The latest CPI inflation data was released this morning. Mostly the new data just confirms what we’ve seen the past few months: consumer price inflation is at the highest levels in decades, and it is now very broad based.
To see how broad based the inflation is, we can look at any of the “special aggregates” that the BLS produces. CPI less food. CPI less shelter. CPI less food, shelter, energy, used cars and trucks (what a mouthful!). All of these are up substantially over the past year. The lowest number you can get is that last aggregate I listed, which excludes almost 60% of consumer spending, and even it is up 4.7% over the past year — the largest increase since 1991 for that particular special index.
Or, you can just look at food. We all have probably observed that meat prices are way up recently — about 15% over the past year. But it’s not just meat. It’s fruit, vegetables, grains, dairy… the whole darn food pyramid. In fact, there are only two food categories (hot dogs and cheese) and two drinks (tea and wine) that are actually down since December 2020.
Inflation is colloquially defined as, “Too much money chasing too few goods (and services)”. Supply chain constraints get talked about, and these are widely blamed for the inflation we are seeing. Of course, supply limitations play into inflation, but to focus on them is to miss the elephant in room. The primary driver of this inflation is not “too few goods”, but “too much money.”
While the headlines tend to focus on the micro elements of the supply shock (the LA port, coal in China, natural gas in Europe, semiconductors globally, truckers in the UK, etc.), this perspective largely misses the macro cause that is likely to persist and for which there is no idiosyncratic solution. This is not, by and large, a pandemic-related supply problem: as we’ll show, supply of almost everything is at all-time highs. Rather, this is mostly an MP3-driven upward demand shock. [emphases in the original]
In Bridgewater’s terminology, “MP3” is “Monetary Policy #3”, and refers to massive deficit spending combined with central bank quantitative easing. We saw this implemented in 2020-2021 when the federal government pumped out trillions of dollars of stimulus payments and enhanced unemployment benefits, and the Fed instantly soaked up the bonds that were issued to pay for these trillions. This fed/Fed combo amounts to simply printing money on an enormous scale.
Those trillions of dollars funded a huge surge in durable goods purchases. By late 2021 the supply of these goods was well above 2019 (pre-COVID) levels, and even above normal growth trendlines. However, the supply and transport systems simply could not grow fast enough to accommodate this insatiable demand. Charts below substantiate this. To focus on supply chain bottlenecks of themselves is misleading. The primary driver for this inflation has been the trillions of dollars of federal largesse. The Fed knows all this, obviously, but Jay Powell (the Chief Enabler of this deficit spending) would likely not have been reappointed if he spoke too directly about the cause of this inflation. Hence the endless prattle about supply chains.
Keeping a fixed price is a somewhat rare, but fascinating pricing strategy. It can even become part of the identity of the product. The most famous example was Coca-Cola, which sold a 6.5 ounce bottle for 5 cents from 1886 to 1959. It’s so famous that it has its own Wikipedia page! “Always 5 cents” became a marketing slogan for them. And while we may regard that time period as one of generally low inflation, consumer prices on average more than tripled from 1886 to 1959.
Probably the most famous recent example is Costco’s $1.50 hot dog and soda combo, which has been stable in price since 1985. Rumor has it that the founder of Costco once told the current CEO that he’d kill him if he raised the price of the hot dog. Since 1985, nominal median wages in the US have tripled, meaning that your Costco Hot Dog Standard of Living has also tripled.
The concept of nickel and dime stores and later dollar stores are similar concepts, but they aren’t necessarily selling the exact same products over time. Coca-Cola, Hot-N-Ready pizzas, and Costco hot dogs really are the same product from year-to-year, so these products stand out as amazing examples of price stability during periods of time when most prices were rising in nominal terms (other than new technologies).
What are some other examples of consistently stable prices?
