inflation – Page 14 – HubbardOBrienEconomics.com Blog

Inflation, Supply Chain Disruptions, and the Peculiar Process of Purchasing a Car

Inflation as measured by the percentage change in the consumer price index (CPI) from the same month in the previous year was 7.9 percent in February 2022, the highest rate since January 1982—near the end of the Great Inflation that began in the late 1960s. The following figure shows inflation in the new motor vehicle component of the CPI. The 12.4 percent increase in new car prices was the largest since April 1975.

The increase in new car prices was being driven partly by increases in aggregate demand resulting from the highly expansionary monetary and fiscal policies enacted in response to the economic disruptions caused by the Covid-19 pandemic, and partly from shortages of semiconductors and some other car components, which reduced the supply of new cars.

As the following figure shows, inflation in used car prices was even greater. With the exception of June and July of 2021, the 41.2 percent increase in used car prices in February 2022 was the largest since the Bureau of Labor Statistics began publishing these data in 1954.

Because used cars are a substitute of new cars, rising prices of new cars caused an increase in demand for used cars. In addition, the supply of used cars was reduced because car rental firms, such as Enterprise and Hertz, had purchased fewer new cars during the worst of the pandemic and so had fewer used cars to sell to used car dealers. Increased demand and reduced supply resulted in the sharp increase in the price of used cars.

Another factor increasing the prices consumers were paying for cars was a reduction in bargaining—or haggling—over car prices. Traditionally, most goods and services are sold at a fixed price. For example, some buying a refrigerator usually pays the posted price charged by Best Buy, Lowes, or another retailer. But houses and cars have been an exception, with buyers often negotiating prices that are lower than the seller was asking.

In the case of automobiles, by federal law, the price of a new car has to be posted on the car’s window. The posted price is called the Manufacturer’s Suggested Retail Price (MSRP), often referred to as the sticker price. Typically, the sticker price represents a ceiling on what a consumer is likely to pay, with many—but not all—buyers negotiating for a lower price. Some people dislike the idea of bargaining over the price of a car, particularly if they get drawn into long negotiations at a car dealership. These buyers are likely to pay the sticker price or something very close to it.

As a result, car dealers have an opportunity to practice price discrimination: They charge buyers whose demand for cars is more price elastic lower prices and buyers whose demand is less price elastic higher prices. The car dealers are able to separate the two groups on the basis of the buyers willingness to haggle over the price of a car. (We discuss price discrimination in Microeconomics and Economics, Chapter 15, Section 15.5.) Prior to the Covid-19 pandemic, the ability of car dealers to practice this form of price discrimination had been eroded by the availability of online car buying services, such as Consumer Reports’ “Build & Buy Service,” which allow buyers to compare competing price offers from local car dealers. There aren’t sufficient data to determine whether using an online buying service results in prices as low as those obtained by buyers willing to haggle over price face-to-face with salespeople in dealerships.

In any event, in 2022 most car buyers were faced with a different situation: Rather than serving as a ceiling on the price, the MSRP, had become a floor. That is, many buyers found that given the reduced supply of new cars, they had to pay more than the MSRP. As one buyer quoted in a Wall Street Journal article put it: “The rules have changed so dramatically…. [T]he dealer’s position is ‘This is kind of a take-it-or-leave-it proposition.’” According to the website Edmunds.com, in January 2021, only about 3 percent of cars were sold in the United States for prices above MSRP, but in January 2022, 82 percent were.

Car manufacturers are opposed to dealers charging prices higher than the MSRP, fearing that doing so will damage the car’s brand. But car manufacturers don’t own the dealerships that sell their cars. The dealerships are independently owned businesses, a situation that dates back to the beginning of the car industry in the early 1900s. Early automobile manufacturers, such as Henry Ford, couldn’t raise sufficient funds to buy and operate a nationwide network of car dealerships. The manufacturers often even had trouble financing the working capital—or the funds used to finance the daily operations of the firm—to buy components from suppliers, pay workers, and cover the other costs of manufacturing automobiles.

The manufacturers solved both problems by relying on a network of independent dealerships that would be given franchises to be the exclusive sellers of a manufacturer’s brand of cars in a given area. The local businesspeople who owned the dealerships raised funds locally, often from commercial banks. Manufacturers generally paid their suppliers 30 to 90 days after receiving shipments of components, while requiring their dealers to pay a deposit on the cars they ordered and to pay the balance due at the time the cars were delivered to the dealers. One historian of the automobile industry described the process:

The great demand for automobiles and the large profits available for [dealers], in the early days of the industry … enabled the producers to exact substantial advance deposits of cash for all orders and to require cash payment upon delivery of the vehicles …. The suppliers of parts and materials, on the other hand, extended book-account credit of thirty to ninety days. Thus the automobile producer had a month or more in which to assemble and sell his vehicles before the bills from suppliers became due; and much of his labor costs could be paid from dealers’ deposits.

