Brian Albrecht Is a master bowler. He sets up the economic folly pins carefully and knocks them all down most satisfactorily. Today he hands the ball -- Most Inflation Stories Don't Add Up -- to Josh Hendrickson who can also make the pins fly. Unfortunately, today he bowls a high spare.
“When prices rise rapidly across the economy, how do we determine what’s actually causing those increases? Everyone has their preferred explanation—supply chain disruptions, excessive demand, or maybe corporate greed. But rather than debating magnitudes, we should first ask: What’s the mechanism behind each claim? What would we expect to see in the data if that mechanism was actually driving inflation?”
Hendrickson is very good at demonstrating why each of “supply chain disruptions, excessive demand, or maybe corporate greed” cannot be the cause, although “excessive demand” comes close. Those are pins worth knocking down. But the sum of those demonstrations does not provide an explanation for what _does_ cause inflation. Inflation is an emergent phenomenon, consistent with the laws of microeconomics but separate from them.[1] Like temperature and the movement of molecules in a closed system, the higher-level phenomenon cannot be derived by knowledge of the more basic level.[2]
US inflation is, as I suppose Henrickson knows, produced only by the Fed. No matter how greedy the corporations, how disrupted the supply chains or how excessive the spending (to call it excessive “demand” gives the game away) and however better off we might be with less greed, disruptions and spending, none of these things can produce inflation without the Fed. In Aristotelian terms, microeconomic phenomena can be the “material cause” of inflation (The table is made of wood); Fed monetary policy is the “proximate cause” (The carpenter made the table.)[3]
Hendrickson approaches the foul line smoothly:
“How Can We Determine Whether Inflation Was Caused by Supply or Demand?”
As argued above, we can’t; it’s a meaningless question. Was the table made by an oak or a pine? Neither. But we can ask whether it was made _of_ oak or pine. Similarly, we can ask what kind of shock was the motive to the Fed’s production of inflation (or above target inflation as it was already running a 2% FAIT regime)? Shocks require changes in relative prices if all markets are to clear, no unemployment is to develop. When some prices, by contract or custom, can hardly adjust downwardly, the required change in relative prices can be accomplished by other prices going up. Some up and none down equals a rise in the average price level: inflation. But those rising prices do not accomplish this by themselves. It requires the Fed to allow/produce the rise in the price level.[4]
There follows a demonstration that nominal GDP decline at the beginning of the Pandemic and then began rising and that he can predict the 2022 inflation on the base of monetary policy in 2021 and Hendrickson concludes:
No one would deny that supply-side factors played a role. We know that supply chain disruptions took place. However, if you take the basic price-theoretic insight seriously, it seems quite clear that inflation was primarily demand-driven. The period of high inflation was associated with an acceleration in the growth of nominal GDP, precisely what a price theorist would predict from demand-driven inflation.
But Fed policy/supply-side factor are just not alternatives causes of inflation. Hendrickson is the victim of a category mistake.[i] A supply side factors are a reason for the Fed to create “demand driven” inflation.
In arguing against “that rising markups were evidence of supply-driven inflation,” Hendrickson and Albrecht, “Inflation Confusion, or When Can Waffle House Raise its Prices?” argues that markups cannot be an independent suppl side shock at all. (I think it is better to say that hypothetically they could be, but there is no evidence they were.)
This brings us to Hendrickson’s discussion of Peter Orszag “Inflation wasn’t caused by the American Rescue Plan .[5] Orszag gets a wrong answer to the (meaningless) supply/demand cause question, “Supply” that is the opposite of Hendrickson’s wrong answer, “Demand.” Fortunately for Orszag, his error does not invalidate his conclusion. Neither supply disruptions nor the ARA (i.e. spending) nor sectoral demand shifts nor any other creature caused inflation.
Whoever rubs that lamp the same genie come out: the Fed.
My plea to everyone who feels the urge to find the causes of inflation to sublimate that desire. Turn it into interesting questions such as:
Which shocks – COVID lockdowns, Covid induced shifts from services to goods demand, WFH, Putin’s invasion of Ukraine -- was the Fed reacting to as different sages.
Could the Fed have acted more quickly to prevent the fall in prices in early 2020?
Did the Fed produce higher inflation and or prolong it more than necessary to achieve recovery? When should it have begun to dial inflation back?
With an earlier lower peak could the Fed have brough inflation back to target earlier with less increase in unemployment?
What does the pandemic inflation episode tell us about Fed decision making procedures? [https://thomaslhutcheson.substack.com/p/improving-fed-decisions]
Image prompt: Professors standing around rubbing an “Aladdin’s lamp” from which a genie labeled “Fed” comes out.
[Standard bleg: Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail. I would welcome comments on these views.]
[1] I recommend this Sean Caroll podcast “Emergence and Layers of Reality” for a deep discussion of emergence.
[2] In practice this is true even in some cases where it _is_ theoretically possible to derive the emergent (macro) state from the underlying (micro) state. But I’d argue that inflation and relative prices are not one of those cases.
[3] For a discussion of the four Aristotelian causes, see Peter Adamson, Classical Philosophy: A history of philosophy without any gaps, Volume 1
[4] Hendrickson does not want to call this increase in the price level “inflation.”
Since we measure the price level using a weighted average of prices, these changes can cause the price level to increase. However, inflation refers to a sustained increase in the price level over time. A supply shock increases the price level, not the inflation rate.
Sustained! / Explained! While it is going one, It sure smells like teen spirt to me.
[5] For which I am quite grateful as this saves me having to write an “Actually, …” post about Orszag.
[i] If I were to be cruel, I would accuse him of “reasoning from a price change.” 😊
If inflation is caused by the Fed, how do you explain it being a world-wide phenomenon? Imagine OPEC restricts the supply of oil for political reasons, as in the 70s. This supply shock raises input costs of many goods. How is the Fed needed? Your approach simply assumes a (Fed caused) solution and I don’t see how the data is consistent with it….
American Yale Professor Irving Fisher figured it out long ago. The math is science. The lags are constants.