I remember people talking about Covid-19 in January of 2020. There had been several epidemic scare-claims from major news outlets in the decade prior and those all turned out to be nothing. So, I was not excited about this one. By the end of the month, I saw people making substantiated claims and I started to suspect that my low-information heuristic might not perform well.
People are different. We have different degrees of excitability, different risk tolerances, and different biases. At the start of the pandemic, these differences were on full display between political figures and their parties, and among the state and municipal governments. There were a lot of divergent beliefs about the world. Depending on your news outlet of choice, you probably think that some politicians and bureaucrats acted with either malice or incompetence.
I think that the Federal Reserve did a fine job, however. What follows is an abridged timeline, graph by graph, of how and when the Fed managed monetary policy during the Covid-19 pandemic.
February, 2020: Financial Markets recognize a big problem
The S&P begins its rapid decent on February 20th and would ultimately lose a third of its value by March 23rd. Financial markets are often easily scared, however. The primary tool that the Fed has is adjusting the number of reserves and the available money supply by purchasing various assets. The Fed didn’t begin buying extra assets of any kind until mid-March. There is a clear response by the 18th, though they may have started making a change by the 11th. One might argue that they cut the federal funds rate as early as the 4th, but given that there was no change in their balance sheet, this was probably demand driven.
March, 2020: The Fed Accommodates quickly and substantially.
In the month following March 9th, the Fed increased M2 by 8.3%. By the week of March 21st, consumer sentiment and mobility was down and economic policy uncertainty began to rise substantially – people freaked out. Although the consumer sentiment weekly indicator was back within the range of normal by the end of April, EPU remained elevated through May of 2020. Additionally, although lending was only slightly down, bank reserves increased 71% from February to April. Much of that was due to Fed asset purchases. But there was also a healthy chunk that was due to consumer spending tanking by 20% over the same period.
In the 18 months prior to 2020, M2 had grown at rate of about 0.5% per month. For the almost 18 months following the sudden 8.3% increase, the new growth rate of M2 almost doubled to about 1% per month. The Fed accommodated quite quickly in March.
April, 2020: People are awash with money
Falling consumption caused bank deposit balances to rise by 5.6% between March 11th and April 8th. The first round of stimulus checks were deposited during the weekend of April 11th. That contributed to bank deposits rising by another 6.7% by May 13th.
By the end of March, three weeks after it began increasing M2, the Fed remembered that it really didn’t want another housing crisis. It didn’t want another round of fire sales, bank failures, disintermediation, collapsed lending, and debt deflation. It went from owning $0 in mortgage-backed securities (MBS) on March 25th to owning nearly $1.5 billion worth by the week of April 1st. Nobody’s talking about it, but the Fed kept buying MBS at a constant growth rate through 2021.
May, 2020 – December, 2021: The Fed Prevents Last-Time’s Crisis
Jerome Powell presided over the shortest US recession ever on record. The Fed helped to successfully avoid a housing collapse, disintermediation, and debt deflation – by 2008 standards. The monthly supply of housing collapsed, but it had bottomed out by the end of the summer. By August of 2021, the supply of housing had entirely recovered. The average price of new house sales never fell. Prices in April of 2020 were typical of the year prior, then rose thereafter. A broader measure of success was that total loans did not fall sharply and are nearly back to their pre-pandemic volumes. After 2008, it took six years to again reach the prior peak. A broader measure still, total spending in the US economy is back to the level predicted by the pre-pandemic trend.
The Fed can’t control long-run output. As I’ve written previously, insofar as aggregate demand management is concerned, we are perfectly on track. The problem in the US economy now is real output. The Fed avoided debt deflation, but it can’t control the real responses in production, supply chains, and labor markets that were disrupted by Covid-19 and the associated policy responses.
What was the cost of the Fed’s apparent success? Some have argued that the Fed has lost some of its political insulation and that it unnecessarily and imprudently over-reached into non-monetary areas. Maybe future Fed responses will depend on who is in office or will depend on which group of favored interests need help. Personally, I’m not so worried about political exposure. But I am quite worried about the Fed’s interventions in particular markets, such as MBS, and how/whether they will divest responsibly.