The franchise system had some drawbacks for car manufacturers, however. A car dealership benefits from the reputation of the manufacturer whose cars it sells, but it has an incentive to free ride on that reputation. That is, if a local dealer can take an action—such as selling cars above the MSRP—that raises its profit, it has an incentive to do so even if the action damages the reputation of Ford, General Motors, or whichever firm’s cars the dealer is selling. Car manufacturers have long been aware of the problem of car dealers free riding on the manufacturer’s reputation. For instance, in the 1920s, Ford sent so-called road men to inspect Ford dealers to check that they had clean, well-lighted showrooms and competent repair shops in order to make sure the dealerships weren’t damaging Ford’s brand.

As we discuss in Microeconomics and Economics, Chapter 10, Section 10.3, consumers often believe it’s unfair of a firm to raise prices—such as a hardware store raising the prices of shovels after a snowstorm—when the increases aren’t the result of increases in the firm’s costs. Knowing that many consumers have this view, car manufacturers in 2022 wanted their dealers not to sell cars for prices above the MSRP. As an article in the Wall Street Journal put it: “Historically, car companies have said they disapprove of their dealers charging above MSRP, saying it can reflect poorly on the brand and alienate customers.”

But the car manufacturers ran into another consequence of the franchise system. Using a franchise system rather than selling cars through manufacturer owned dealerships means that there are thousands of independent car dealers in the United States. The number of dealers makes them an effective lobbying force with state governments. As a result, most states have passed state franchise laws that limit the ability of car manufacturers to control the actions of their dealers and sometimes prohibit car manufacturers from selling cars directly to consumers. Although Tesla has attained the right in some states to sell directly to consumers without using franchised dealers, Ford, General Motors, and other manufacturers still rely exclusively on dealers. The result is that car manufacturers can’t legally set the prices that their dealerships charge.

Will the situation of most people paying the sticker price—or more—for cars persist after the current supply chain problems are resolved? AutoNation is the largest chain of car dealerships in the United States. Recently, Mike Manley, the firm’s CEO, argued that the substantial discounts from the sticker price that were common before the pandemic are a thing of the past. He argued that car manufacturers were likely to keep production of new cars more closely in balance with consumer demand, reducing the number of cars dealers keep in inventory on their lots: “We will not return to excessively high inventory levels that depress new-vehicle margins.”

Only time will tell whether the situation facing car buyers in 2022 of having to pay prices above the MSRP will persist.

Sources: Mike Colias and Nora Eckert, “A New Brand of Sticker Shock Hits the Car Market,” Wall Street Journal, February 26, 2022; Nora Eckert and Mike Colias, “Ford and GM Warn Dealers to Stop Charging So Much for New Cars,” Wall Street Journal, February 9, 2022; Gabrielle Coppola, “Car Discounts Aren’t Coming Back After Pandemic, AutoNation Says,” bloomberg.com, February 9, 2022; cr.org/buildandbuy; Lawrence H. Seltzer, A Financial History of the American Automobile Industry, Boston: Houghton-Mifflin, 1928; and Federal Reserve Bank of St. Louis.

Would Cutting the Federal Excise Tax on Gasoline Lower the Price that Consumers Pay?

The federal government levies an excise tax of 18.4 cents per gallon of gasoline. (An excise tax is a tax that a government imposes on a particular product. In addition to the tax on gasoline, the federal government imposes excise taxes on tobacco, alcohol, airline tickets, and a few other products.) In February 2022, inflation was running at the highest level in several decades. The average retail price of gasoline across the country had risen to $3.50 per gallon from $2.60 per gallon a year earlier. The following figure shows fluctuations in the retail price of gasoline since January 2000.

Policymakers were looking for ways to lessen the effects of inflation on consumers. An article in the Wall Street Journalreported that several Democratic members of the U.S. Senate, including Mark Kelly of Arizona, Maggie Hassan of New Hampshire, and Raphael Warnock of Georgia proposed that the federal excise tax on gasoline be suspended for the remainder of 2022. The sponsors of the proposal believed that cutting the tax would reduce the price of gasoline that consumers pay at the pump. Other members of the Senate weren’t so sure, with one quoted as saying that cutting the tax was “not going to change anything” and another arguing that oil companies would receive most of the benefit of the tax cut.

Some members of Congress were opposed to suspending the gasoline tax because the revenue raised from the tax is placed in the highway trust fund, which helps to pay for federal contributions to highway building and repair and for mass transit. In that sense, the gasoline tax follows the benefits-received principle, under which people who receive benefits from a government program—in this case, highway maintenance—should help pay for the program. (We discuss the principles for evaluating taxes in Microeconomics, Chapter 17, Section 17.2 and in Economics, Chapter 17, Section 17.2) Other members of Congress were opposed to suspending the tax because they believe that the tax helps to reduce the quantity of gasoline consumed, thereby helping to slow climate change.

Focusing just on the question of the effect of suspending the tax on the retail price of gasoline, what can we conclude? The question is one of tax incidence, which looks at the actual division of the burden of a tax between buyers and sellers in a market. In other words, tax incidence looks beyond the fact that gasoline stations collect the tax and send the revenue to federal government to the issue of who actually pays the tax. As we note in Chapter 17, Section 17.3:

When the demand for a product is less elastic than supply, consumers pay the majority of the tax on the product. When the demand for a product is more elastic than supply, firms pay the majority of the tax on the product.

