Supply-Side Inflation And Its Cures David P. Goldman
The Federal Reserve failed to anticipate the worst inflation since the 1970s and is now administering medicine that will sicken rather than cure the patient. As Fed Chair Jerome Powell said recently: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions.”
This is entirely misguided: unlike the 1970s, today’s inflation is the result of too little labor and too little capital investment – in manufacturing as well as energy. To a great extent, it is a supply-side problem. Discouraging employment and investment by raising interest rates will only make things worse. What the United States requires, rather, is incentives for investment and employment in manufacturing and construction.
The impulse from inflation came from a fiscal shock in the form of federal transfer payments in response to the COVID-19 pandemic.
With a lag of zero to six quarters, transfer payments show a high correlation with year-on-year changes in the Consumer Price Index, as in the cross-correlogram above. A predictive equation that relates year-on-year changes in CPI with lagged values of transfer payments explains most of the change in CPI.
That is a basic difference between the present inflation and the inflation of the 1970s. Transfer payments were not an important factor in the last bout of high inflation.
The inflation of the 1970s, by contrast, occurred during a period of extremely rapid credit expansion.
During the period 1977–1979, the total loans and leases of U.S. commercial banks grew by a record 35%. During 2019–2021, by contrast, bank credit grew by less than 10%.
Extremely high credit growth as a driver of inflation implies deeply entrenched inflationary expectations. During the 1970s, market participants from homebuyers to corporations sought to buy real assets with debt, in the expectation that real assets would appreciate while the real cost of debt service would fall due to inflation. Paul Volcker’s Federal Reserve responded by drastically increasing the cost of credit in order to persuade investors to change their behavior.
Today’s inflation, by contrast, began with two fiscal shocks, in 2020 and 2021, respectively. It was not accompanied by rapid credit growth. On the contrary, credit outstanding at commercial banks fell during the first year of the pandemic, as the chart above makes clear. The demand-side inflationary shock from fiscal policy ran headlong into a supply-side barrier. U.S. industrial capacity could not meet the demand surge. The rise in transfer payments, meanwhile, discouraged labor force participation. A demand shock in the presence of capital and labor shortages was the cause of the present crisis.
The Federal Reserve’s response to inflation – namely, tightening credit conditions – is doubly wrong: it does not attack the source of inflation, and it discourages the capital investment required to solve the supply-side constraints.
In 1979, the Federal Reserve’s monetary tightening addressed the manifest problem of excess credit creation driven by inflation expectations. But the Volcker monetary tightening was only one half of a successful policy combination inspired by Robert Mundell: tight money to reduce inflation and deep tax cuts to promote growth. The 1981 Kemp-Roth tax cut reduced the U.S. top marginal personal rate to 40% from 70% and drew out reserves of labor and entrepreneurship.
The Supply-Side Constraints
The United States cannot marshal enough capital and labor to meet demand. Contrary to what we learn in Economics 101, demand curves in the U.S. seem to be sloping upward. Despite an unprecedented increase in the prices of homes and autos – the two largest items in the household budget for goods – supply has declined. Making sense of that anomaly is a precondition for effective policy.
Used car prices on the Manheim Index have risen 35% since 2019, while home prices are up more than 40%, according to the S&P Case-Shiller National Home Price Index.
Remarkably, the supply of new cars and new homes has declined despite the unprecedented rise in prices.
Manufacturers and builders can’t find workers. Job openings in both construction and manufacturing stand at the highest levels since data were compiled.
Labor force participation, meanwhile, is at a historic low for men and a generational low for women. Without question, fiscal support for incomes is a major cause of low labor force participation. As Goldman Sachs economists led by Jan Hatzius wrote in December 2021: “We attribute about one-half of the U.S. labor force participation rate shortfall to generous fiscal support, which likely discouraged labor supply. . . . Second, we attribute about a third of the U.S. participation shortfall to the form in which fiscal support was delivered, through generous unemployment benefits instead of job retention schemes. Such schemes kept workers attached to their employers in most of the OECD despite similarly large declines in hours worked. Finally, we estimate that the remaining one-sixth of the U.S. participation rate shortfall reflects the labor market response to virus fears, which have likely discouraged people from returning to work.”
Another factor affecting labor force participation is declining real compensation. The recent sharp decline in real median weekly earnings reported by the Bureau of Labor Statistics is as steep as during the 1980 recession. For low-income workers, the impact of inflation is worse due to bracket creep.
Manufacturing investment in real terms remains well below levels of a few years ago. Shown below are the projected capital expenditures for the 80 companies in the S&P 500 Industrial Sub-Index, deflated by the PPI for private investment goods.
Energy is a significant contributor to inflation. U.S. oil production remains below pre-pandemic levels due in large part to the Biden administration’s hostility to carbon fuel development, including a suspension of oil and gas leasing on public lands.
Capital Investment Remains Depressed
By another gauge – deflated orders for nondefense capital goods by U.S. manufacturers – most categories of capital goods are below their 2006 peak.
With domestic production constrained, American consumers bought a record amount of foreign products, and the U.S. trade balance reached an all-time low of $127 billion in March 2022, or more than $1.5 trillion annualized.
Conclusion
Tightening credit conditions is not a remedy for the present wave of inflation. It does not address the causes of inflation, and it will make inflation worse by constraining investment. The Federal Reserve should end its tightening cycle immediately. The United States urgently requires policy measures to increase supply. The Kemp-Roth tax cuts were an effective solution forty years ago, but conditions are different today. We need to revive investment in manufacturing, mining, and energy extraction, and we must encourage Americans to return to work.
Supply-side solutions to inflation should include:
1) Restoring incentives for U.S. oil and gas production
2) Revision of the corporate tax code to favor capital-intensive manufacturing investment (including full first-year tax deduction of capital investment)
3) An end to loopholes that permit Big Tech to shift intellectual property to low-tax countries overseas
4) Encourage firms to buy back their stock rather than invest in new capacity
5) Indexing of tax brackets for inflation and lowering of marginal tax rates for low- and middle-income workers at the federal and state level
6) Public-private partnerships for training skilled workers.
David P. Goldman is deputy editor of Asia Times, a Washington fellow of the Claremont Institute, and a senior writer for Law & Liberty.
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