Of course, another cost of the Fed’s policies has been higher inflation. During the 17 months prior to the pandemic, inflation was 0.125% per month. During the pandemic recession, consumer prices dipped and inflation was moderate through November. But, in the 16 months since April of 2020, consumer prices have grown at a rate of 0.393% per month – more than three times the previous rate. Some of that is catch-up after the brief fall in prices.
Although people are genuinely worried about inflation, they were also worried about if after the 2008 recession and it never came. This time, inflation is actually elevated. But people were complaining about inflation before it was ever perceptible. The compound annual rate of inflation rose to 7% in March of 2021. But it had been almost zero as recent as November, 2020. That March 2021 number is misleading. The actual change in prices from February to March was 0.567%. Something that was priced at $10 in February was then priced at $10.06 in March. Hardly noticeable, were it not for headlines and news feeds.
Inflation is on everyone’s mind. Everybody freaks out. You cannot do anything about it. As such, lets talk about something mildly related: how price indexes (those that we use to talk about inflation) deal with quality changes.
One big problem when we try to measure the cost of living is that the price information we collect does not reflect the same thing we consume. I know that sentence seems weird. After all, 1$ for a pound of bread is 1$ for a pound a bread. And if prices go up 10%, then the price per pound of bread is 1.10$!
If you think that, you’re wrong. Think about the following example from my native province of Quebec. In the 1990s, Quebec deregulated opening hours for grocery stores. The result was … higher prices at large superstores. Why? Before the reform, stores had shorter hours especially on sundays. This meant that stores were competing with each other on a smaller quality dimension which meant more price-based competition. With deregulation, some consumers were willing to pay slightly higher prices to shop at ungodly hours. What were these consumers consuming? Were they consuming only the breadloafs they bought or were they consuming those loafs and the flexible schedule of the grocery stores? The answer is the latter! Ergo, the change from 1$ per pound to 1.10$ per pound does not meanthat the price of bread alone increased — it may have even fallen all else being equal!
So how do you adjust for that? There are many papers on how to do hedonic adjustments (hedonic is the fancy words we use to say “quality-adjusted”) and they are all a pain to read unless you are very familiar with real analysis, set theory and advanced calculus (and even there, its still a pain). Fortunately, I recently found a neat little application from an old econometrics graduate text from the 1960s (see image below) that allows me to teach this to my students (and now, you too!) in an easy-to-get format.
The book has a neat chapter by one of the most famous econometricians of the 20th century, Zvi Griliches, titled “Hedonic Price Indexes for Automobiles: An Econometric Analysis of Quality Change”. In the chapter, Griliches points out that from 1954 to 1960, car prices went up some 20% — well above the overall price index. From 1937 to 1950, prices for cars went up in line with inflation. Taken together, these two facts suggest that the real price of cars stayed constant from 1937 to 1950 and increased to 1960. But that suggestion is wrong Griliches points out because of our aforementioned quality issues. Up until 1960, there were considerable improvement in vehicle quality: better gears, better brakes, more horsepower, safer settings, automatic transmission, hardtops, switching to V-8 engines rather than 6 cylinders engines etc.
How do you account for these quality changes? Griliches simply went about consulting guide books for autobuyers. He collected price data for the cars as well the details regarding quality. And he used this very simple specification where the log of the nominal price is set as a dependent variable.
The vector Xis all the quality dimensions he could find (horsepower, shipping weight, length, V-8 engine, hardtop, automatic transmission, power steering, power brakes, compact car). All of these dimensions were statistically significant determinants of the price of cars (with the exception of V-8 engines which was not significant). Then, Griliches assumed that all quality dimensions were “unchanged” from 1954 to 1960 in order to see how prices would have evolved without any changes in quality. The result is the figure below. The blue line depicts the actual prices he collected where you can see the 20% increase to 1960 (which is a 30%+ increase to 1959). The orange line depicts the price holding quality constant. That orange line is unambiguous: quality-constant car prices didn’t change much during the 1950s. Adjusting for inflation during the period suggests a drop in 10% in the real price of a quality-constant car.