Consumers would receive all of the tax cut—that is, the retail price of gasoline would fall by 18.4 cents—only in the polar case where the demand for gasoline were perfectly price inelastic. Similarly, consumers would receive none of the tax cut and the price of gasoline would remain unchanged—so oil companies would receive all of the tax cut—only in the polar case where the demand for gasoline is perfectly price inelastic. (It’s a worthwhile exercise to show these two cases using demand and supply graphs.)

In the real world, we would expect to be somewhere in between these two cases, with consumers receiving some of the benefit of suspending the tax and producers receiving the remainder of the benefit. The short-run price elasticity of demand for gasoline is quite small; according to one estimate it is only −.06. The short-run price elasticity of supply of gasoline is likely to be somewhat larger than that in absolute value, which means that we would expect that consumers would receive the majority of the tax cut. (Note that we would expect the long-run price elasticities of demand and supply to both be larger for reasons we discuss in Chapter 6, Section 6.2 and 6.6.) In other words, the retail price of gasoline would fall, holding all other factors constant, but not by the full tax cut of 18.4 cents.

Joseph Doyle of MIT and Krislert Samphantharak of the University of California, San Diego studied the effect of suspension in the state excise tax on gasoline in Indiana and Illinois in 2000. In that year, Indiana suspended collecting its gasoline excise tax for 120 days and Illinois suspended its tax for 184 days. The authors estimate that consumers received about 70 percent of the tax cut in the form of lower gasoline prices. If we apply that estimate to the federal gasoline tax, then suspending the tax would lower the price of gasoline by about 12.9 cents per gallon, holding all other factors that affect the price of gasoline constant. As the above figure shows, the retail price of gasoline frequently fluctuates up and down by more than 12.9 cents, even over fairly brief periods of time. In that sense, the effect on the gasoline market of suspending the federal excise tax on gasoline would be relatively small.

Sources: Andrew Duehren and Richard Rubin, “Some Lawmakers Want to Halt Gas Tax Amid High Inflation. Others See a Gimmick,” Wall Street Journal, February 16, 2022; Tony Romm and Jeff Stein, “White House, Congressional Democrats Eye Pause of Federal Gas Tax as Prices Remain High, Election Looms,” Washington Post, February 15, 2022; Joseph J. Doyle, Jr., Krislert Samphantharak, “$2.00 Gas! Studying the Effects of a Gas Tax Moratorium,” Journal of Public Economics, Vol. 92, No.s 3-4, April 2008, pp. 869-884; and Federal Reserve Bank of St. Louis.

Are Economic Profits a Sign of Market Power?

Cecilia Rouse, chair of the Council of Economic Advisers. Photo from the *Washington Post*.

An article in the Washington Post discussed a debate among President Biden’s economic advisers. The debate was over “over whether the White House should blame corporate consolidation and monopoly power for price hikes.” Some members of the National Economic Council supported the view that the increase in inflation that began in the spring of 2021 was the result of a decline in competition in the U.S. economy.

Some Democratic members of Congress have also supported this view. For instance, Massachusetts Senator Elizabeth Warren argued on Twitter that: “One clear explanation for higher inflation? Giant corporations are exploiting their market power to further raise prices. And corporate executives are bragging about their higher profits.” Or, as Vermont Senator Bernie Sanders put it: “The problem is not inflation. The problem is corporate greed, collusion & profiteering.”

But according to the article, Cecilia Rouse, chair of the President’s Council of Economic Advisers (CEA), and other members of the CEA are skeptical that a lack of competition are the main reason for the increase in inflation, arguing that very expansionary monetary and fiscal policies, along with disruptions to supply chains, have been more important.

In an earlier blog post (found here), we noted that a large majority of more than 40 well-known academic economists surveyed by the Booth School of Business at the University of Chicago disagreed with the statement: “A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.”

One difficulty with the argument that the sharp increase in inflation since mid-2021 was due to corporate greed is that there is no particular reason to believe that corporations suddenly became more greedy than they had been when inflation was much lower. If inflation were mainly due to corporate greed, then greed must fluctuate over time, just as inflation does. Economic writer and blogger Noah Smith poked fun at this idea in the following graph.

It’s worth noting that “greed” is one way of characterizing the self-interested behavior that underlies the assumption that firms maximize profits and individual maximize utility. (We discuss profit maximization in Microeconomics, Chapter 12, Section 12.2, and utility maximization in Chapter 10, Section 10.1.) When economists discuss self-interested behavior, they are not making a normative statement that it’s good for people to be self-interested. Instead, they are making a positive statement that economic models that assume that businesses maximize profit and consumers maximize utility have been successful in analyzing and predicting the behavior of businesses and households.

Corporate profits increased from $1.95 trillion in the first quarter of 2021 to $2.40 trillion in third quarter of 2021 (the most recent quarter for which data are available). Using another measure of profit, during the same period, corporate profits increased from about 16 percent of value added by nonfinancial corporate businesses to about 18 percent. (Value added measures the market value a firm adds to a product. We discuss calculating value added in Macroeconomics, Chapter 8, Section 8.1.)

