Prominent Democrats are doubling down on the supply-side inflation narrative. At the semiannual monetary-policy report to Congress, there was a concerted effort to portray ongoing inflation as beyond the Fed’s control. Supply-side inflation is possible, and in the early post-pandemic months, it was a reasonable concern. But the facts since then don’t fit the story. This is old-fashioned, demand-driven, monetary-policy-induced inflation — and the data prove it.
If supply problems were in the driver’s seat, we would observe rising prices and falling output. But only the first holds. Since the pandemic, real GDP has consistently increased. In the fourth quarter of 2022, it grew at a respectable annualized rate of 2.7 percent. The fact that prices and output are moving in the same direction is a dead giveaway that, whatever supply problems remain, demand expansion is contributing more to inflation.
The narrative of supply-side inflation implies that as supply constraints ease, we should see rising income growth and falling prices — outright deflation. Transportation bottlenecks and energy shocks temporarily cause prices to rise, but what goes up must come down. When the pressures ease, the general price level must fall. We’ve seen some disinflation in recent months, meaning a slowdown in the rate of inflation. But we’re still nowhere near a decline in the price level.
We also have independent confirmation that demand is high, and has been so for years. The best measure of economy-wide demand is nominal GDP: total output valued at current market prices. This was about $26 trillion in the last quarter of 2022. Estimates of the neutral level of NGDP, the maximum consistent with full employment of the economy’s scarce resources, was about $24.5 trillion. Total demand is between 3 percent and 8 percent above its trend level from before the pandemic. We’re definitely still in excess-demand territory.
Interest rates, a more conventional measure of demand, tell a similar story. The Fed’s preferred price index rose at an annualized rate of 7.2 percent last month. Using the current federal-funds-rate target of 4.75 percent, the inflation-adjusted rate is a negative 2.7 percent. That’s still easy money, which contributes to high demand. Most economists think the real federal funds rate (the nominal rate minus the inflation rate) consistent with a healthy market for bank reserves is 0.25 to 0.5 percent. The federal funds rate would need to rise from 7.45 to 7.7 percent to achieve this.
Inflation supply-siders have one final refuge: falling productivity growth. If the economy grows more slowly than total demand, prices may rise faster. Compared to pre-pandemic trends, average labor productivity is indeed down. But it hasn’t fallen enough to explain the bulk of inflation. At most, productivity problems explain about 2 percentage points of ongoing inflation. That means we’re left with a residual annualized inflation rate of 5.2 percent, which is more than double the Fed’s target.
We can’t beat inflation if we get its causes wrong. Supply problems were at work in the past and may linger still. But easy money is the main obstacle, and until we rein it in, the American economy will continue to suffer needlessly from inflation. Chairman Powell and the FOMC should stay the course until inflation is well and truly whipped, rather than conveniently blaming factors beyond their control.