Isn’t that a fascinating way to understand what we are actually measuring when we collect prices to talk about inflation? I find this to be an utterly fascinating example (and a useful teaching tool). Okay, I am done, you can go back to freaking out about inflation and how bad the Fed, Bank of Canada, ECB are.
But is it true? In short: no. I’ll explain why, but my larger goal is to get you to think more clearly about inflation.
How should we measure the cost of a Thanksgiving meal? A widely used measure comes from the Farm Bureau, which shows that the cost of a traditional turkey-centric meal costs about 14% more than last year. In dollar terms it is $53.31 for a turkey, a pumpkin, cranberries, sweet potatoes, stuffing, etc. That’s more that it has ever been, in dollar terms. Farm Bureau has been tracking the cost of this same meal since 1986.
So in one sense, it seems like the headline claim is true. Most expensive Thanksgiving ever!
But we need to think deeper. A nominal price doesn’t actually tell us much. If a long-lost cousin from the Republic of Horpedahl told you it costs 1 million Jeremys to buy a Thanksgiving dinner, what would your reaction be? The first and best reaction is: how much do people earn in the Republic of Horpedahl?
We should ask the same question in the United States today: how do incomes today compare to incomes in the past? Which measure of income you use is important, but if we use median usual weekly earnings of full-time workers, we can make a simple comparison of how much of your weekly earnings would be needed to buy a traditional Thanksgiving meal. This chart shows exactly that. In 2021 that meal will be the second lowest it has ever been as a percent of median earnings — higher than last year, but tied with 2019 for the second lowest. And much less than in the late 1980s and early 1990s (I use third quarter data for each year, the most recent available).
Adjusting for income is the best way to look at this question. It’s not perfect — part of this depends on what income measure you use — but it’s much better than the alternative. The worst approach is to just look at nominal prices. This tells you virtually nothing.
The recent debate over US inflation seems to be full of mood affiliation on both sides, where people start with a mood (“panic” or “don’t worry”) and then look for facts to fit the mood.
My natural temperament is “don’t worry” and that is what I’ve generally thought about inflation, but the latest number of 6.2% inflation over the last year is a bit concerning, and makes me glad the the Fed has announced they plan to taper off of new asset purchases. But overall I think people are still talking past each other, and I wish more people would answer these questions:
What will CPI inflation be over the next 12 months?
What specifically should the Fed do differently, if anything? How quickly should they taper and raise rates?
If you are currently thinking “panic” or “don’t worry”, what data could come in that would change your mind?
I’ll start with my answers, informed more by my gut than by quantitative models: my guess for inflation over the next year is 4-5%, the Fed has things about right but I’d say “tighten faster” rather than “tighten slower” if I had to pick. I expect inflation to slow noticeably in the spring as the economy transitions from the unusual boom in demand for goods back to demand for services after Christmas and the Delta wave, as more people get back to work and supply bottlenecks have time to work themselves out. I would start to get more seriously concerned if we see no slowing by June, or if market-based measures of inflation or NGDP projections start to move substantially (2pp) higher.
To the extent that I’ve been on the wrong side of this, I blame the cognitive bias I seem to fall prey to most often- mistaking reversed stupidity for intelligence. Just because lots of people make obviously incorrect predictions of hyperinflation doesn’t mean that inflation will be low.
*The usual disclaimer applies- my affiliation with the Fed gives me zero insider information about or influence over monetary policy and I don’t speak for them.
The latest CPI release today shows that real inflation is here. Headline inflation for consumer prices is up 6.2% compared to a year ago and a almost full percentage point in just the past month (seasonally adjusted, so compared to the normal monthly increase).