There have been mergers in some industries that may have contributed to an increase in profits—the Biden Administration has singled out mergers in the meatpacking industry as having led to higher beef and chicken prices. At this point, though, it’s not possible to gauge the extent to which mergers have been responsible for higher prices, even in the meatpacking industry.

An increase in profit is not by itself an indication that firms have increased their market power. We would expect that even in a perfectly competitive industry, an increase in demand will lead in the short run to an increase in the economic profit earned by firms in the industry. But in the long run we expect economic profit to be competed away either by existing firms expanding their production or by new firms entering the industry.

In Chapter 12, we use Figure 12.8 to illustrate the effects of entry in the market for cage-free eggs. Panel (a) shows the market for cage-free eggs, made up of all the egg sellers and egg buyers. Panel (b) shows the situation facing one farmer producing cage-free eggs. (Note the very different scales of the horizontal axes in the two panels.) At $3 per dozen eggs, the typical egg farmer is earning an economic profit, shown by the green rectangle in panel (b). That economic profit attracts new entrants to the market—perhaps, in this case, egg farmers who convert to using cage-free methods. The result of entry is a movement down the demand curve to a new equilibrium price of $2 per dozen. At that price, the typical egg farmer is no longer earning an economic profit.

A few last observations:

The recent increase in profits may also be short-lived if it reflects a temporary increase in demand for some durable goods, such as furniture and appliances, raising their prices and increasing the profits of firms that produce them. The increase in spending on goods, and reduced spending on services, appears to have resulted from: (1) Households having additional funds to spend as a result of the payments they received from fiscal policy actions in 2020 and early 2021, and (2) a reluctance of households to spend on some services, such as restaurant meals and movie theater tickets, due to the effects of the Covid-19 pandemic.
The increase in profits in some industries may also be due to a reduction in supply in those industries having forced up prices. For instance, a shortage of semiconductors has reduced the supply of automobiles, raising car prices and the profits of automobile manufacturers. Over time, supply in these industries should increase, bringing down both prices and profits.
If some changes in consumer demand persist over time, we would expect that the economic profits firms are earning in the affected industries will attract the entry of new firms—a process we illustrated above. In early 2022, this process is far from complete because it takes time for new firms to enter an industry.

Source: Jeff Stein, “White House economists push back against pressure to blame corporations for inflation,” Washington Post, February 17, 2022; Mike Dorning, “Biden Launches Plan to Fight Meatpacker Giants on Inflation,” bloomberg.com, January 3, 2022; and U.S. Bureau of Economic Analysis.ec

Does Inflation Affect Lower-Income People More than Higher-Income People?

There’s a consensus among economists that increases in unemployment during a recession typically are larger for lower-income people than for higher-income people. Lower-income people are more likely to hold jobs requiring fewer skills and firms typically expect that when they lay off less-skilled workers during a recession they will be able to higher them—or other workers with similar skills—back after the recession ends. Because higher income have skills that may be difficult to replace, firms are more reluctant to lay them off.

For instance, in an earlier blog post (found here) we noted that during the period in 2020 when many restaurants were closed, the Cheesecake Factory continued to pay its 3,000 managers while it laid off most of its servers. That strategy made it easier for the restaurant chain to more easily expand its operations when the worst of government-ordered closures were over. More generally, Serdar Birinci and YiLi Chien of the Federal Reserve Bank of St. Louis found that workers in the lowest 20 percent (or quintile) of earnings experienced an increased unemployment rate from 4.4 percent in January 2020 to 23.4 percent in April 2020, whereas workers in the highest quintile of earnings experienced an increase only from 1.1 percent in January to 4.8 percent in April.

If lower-income people are hit harder by unemployment, are they also hit harder by inflation? Answering that question is difficult because the U.S. Bureau of Labor Statistics (BLS) doesn’t routinely release data on inflation in the prices of goods and services purchased by households at different income levels. The main measure of consumer price inflation compiled by the BLS represents changes in the consumer price index (CPI). The CPI is an index of the prices in a market basket of goods and services purchased by households living in urban areas. The information on consumer purchases comes from interviews the BLS conducts every three months with a sample of consumers and from weekly diaries in which a sample of consumers report their purchases. (We discuss the CPI in Macroeconomics, Chapter 9, Section 9.4 and in Economics, Chapter 19, Section 19.4.)

The BLS releases three measures of the CPI, the two most widely used of which are the CPI-U for all urban consumers and CPI-W for urban wage earners. CPI-W covers the subset of households that receive at least half their household income from clerical or wage occupations and who have at least one wage earner who worked for 37 weeks or more during the previous year. CPI-U represents about 93 percent of the U.S. population and CPI-W represents about 29 percent of the U.S. population. Finally, in 1988 Congress instructed the BLS to compile a consumer price index reflecting the purchases of people aged 62 and older. This version of the CPI is labeled R-CPI-E; the R indicates that it is a research series and the E indicates that it is intended to measure the prices of goods and services purchased by elderly people. Because the sample used to calculate the R-CPI-E is relatively small and because of some other difficulties that may reduce the accuracy of the index, the BLS considers it a series best suited for research and does not include the data in its monthly “Consumer Price Index” publication. In any event, as the following figure shows, inflation, measured as the percentage change in the CPI from the same month in the previous year, has been very similar for all three measures of the CPI.

