Inflation Blame Game: Whose Fault Is This Really?

There’s no shortage of debate around the relative wisdom of deploying draconian rate hikes to combat an inflation problem that has more to do with supply factors than it does with excess demand.

Notwithstanding some of the more abrasive commentary emanating from former government officials and policymakers, it’s a ludicrous stretch to suggest that too much demand (or “money printing”) is the problem. It’s a problem. It may very well be a big problem. And contrary to popular belief, central banks are aware of it. For example, Bank of England Chief Economist Huw Pill last week said that although monetarism “remains unfashionable in academic and central banking circles, perhaps it has contributed more to the past, present and potential future of monetary policy than we conventionally admit.”

But if there’s not enough natural gas or not enough oil or not enough refining capacity for the oil we do have or not enough wheat or not enough logistical wherewithal to get the wheat where it needs to go and so on, then there’s not enough. Period. That’s the problem. You can exacerbate a supply problem by turbocharging demand, thereby straining both sides of the equation. And we unquestionably did that. But gas prices aren’t high because Americans are driving “too much” and the proximate cause of higher prices for flavored Triscuits isn’t suddenly voracious Triscuit demand.

Elizabeth Warren sought to drive home these points last week during a somewhat contentious exchange with Jerome Powell, whose semi-annual interrogation on Capitol Hill was dominated by the inflation discussion.

It’s certainly true that the Fed can influence the demand side. Of course, fiscal policy can too, but to the extent the pandemic equity market bonanza and accompanying property bubble were attributable to monetary largesse, the Fed bears some responsibility for the inflation problem given the read-through of a $40 trillion wealth effect impulse for demand and the labor force.

But who’s responsible for addressing the supply factors? Surely we need to ask that, right? After all, that’s where the real problem is, and nobody argues that the Fed has the capacity to address those factors (or the problems that go along with them) unless “address” means engineering a deep recession.

A recent San Francisco Fed paper found the bank’s vice president of economic research, Adam Hale Shapiro, arguing that supply factors explain “about half of the run-up in current inflation levels,” while demand factors are responsible for just a third. He attributed the rest to “ambiguous factors.” The figure (below) shows the breakdown.

The paper documented well-known pandemic effects. Categories subject to “extraordinarily frequent supply-driven price changes” included new cars and fuel, while categories experiencing frequent demand-driven price changes included home goods like furniture and video equipment and, depending on the month, reopening categories.

Shapiro briefly recapped the evolution of these factors over the past 18 or so months. In March of 2021, the combination of reopening and Joe Biden’s stimulus package led to a demand-driven surge in inflation. As the Delta wave came ashore, demand factors contributed less, but reasserted themselves a few months later.

Supply factors, Shapiro wrote, started to show up last April, have “remained elevated since then” and “appear to be rising more recently” due to “food and energy disruptions,” some of which are “associated with the invasion of Ukraine.” By contrast, the impact from the demand side “appear[s] to be diminishing,” he said, which isn’t surprising given the diminished wealth effect and waning fiscal impulse. The figure (below) shows the deviation in supply- and demand-driven headline inflation contributions from their 2010-2019 average.

Plainly, the supply overshoot is much more pronounced. When considered with the impact of what the San Francisco Fed labeled “ambiguous” factors, the takeaway is that “factors other than demand account for about two-thirds of recent elevated inflation.”

That’s problematic. Deutsche Bank’s Aleksandar Kocic explained why in a characteristically eloquent new note. “The bulk of the work should, in principle, be a job for politics to address. With the current political configuration this is bad news,” he wrote, adding that,

When it comes to labor and energy supply, these issues reside within the territory controlled by Congress and politics in general. While economic interests are global, politics (the ability to decide) remains (passionately) local — and increasingly unable to operate effectively. Power to act has been moving further away, to the politically uncontrollable global space. As a result, politics has been beleaguered by high entropy and uncertainty. The underlying sensitivity of inflation to controversial political developments is, therefore, unsettling and presents ex-ante a major source of anxiety for the markets.

US politics is defined by gridlock. The situation has become so intractable inside the Beltway that even one-party control over both chambers of Congress and the White House is insufficient to thaw the legislative permafrost. Inter-party rancor is the worst it’s been in modern US history and the situation is exacerbated materially by intra-party divisions on both sides of the aisle.

“The danger is that politics is less likely to do its part, and the discussion about the necessary blend of policy response could easily turn into a blame game and create a stalemate that would allow inflation expectations (that react to both demand and supply sides) to keep rising and possibly pressure the Fed to do more,” Kocic went on to say.

The tragic irony is that the very same inflation blame game is likely to result in an even more intractable D.C. stalemate given the likelihood of the GOP capitalizing on America’s inflation problem during the midterms. Divided government after November is likely to render fiscal policy totally inert and result in near complete legislative paralysis.

To the extent supply factors are the purview of politicians, ineffectual government risks a scenario where those factors linger for longer. Politicians are loath to accept blame, especially for something (inflation) that, by statute, isn’t their responsibility. That leaves the Fed in a very tough spot.

“The large impact of supply factors implies that inflationary pressures will not completely subside until labor shortages, production constraints and shipping delays are resolved,” the San Francisco Fed said. Resolving those problems requires political solutions or a recession. If it has to be the latter, some of the blame lies in D.C. And not at the Eccles building.