Back in June, we could reasonably say that 45% of the increase that month (and 27% over the prior year) had been due to just the price of new and used cars, in the past month only 17% can be attributed to vehicle prices. That’s still a lot, considering cars are only about 8 percent of the overall CPI, but inflation is clearly showing up in other areas.
Gasoline prices (also car related!) are always volatile, but they are up sharply in the past year. The over 50% increase for regular unleaded gasoline translates to $1.22 more per gallon than a year ago (and $1.50 more gallon than Spring 2020), which is the largest nominal price increase consumers have seen in a 12-month period (the data stretches back to 1977).
But gasoline is only about 4 percent of consumer spending. What if we look more broadly? Even excluding energy prices, inflation is 4.7% over the past year, the highest increase since 1991.
The natural related questions are Why? And what can we do about it?
The Why question is tricky. The Federal Reserve is very interested in whether the increase in prices is caused by monetary policy. It very much guides their action. Consumers don’t really care that much. They just want the pain to stop. Unfortunately, though, part of the pain may be induced by consumers themselves: spending on goods is extremely high right now, with the year so far 18% above the comparable period in 2019. Higher spending will increase prices in any environment, but the strain it is putting on supply chains only exacerbates the problem. This is not to “blame the victim,” but rather to understand what is going on.
What can be done? That’s an even harder question. It’s convenient to blame the President for things like gas prices. And certainly many voters and pundits will blame him. This charge is not completely without basis, as there are certainly things at the margin a president could do to ease gas prices in the short run (allow more drilling, gas tax hiatus), but we shouldn’t oversell this. And in other areas too, perhaps there are changes that could be made at the margin. But given the massive increases in consumer spending (at least for now), any changes won’t put a dent in the overall inflation rate.
But what about at the individual level? Milton Friedman was asked this question in 1980. That year inflation was 13.5%, the highest since World War II. Friedman’s answer: high living. He said there is no asset which you can expect to protect you against inflation, so you should spend what you have now on something nice. Buy a nice house, a nice suit, a picture to hang on the wall. This is what economists sometimes call “the flight to real values,” or as Phil Donahue put it “convert your money into material things.” While this advice may make sense at the individual level, it doesn’t have great implications for the current supply chain issues.
Friedman did have clear advice for the nation: the Federal Reserve should stop increasing the money supply. Whether that advice will work in the current environment, or whether it will stall the economic recovery, is the hard question the Fed is wrestling with at this very moment.
I’m a big fan of Milton Friedman. I’m also a big fan of easy-to-remember phrases that impart great wisdom. It honestly made me wince the first time I said the following:
“Inflation is *not* everywhere and always a monetary phenomenon“.
The reasoning is as plain as day. Consider the quantity equation:
For the uninitiated, M is the money supply, V (velocity) is the average number of times dollars transacts during a period, P is the price level, and finally Y is real output during a period. This equation is often called the “equation of exchange” or “the quantity equation”. Strictly speaking, it is an identity. It is a truism that cannot be violated. All economists agree that the equation is true, though they may disagree on its usefulness.
Inflation is simply the percent change in price. We can rearrange the quantity equation, solving for price, in order to see the relationship between the price level and its determinants.
What does this mean? It means that more money results in more inflation, all else held constant. It means that higher velocity results in more inflation, all else held constant. It means that less output results in more inflation, all else held constant.
Why would Milton Friedman say that inflation is always caused by changes in the money supply if it is clear that there are two other causes of the price level? When Milton Friedman said his famous quote, output growth was relatively steady. Velocity growth was relatively steady. For his context, Milton Friedman was right. The majority of price and inflation volatility was found in changes in M. See below.
Strictly speaking however, Milton Friedman knew better and he knew that the statement was not strictly correct. Friedman was a public intellectual and he was a great simplifier. He taught many people many true things. At the time, people were blaming inflation on a great variety of things: taxes, fish catches, and unions, to name a few. Arguably, Friedman got them closer to the truth.
