. Eventually a painful Volcker-like adjustment would become necessary, throwing millions out of work.

This is an outcome to be avoided. As I see it, the Fed is the key actor here. Powell & co. can’t buy into Biden’s B.S. about consumer subsidies being an inflation-fighting measure. And even if they still believe inflation is probably transitory, they can’t afford to create the public perception that they’re on “Team Transitory” — dogmatically insisting that inflation will go back down because they want to support Congress’ spending plans.

A little bit of tough talk on inflation now could avoid a lot of pain two years or five years down the line. An ounce of prevention, etc. etc.