Because the market baskets of goods and services consumed by a mix of high and low-income households is included in all three versions of the CPI, none of the versions provides a way to measure the possibly different effects of inflation on low-income and on high-income households. A study by Josh Klick and Anya Stockburger of the BLS attempts to fill this gap by constructing measures of the CPI for low-income and for high-income households. They define low-income households as those in the bottom 25 percent (quartile) of the income distribution and high-income households as those in the top quartile of the income distribution. During the time period of their analysis—December 2003 to December 2018—the bottom quartile had average annual incomes of $12,705 and the top quartile had average annual incomes of $155,045.

The BLS researchers constructed market baskets for the two groups. The expenditure weights—representing the mix of products purchased—don’t differ too strikingly between lower-income and higher-income households, as the figure below shows. The largest differences are housing, with low-income households having a market basket weight of 45.2 percent and high-income households having a market basket weight of 39.5 percent, and transportation, with low-income households having a market basket weight of 13.0 percent and high-income households having a market basket weight of 17.2 percent.

The following table shows the inflation rate as measured by changes in different versions of the CPI over the period from December 2003 to December 2018. During this period, the CPI-U (the version of the CPI that is most frequently quoted in news stories) increased at an annual rate of 2.1 percent, which was the same rate as the CPI-W. The R-CPI-E increased at a slightly faster rate of 2.2 percent. Lower-income households experienced the highest inflation rate at 2.3 percent and higher-income households experienced the lowest inflation rate of 2.0 percent.

CPI-U	CPI-W	R-CPI-E	CPI for lowest income quartile	CPI for highest income quartile
2.1%	2.2%	2.1%	2.3%	2.0%

The differences in inflation rates across groups were fairly small. Can we conclude that the same was true during the recent period of much higher inflation rates? We won’t know with certainty until the BLS extends its analysis to cover at least the years 2021 and 2022. But we can make a couple of relevant observations. First, for many people the most important aspect of inflation is whether prices are increasing faster of slower than their wages. In other words, people are interested in what is happening to their real wage. (We discuss calculating real wage rates in Macroeconomics, Chapter 9, Section 9.5 and in Economics, Chapter 19, Section 19.5.)

The Federal Reserve Bank of Atlanta compiles data on wage growth, including wage growth by workers in different income quartiles. The following figure shows that workers in the top quartile have experienced more rapid wage growth in the months since the beginning of the Covid-19 pandemic than have workers in the other quartiles. This gap continues a trend that began in 2015. The bottom quartile has experienced the slowest rate of income growth. (Note that the researchers at the Atlanta Fed compute wage growth as a 12-month moving average rather than as the percentage from the same month in the previous year, as we have been doing when calculating inflation using the CPI.) For example, in January 2022, calculated this way, average wage growth in the top quartile was 5.8 percent as opposed to 2.9 percent in the bottom quartile.

As with any average, there is some variation in the experiences of different individuals. Although, as a group, lower-income workers have seen wage growth that lags behind other workers, in some industries that employ many lower-income people, wage growth has been strong. For instance, as measured by average hourly earnings, wages for all workers in the private sector increased by 5.7 percent between January 2021 and 2022. But average hourly earnings in the leisure and hospitality industry—which employs many lower-income workers—increased by 13.0 percent.

Overall, it seems likely that the real wages of higher-income workers have been increasing while the real wages of lower-income workers have been decreasing, although the experience of individual workers in both groups may be very different than the average experience.

Sources: Josh Klick and Anya Stockburger, “Experimental CPI for Lower and Higher Income Households Serdar,” U.S. Bureau of Labor Statistics, Working Paper 537, March 8, 2021; Birinci and YiLi Chien, “An Uneven Crisis for Lower-Income Households,” Federal Reserve Bank of St. Louis, Annual Report 2020, April 7, 2021; and Federal Reserve Bank of Atlanta, “Wage Growth Tracker,” https://www.atlantafed.org/chcs/wage-growth-tracker.

The Controversy over Modern Monetary Theory (MMT)

On Sunday, February 6, the New York Times ran an article on Modern Monetary Theory (MMT) on the front page of its business section with the title, “Time for a Victory Lap.” Link here, subscription may be required. (Note: The title of the article was later changed on the nytimes.com site to “Is This What Winning Looks Like?” perhaps because of the controversy linked to below.)

The article led to a controversy on Twitter (but, then, what topic doesn’t lead to a controversy on Twitter?). Social media is, obviously, not always the best place to discuss economic theory and policy, but instructors and students interested in the debate may find the following links useful both because of the substantive issues raised and as an example of how debates over economic policy can sometimes become heated.

Harvard economist Lawrence Summers reacts negatively to the content of the New York Times article (and to MMT) here.

Economics blogger Noah Smith also reacts negatively to the article here. Smith’s blog post discussing the article at length is here, subscription may be required.

Former Fed economist Claudia Sahm defends the article (and MMT) here.

Jeanna Smialek, the author of the New York Times article, reacts to critics of the article here and to Noah Smith’s blog post here. Smith responds to her response here.

