Supply and Demand in Disinflation – A Reply to Bourne

2024-01-04

Yes, Demand Can Explain (Most Of) The American Disinflation

Ray Bourne downplays supply responses in explaining the 2021-23 disinflation.  In particularly he takes issue with “Team Transitory”

Starting mid-last year, notable commentators like Paul Krugman interpreted the simultaneous trends of sharply falling inflation, robust real growth, and low unemployment as vindicating “team transitory.” Inflation, this implies, would have fallen significantly anyway, without Federal Reserve action to tighten monetary policy.

Since then, others, such as Mike Konczal, have expressed an even stronger version of this thesis, which says that the disinflation we’ve seen has overwhelmingly been due to improvements to aggregate supply pushing prices lower, and little to do with weakening demand. Janet Yellen, Joe Biden’s Treasury secretary, has even claimed government policy helped here, writing that the administration has “helped ease supply-chain bottlenecks that had contributed to a surge in goods inflation.”    

I, too, have expressed reservations on Krugman’s views on inflation, but I do not think that the position of either Krugman or anyone of “Team Transitory” ever implied that inflation had gone up or would come down w/o Fed intervention.  At the risk of reading my own views into theirs, I see that position as just pushback against the idea that the Fed would have to aggressively reduce aggregate demand as if inflation had thrown goods prices out of line with wages which would require a large reduction in real wages to restore equilibrium, which would, because wages are downwardly sticky, produce high unemployment and a recession. 

Instead, if inflation — at least THIS inflation — was the process by which many relative goods prices were being adjusted to accommodate shifts in sectoral supplies and demands arising from COVID/COVID recovery/oil and grain shocks, Fed policy to bring down inflation should and could be less aggressive without necessarily producing recession.  Supply response to shifts in changes in sectoral demands (maybe even aided by Administration actions like opening ports 24/7 and sales from the SPR) were, in the Team Transitory view, part of the reason that the Fed could be less aggressive while still successfully bring inflation back to target.

I think that Bourne’s “demand only” analysis” executed in the M x V = P x Y framework misses to key point that the economy is not, for policy making purposes, well modeled as having one good, Y, with one price, P.  [The standard New Keynesian model that lies behind the Phillips Curve [See (3) The Rise and Fall(?) of the Phillips Curve (substack.com)] suffers the same defect.]  My complaint against the one good - one labor input - one price approach is that it is not even wrong.

Bourne then asks:

So, why are so many smart people claiming that disinflation has nothing to do with demand?

[My answer is found at “(3) Why No Recession? - by Thomas L. Hutcheson (substack.com.) Bourne answers:

Scott Sumner, I think, gets closest to an explanation. A lot of Keynesians see that unemployment is still low, or that real consumption expenditures are on trend, and can’t fathom how anyone could argue that a slowdown in demand explains what we’ve seen. That’s because they think real downturns or unemployment *cause* disinflation, as opposed to unemployment being caused by disinflations where total spending growth is too slow, or even negative

Sumner’s criticism – “because they think real downturns or unemployment *cause* disinflation, as opposed to unemployment *being caused by* disinflations” -- with which both Bourne and I agree, is actually better aimed at the conventional “Phillips Curve” approach of “a lot of Keynesians,” than it is at Team Transitory who do not in fact claim that “disinflation has nothing to do with demand.” 

Sumner’s criticism still misses the point, however, by analyzing the economy exclusively in terms of excessive or deficient undifferentiated aggregated supply and demand.  In order for the Fed to figure out how to set its policy instruments, it is important to take account of what the inflation or disinflation it is engineering is trying to accomplish.  Is the aim to restore a single wage/price relation or is it, rather aimed at accommodating an income-maximizing vector of relative prices and wages.

[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.]