What caused the high inflation?
By: Scott Sumner
In a recent interview, SF Fed President Mary Daly listed 4 factors that caused inflation to exceed her expectations. The first three are supply issues, while the fourth relates to demand:
4. Unexpectedly high consumer demand
The final factor that Daly says she underestimated was consumer demand. “The American consumer has been incredibly resilient and incredibly interested in purchasing things when they couldn’t purchase services,” she said. At some point, she believed that Americans had “purchased as many Pelotons as we can possibly use.” And yet, the demand seems insatiable.
In February, overall retail sales increased 0.3% from January and were up 17.6% year-over-year, according to U.S. Census Bureau. And that’s set to continue. The National Retail Federation predicts that sales will grow between 6% and 8% this year.
I have several problems with this claim. First, it’s pretty obvious that most people have effectively “insatiable” preferences for a higher living standard. Even if at some point people have all the Pelotons they want (and I for one do not), they would simply begin to desire other goods. I find it a bit worrisome that a top Fed official would view consumer satiation as a reason not to worry too much about inflation.
Second, it makes more sense to focus on total aggregate demand rather than just consumer demand. In some cases, excessive aggregate demand shows up in rapid growth in investment spending, which can be just as inflationary as rapid growth in consumption.
Third, there is no mention of the role of monetary policy in creating the inflation. Fed policy was clearly too expansionary last year, and as a result aggregate demand (M*V) rose at an excessive rate. Fast growth in nominal spending will lead to high inflation regardless of whether consumers have enough Pelotons or not. If the consumer saving rate rises because their garages are packed with expensive toys, then fast growth in nominal spending would lead to higher investment spending. Or perhaps government spending increases. One way or another, a monetary policy that leads to excessive growth in nominal spending is almost certain to lead to excessive inflation.
When I hear Fed officials talk about inflation, it often seems as if they regard it as some sort of mysterious problem that befell our economy. Excessive inflation is a product of excessively expansionary monetary policy. Demand is a nominal concept; don’t talk about it like it’s a real concept. Aggregate demand rose by more than 100 billion-fold in Germany during the early 1920s, and it wasn’t because Germans suddenly had an insatiable demand for exercise equipment.
That does not mean that all inflation above 2% is excessive. The Fed has a flexible average inflation target, and when there are supply shocks it is appropriate to allow above 2% inflation for a brief period in order to better achieve the Fed’s dual mandate. But when inflation is excessive even from a dual mandate perspective (as it clearly is today), that’s a failure of monetary policy. It’s that simple. Fed officials are perfectly justified in talking about supply problems, which do provide justification for temporarily allowing above 2% inflation. But instead of talking about mysterious increases in “demand”, I wish they’d simply say that monetary policy in 2021 was too expansionary. Why is that so hard to do?
Arsonists don’t need to fix the house burning problems; they need to stop burning down houses. The Fed doesn’t need to “fix” the inflation problem; it needs to stop creating inflation.
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