Jason Furman of Harvard’s Kennedy School provides a brief discussion of whether MMT has had much influence on monetary policy here.

We discuss MMT in the Apply the Concept, “Modern Monetary Theory: Should We Stop Worrying and Love the Debt?” in Macroeconomics, Chapter 16, Section 16.6 and in Economics, Chapter 26, Section 26.6.

AIT or FAIT: How Will the Fed’s New Monetary Policy Strategy Deal with High Inflation Rates?

Congress has given the Fed a mandate to achieve the goal of price stability. Until 2012, the Fed had never stated explicitly how they would measure whether they had achieved this goal. One interpretation of price stability is that the price level remains constant. But a constant price level would be very difficult to achieve in practice and the Fed has not attempted to do so. In 2012, the Fed, under then Chair Ben Bernanke, announced that it was targeting an inflation rate of 2 percent, which it believed was low enough to be consistent with price stability: “When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.” (We discuss inflation targeting in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.)

In August 2020, the Fed announced a new monetary policy strategy that modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time, although the Fed has not explicitly stated how long the period of time may be. In other words, the Fed hasn’t indicated the time horizon during which it intends inflation to average 2 percent.

The Fed uses changes in the personal consumption expenditure (PCE) price index to measure inflation, rather than using changes in the consumer price index (CPI). The Fed prefers the PCE to the CPI because the PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The following figure shows inflation for the period since 2006 measured by percentage changes in the PCE from the corresponding month in the previous year. (Members of the Fed’s Federal Open Market Committee generally consider changes in the core PCE—which excludes the prices of food and energy—to be the best measure of the underlying rate of inflation. But because the Fed’s inflation target is stated in terms of the PCE rather than the core PCE, we are looking here only at the PCE.) The figure shows that for most of the period from 2012 to early 2021, inflation was less than the Fed’s target of 2 percent.

The figure also shows that since March 2021, inflation has been running above 2 percent and has steadily increased, reaching a rate of 5.8 percent in December 2021. Note that a strict interpretation of AIT would mean that the Fed would have to balance these inflation rates far above 2 percent with future inflation rates well below 2 percent. As Ricardo Reis, an economist at the London School of Economics, noted recently: “If the [Fed’s time] horizon is 3 years, the Fed … will [have to] pursue monetary policy to achieve annual inflation of… −0.5% over the next year and a half. If the horizon is 5 years, the Fed … will [have to] pursue policy to achieve annual inflation of 0.9% over the next 3.5 years.” It seems unlikely that the Fed would want to bring about inflation rates that low because doing so would require raising its target for the federal funds rate to levels likely to cause a recession.

Another interpretation of the Fed’s monetary policy strategy is that involves a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Former Fed Vice Chair Richard Clarida discussed this interpretation of the Fed’s strategy in a speech in November 2020. He noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”

Under this interpretation, particularly if Fed policymakers believe that the high inflation rates of 2021 were the result of temporary supply chain problems and other factors caused by the pandemic, it would not need to offset them by forcing inflation to very low levels in order to make the average inflation rate over time equal 2 percent. Critics of the FAIT approach to monetary policy note that the approach doesn’t provide investors, household, and firms with much guidance on what inflation rates the Fed may find acceptable over the short-term of a year or so. In that sense, the Fed is moving away from a rules-based policy, such as the Taylor rule that we discuss in Chapter 15. Or, as a columnist for the Wall Street Journal wrote with respect to FAIT: “Of course, the word ‘flexible’ is there because the Fed doesn’t want to be tied down, so it can do anything.”

The Fed’s actions during 2022 will likely provide a better understanding of how it intends to implement its new monetary policy strategy during conditions of high inflation.

Sources: Board of Governors of the Federal Reserve, “Why does the Federal Reserve aim for inflation of 2 percent over the longer run?” federalreserve.gov, August 27, 2020; Board of Governors of the Federal Reserve, “2020 Statement on Longer-Run Goals and Monetary Policy Strategy,” federalreserve.gov, January 14, 2021; Ricardo Reis’s comments are from this Twitter thread: https://mobile.twitter.com/R2Rsquared/status/1488552608981827590, Richard H. Clarida, “The Federal Reserve’s New Framework: Context and Consequences,” federalreserve.gov, November 16, 2020; and James Mackintosh, “On Inflation Surge, the Fed Is Running Out of Excuses,” Wall Street Journal, November 14, 2021.

The Employment Cost Index, Inflation, and the Possibility of a Wage-Price Spiral

In respect to its mandate to achieve price stability, the Federal Open Market Committee focuses on data for the personal consumption expenditure (PCE) price index and the core PCE price index. (The core PCE price index omits food and energy prices, as does the core consumer price index.) After the March, June, September, and December FOMC meetings, each committee member projects future values of these price indexes. The projections, which are made public, provide a means for investors, businesses, and households to understand what the Fed expects to happen with future inflation.