What does this mean? It means that higher NGDP results in more inflation, all else held constant. It means that less output results in more inflation, all else held constant.
But economists dismissing M in lieu of AD are committing the same oversimplification. Y can also change! Maybe economists figure that our recent history is full of relatively stable Y growth and that we ought not pay attention to it. And indeed, unsurprisingly, RGDP growth has been less than NGDP growth.
But what is driving the current bought of inflation?
Pardon the crude image. The pink lines are eye-balled trend lines on natural logged data for AD, Y, and P. Prices are up. Is it because of exceptionally high NGDP? Nope. Total spending is back on pre-2020 trend. Does Y happen to be down? Yep, it sure is.
Right now, assuming the previous trend was anywhere close to potential output, inflation is not being driven by excess aggregate demand. It’s being driven by inadequate real output. The news tells the story. There have been supply-chain bottle-necks, difficulty employing, lockdowns, and fear of covid. Right now we have an output problem and higher prices are a symptom. We do not have an aggregate spending problem.
PS – In fact, it is my belief that the Fed successfully avoided a debt-deflation aggregate demand tumble that would have been catastrophic. Inflation is expected when supplies of goods decline.
The title question may seem obvious. “We” care about inflation because, ultimately, any dollars we have saved will purchase fewer real goods and services. Additionally, we might worry that our incomes are not keeping pace with the increase in the prices of good and services that we want to purchase.
But the answer to that question is a little more nuanced. “We” also care about why prices are increasing. I keep putting “we” in quotation marks because who the we is crucial for answering the question. For example, individuals and families primarily care about inflation for the reasons I stated in the first paragraph.
But central bankers care about inflation for different reasons. In broad terms, monetary policy is an attempt to smooth out the fluctuations in the economy, especially to make recessions shorter and less deep. But monetary officials want to know: is the policy they are putting in place leading to prices rising in general? If so, especially if inflation gets above certain target levels, it may mean that monetary has been “too loose.”
However, if particular prices are rising, say the price of cars (due to a lack of computer chips), central bankers don’t really care about this: it gives them no indication of whether they’ve done “too much” or “too little” with regards to stimulating the economy. Similarly, if gasoline prices rise, consumers really care about this. Central bankers, not so much: it doesn’t really tell them much about their goal (stimulating the economy with stimulating it too much).
And because some prices are so volatile, historical context is important for understanding what a recent increase or decrease means. For example, gasoline prices are up 45% in the past 12 months. That’s a lot! But it’s an increase from a very low base, and the historical reality is that gasoline prices today (around $3.00/gallon on average) are at similar levels to what they were way back in 2006, and are lower than they were for almost all of 2011-2014. And these are all in nominal terms, median household income has gone up a lot since 2006 (up 40% in nominal terms) and even since 2014 (up 25%).
All of this is important background for thinking about the latest release of the CPI-U data this week. The headline inflation number of 5.3% is indeed startling, similar to last month. We haven’t touched that level since mid-2008, and that was only for a few months. If consumer price inflation were to stay at around 5% for a sustained period of time, it would be a new, harsh reality for most consumers today: we haven’t had a year with 5% inflation since 1990, and for the past decade the average has hung around 2%.
So will it stay this high? Sadly, I have no crystal ball and I will just reiterate what I said last month: the picture is just too muddled right now to say anything concrete. Perhaps by the end of the year we will have a better picture. But is there anything we can say right now even with the muddled picture? I continue to like this chart from the Council of Economic Advisors:
Bottom line: if we strip out the unusual supply chain disruptions to automobiles as well as airline/hotel prices making up for lost ground during the pandemic, inflation is at completely normal levels. It’s almost exactly 2%
But is this cheating? Can we really strip out the things that are increasing at rapid rates?