Anatomy of an Inflation Mess

O ctober’s inflation numbers, released this week, notched the highest level since the 1990s. Policy-makers have spent the past year dismissing inflation as a transitory concern, but the 6.2 percent increase in prices is enough to alarm the most dovish economists. For decades, economists have voiced more concern about deflation in the U.S. than inflation. Indeed, inflation has been below the Federal Reserve’s 2 percent target for decades. How, then, did inflation rear its head so quickly?

Since the start of the pandemic, Congress has passed a total of $5 trillion in stimulus spending, totaling more than 20 percent of GDP. Thanks to enhanced unemployment benefits and stimulus checks, Americans saw their personal incomes skyrocket during the pandemic, even while protracted lockdowns curtailed the production of goods and services.

The increase in personal incomes has led to a spike in consumption, which hit pre-pandemic levels earlier this year. Because service industries such as restaurants and travel have been constrained by COVID-19, consumption has shifted to goods such as automobiles. The concentration of demand in goods, which take longer to produce than services, makes shortages more likely.

The supply of goods has increased, but not quickly enough. At the start of the pandemic, social-distancing measures and an uncertain economic outlook led firms to cut back production, but a swift recovery soon reversed that decline. In fact, the supply of goods to U.S. consumers has risen faster than ever over the past few months. Notwithstanding widespread concern about supply-chain disruptions, shipments of goods to U.S. consumers are well above pre-pandemic levels, as shown in the chart below. Despite this supply pickup, however, demand has been high enough to push the volume of unfilled orders above pre-pandemic levels. These data suggest that transitory supply-side wedges are less to blame for inflation than is elevated demand.

While policy-makers seem to believe this mismatch will subside once firms are able to produce more, a pickup in production is hardly inevitable. For one, labor-force participation remains low, despite rapid wage growth and the end of pandemic lockdowns. Firms looking to meet elevated demand are struggling to find workers, and those that manage to hire can do so only at a high cost. If supply ramps up to meet demand, it is likely to do so at a cost that will keep inflation high.

Elevated demand raises prices not just for consumers but also for producers along the supply chain. The cost of inputs — everything from metals to computer chips — has skyrocketed, as has the cost of shipping. The knock-on effects of elevated demand make it more difficult for the economy to reach equilibrium. If, for instance, the labor market normalizes, that solves only one problem among many. Think of the economy as a balloon: If you squeeze the air from one place, it will simply move somewhere else. Supply and demand will have to reach equilibrium in various markets for inflation to subside.

The risk for policy-makers is a doom loop whereby inflation today begets more inflation tomorrow. Higher prices for gas and groceries may push workers to demand higher wages, which in turn leads to higher production prices. A meaningful slowdown in inflation would require a rapid increase in either productive capacity or labor-force participation. It’s possible that price levels will subside as vaccines and the end of pandemic-era transfers push workers to enter the labor force. But it appears more likely at this point that higher prices will stall rather than fuel the recovery. Elevated inflation expectations incentivize workers to hold out for higher-paying jobs, make it difficult for producers and suppliers to lock in contracts at agreed-upon prices, and raise the specter of an economic slowdown induced by an interest-rate hike.

The Fed is in a bind: A rate hike would kneecap the economic recovery, but persistently high inflation would, too. Meanwhile, the White House looks committed to the passage of Biden’s Build Back Better plan, which would send yet more cash to households while likely reducing the supply of labor. A few more months of high inflation may ring the death knell for the White House’s agenda.