In his press conference following the December 2021 FOMC meeting, Chair Jerome Powell surprised some economists by discussing the importance of the employment cost index (ECI) in the committee’s evaluation of the current state of inflation. Powell was asked this question by a journalist: “I wonder if you could talk a little bit about what prompted your recent pivot toward greater wariness around inflation.” He responded, in part:

“We got the ECI reading on the eve of the November meeting—it was the Friday before the November meeting—and it was very high, 5.7 percent reading for the employment compensation index for the third quarter … That’s really what happened [that resulted in FOMC deciding to focus more on inflation]. It was essentially higher inflation and faster—turns out much faster progress in the labor market.”

The ECI is compiled by the Bureau of Labor Statistics and is published quarterly. It measures the cost to employers per employee hour worked. The BLS publishes data that includes only wages and salaries and data that includes, in addition to wages and salaries, non-wage benefits—such as contributions to retirement accounts or health insurance—that firms pay workers. The figure below shows the ECI including just wages and salaries (red line) and including all compensation (blue line). The difference between the two lines shows that wages and salaries have been increasing more rapidly than has total compensation.

A focus on the labor market when analyzing inflation is unsurprising. In Macroeconomics, Chapter 17, Section 17.1 (Economics, Chapter 27, Section 27.1) we discuss how the Phillips curve links the state of the labor market—as measured by the unemployment rate—to the inflation rate. The link between the unemployment rate and the inflation rate operates through the labor market: When the unemployment rate is low, firms raise wages as they attempt to attract the relatively small number of available workers and to keep their own workers from leaving. (As first drawn by economist A.W. Phillips, the Phillips curve showed the relationship between the unemployment rate and the rate of wage inflation, rather than the relationship between the unemployment rate and the rate of price inflation.) As firms’ wage costs rise, they increase prices. So, as Powell noted, we would expect that if wages are rising rapidly, the rate of price inflation will also increase.

Powell noted that the FOMC is concerned that rising wages might eventually lead to a wage-price spiral in which higher wages lead to higher prices, which, in turn, cause workers to press for higher nominal wages to keep their real wages from falling, which then leads firms to increases their prices even more, and so on. Some economists interpret the inflation rates during the Great Inflation for 1968–1982 as resulting from a wage-price spiral. One condition for a wage-price spiral to begin is that workers and firms cease to believe that the Fed will be able to return to its target inflation rate—which is currently 2 percent.

In terms of the Phillips curve analysis of Chapter 17, a wage-price spiral can be interpreted as a shifting up of the short-run Phillips curve. The Phillips curve shifts up when households, firms, and investors increase their expectations of future inflation. We discuss this process in Chapter 17, Section 17.2. As the short-run Phillips curve shifts up the tradeoff between inflation and unemployment becomes worse. That is, the inflation rate is higher at every unemployment rate. For the Fed to reduce the inflation rate—bring it back down to the Fed’s target—becomes more difficult without causing a recession. The Great Inflation was only ended after the Fed raised its target for the federal funds rate to levels that helped cause the severe recession of 1981–1982.

The FOMC has been closely monitoring movements in the ECI to make sure that it heads off a wage-price spiral before it begins.

Sources: The transcript of Chair Powell’s press conference can be found here; the most recent economic projections of FOMC members can be found here; and a news article discussing Powell’s fears of a wage-price spiral can be found here (subscription may be required).

Takeaways from the January 25-26 Federal Open Market Committee Meeting

Fed Chair Jerome Powell (Photo from the Associated Press)

The results of the meeting were largely as expected: The FOMC statement indicated that the Fed remained concerned about “elevated levels of inflation” and that “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

In a press conference following the meeting, Fed Chair Jerome Powell suggested that the FOMC would begin raising its target for the federal funds at its March meeting. He also noted that it was possible that the committee would have to raise its target more quickly than previously expected: “We will remain attentive to risks, including the risk that high inflation is more persistent than expected, and are prepared to respond as appropriate.”

Some other points:

The Federal Reserve Act gives the Federal reserve the dual mandate of “maximum employment” and “price stability.” Neither policy goal is defined in the act. In its new monetary policy strategy announced in August 2020, the Fed stated that it would consider the goal of price stability to have been achieved if annual inflation measured by the change in the core personal consumption expenditures (PCE) price index averaged 2 percent over time. The Fed was less clear about defining the meaning of maximum employment, as we discussed in this blog post.

As we noted in the post, as of December, some labor market indicators—notably, the unemployment rate and the job vacancy rate—appeared to show that the labor market’s recovery from the effects of the pandemic was largely complete. But both total employment and employment of prime age workers remained significantly below the levels of early 2020, just before the effects of the pandemic began to be felt on the labor market.

In his press conference, Powell indicated that despite these conflicting labor market indicators: “Most FOMC participants agree that labor market conditions are consistent with maximum employment in the sense of the highest level of employment that is consistent with price stability. And that is my personal view.”

In March 2020, as the target for the federal funds rate reached the zero lower bound, the Fed turned to quantitative easing (QE), just as it had in November 2008 during the Great Financial Crisis. To carry out its policy of QE, the Fed purchased large quantities of long-term Treasury securities with maturities of 4 to 30 years and mortgage backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae—so-called agency MBS. As a result of these purchases, the Fed’s asset holdings (often referred to as its balance sheet) soared to nearly $9 trillion.

In addition to raising its target for the federal funds rate, the Fed intends to gradually shrink the size of this asset holdings. Some economists refer to this process as quantitative tightening (QT). Following its January meeting, the FOMC issued a statement on “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet.” The statement indicated that increases in the federal funds rate, not QT, would be the focus of its shift to a less expansionary monetary policy: “The Committee views changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy.” The statement also indicated that as the process of QT continued the Fed would eventually hold primarily Treasury securities, which means that the Fed would eventually stop holding agency MBS. Some economists have speculated that the Fed’s exiting the market for agency MBS might have a significant effect on that market, potentially causing mortgage interest rates to increase.

Finally, Powell indicated that the FOMC would likely raise its target for the federal funds more rapidly than it had during the 2015 to 2018 period. Financial market are expecting three or four 0.25 percent increases during 2022, but Powell would not rule out the possibility that the target could be raised during each remaining meeting of the year—which would result in seven increases. The FOMC’s long-run target for the federal funds rate—sometime referred to as the neutral rate—is 2.5 percent. With the target for the federal funds rate currently near zero, four rate increases during 2022 would still leave the target well short of the neutral rate.

Sources: The statements issued by the FOMC at the close of the meeting can be found here; Christopher Rugaber, “Fed Plans to Raise Rates Starting in March to Cool Inflation,” apnews.com, January 26, 2022; Nick Timiraos, “Fed Interest-Rate Decision Tees Up March Increase,” Wall Street Journal, January 26, 2022; Olivia Rockeman and Craig Torres, “Powell Back March Liftoff, Won’t Rule Out Hike Every Meeting,” bloomberg.com, January 26, 2022; and Olivia Rockeman and Reade Pickett, “Powell Says U.S. Labor Market Consistent with Maximum Employment,” bloomberg.com, January 26, 2022.

New 1/25/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, inflation, inflation.

Authors Glenn Hubbard and Tony O’Brien as they talk about the leading economic issue of early 2022 – inflation! They discuss the resurgence of inflation to levels not seen in 40 years due to a combination of miscalculations in monetary and fiscal policy. The role of Quantitative Easing (QE) – and its future – is discussed in depth. Listen today to gain insights into the economic landscape.

Macroeconomics or Microeconomics? Is a Lack of Competition in Some Industries Behind the Increase in Inflation?

In January 2022, the Bureau of Labor Statistics (BLS) announced that inflation, measured as the percentage change in the consumer price index (CPI) from December 2020 to December 2021, was 7 percent. That was the highest rate since June 1982, which was near the end of the Great Inflation that lasted from 1968 to 1982. The following figure shows the inflation rate since the beginning of 1948.

What explains the surge in inflation? Most economists believe that it is the result of the interaction of increases in aggregate demand resulting from very expansionary monetary and fiscal policy and disruptions to supply in some industries as a result of the Covid-19 pandemic. (We discuss movements in aggregate demand and aggregate supply during the pandemic in the updated editions of Economics, Chapter 23, Section 23.3 and Macroeconomics, Chapter 13, Section, 13.3.)

But President Joe Biden has suggested that mergers and acquisitions in some industries—he singled out meatpacking—have reduced competition and contributed to recent price increases. Massachusetts Senator Elizabeth Warren has made a broader claim about reduced competition being responsible for the surge in inflation: “Market concentration has allowed giant corporations to hide behind claims of increased costs to fatten their profit margins. [Corporations] are raising prices because they can.” And “Corporations are exploiting the pandemic to gouge consumers with higher prices on everyday essentials, from milk to gasoline.”

Do many economists agree that reduced competition explains inflation? The Booth School of Business at the University of Chicago periodically surveys a panel of more than 40 well-known academic economists for their opinions on significant policy issues. Recently, the panel was asked whether they agreed with these statements:

A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.
Antitrust interventions could successfully reduce US inflation over the next 12 months.
Price controls as deployed in the 1970s could successfully reduce US inflation over the next 12 months.

Large majorities of the panel disagreed with statements 1. and 2.—that is, they don’t believe that a lack of competition explains the surge in inflation or that antitrust actions by the federal government would be likely to reduce inflation in the coming year. A smaller majority disagreed with statement 3., although even some of those who agreed that price controls would reduce inflation stated that they believed price controls were an undesirable policy. For instance, while he agreed with statement 3., Oliver Hart of Harvard noted that: “They could reduce inflation but the consequence would be shortages and rationing.”

One way to characterize the panel’s responses is that they agreed that the recent inflation was primarily a macroeconomic issue—involving movements in aggregate demand and aggregate supply—rather than a microeconomic issue—involving the extent of concentration in individual industries.

The panels responses can be found here.

Sources for Biden and Warren quotes: Greg Ip, “Is Inflation a Microeconomic Problem? That’s What Biden’s Competition Push Is Betting,” Wall Street Journal, January 12, 2022; and Patrick Thomas and Catherine Lucey, “Biden Promotes Plan Aimed at Tackling Meat Prices,” Wall Street Journal, January 3, 2022; and https://twitter.com/SenWarren/status/1464353269610954759?s=20