What Is Really Driving “Inflation” Today

Roughly speaking — very roughly – there are five theories, and two subsidiary theories, proposed by different groups of economists and others to explain rising prices, or “inflation” so-called:

  1. Bad monetary policy – the central bank “printing too much money” which effectively devalues the currency relative to the value of real goods and services, driving prices up
  2. Corporate Greed – companies exploiting the public, squeezing higher profits and driving prices up
  3. Rising Inflation Expectations – a psychological explanation, which strangely holds that if the public thinks prices will rise, that alone can cause prices to rise
  4. Supply Constraints – bottlenecks in the economy that create shortages of key goods (e.g. energy and other commodities), driving prices up
  5. Demand Pressure – an economy that is running “too hot” with excessive demand that leads buyers to be willing to pay more, driving prices up – which often explained as the result of [these are the subsidiary theories]
  • Loose fiscal policies that give consumers too much “extra” cash to spend, like tax cuts or stimulus checks
  • Wage increases driven by workers’ demands for excessive compensation

These are more than mere theories. They represent distinct and comprehensive worldviews, expressed in broad economic philosophies and partisan political platforms.

Which explanation, or worldview, is correct? The question is important, because different theories lead to different and often mutually incompatible policies. A full answer would call for a book-length treatment. But two general points underscore the complexity of the problem:

  • “Inflation” – which, to be clear, refers very specifically to a measured rise in posted prices of the items in a market basket of goods and services defined by the Bureau of Labor Statistics – seems like a simple symptom, but it can be and likely always is very complicated with multiple contributing causes; in other words, several of these factors may be causally relevant at the same time
  • “Inflation,” so defined, is not the same “always and everywhere” (pace Milton Friedman) – just as a fever in a person can arise from many different causes – some innocuous, some annoying, some lethal – a rise in prices can issue from various sources of stress in the economy, not all of which should carry the same weight in spurring public policy

In the concrete present moment, however, “all of the above” is not a satisfactory answer. Policy-makers – at the Federal Reserve especially, but elsewhere in government – as well as investors, trying to anticipate the direction of the financial markets – need to decide which of these factors – supply, demand, the money supply, psychology – is likely to predominate today, as the immediate guide for action.

The Federal Reserve – following a prevailing fashion in economics – appears to have decided that the psychological explanation carries the greater weight right now. Fed officials have resorted to tough talk, and performative interest rate rises, to try to knock down our inflationary expectations going forward. If they can somehow calm our feverish expectations regarding future inflation – Fed policy folks speak of preventing our expectations from “de-anchoring” – and it brings actual current inflation down, that will constitute the much-desired “soft landing.”

But there is a harsher tone now emerging from the chorus. If (we are told) throwing cold water on the public psyche is insufficient, it may become necessary to inflict damage on our standard of living, to reduce actual demand. How? By raising the unemployment rate for example – as Larry Summers has urged:

  • “‘We need five years of unemployment above 5 percent to contain inflation—in other words, we need two years of 7.5 percent unemployment or five years of 6 percent unemployment or one year of 10 percent unemployment,’ Summers said during a speech at the London School of Economics.”

We need 10% unemployment? This is what a “hard landing” means? According to this view, it will be necessary to inflict actual economic pain on millions of people.

To support this explicitly nasty policy, the sainted Paul Volcker is invoked – he who “broke the back of inflation” 40 years ago – although Larry Summers is more than ready to claim credit for this grim insight.

Frankly, this is an obscene recommendation. But it is worse that that — it is also wrong.

It’s The Supply Chain, Stupid

Step back even a little from last month’s CPI headlines, and the first important Hard Fact to acknowledge is the obvious one: The world economy has been slammed and shaken by three once-in-a century external shocks in the space of less than two years.

  • Covid, the worst global pandemic in 100 years
  • The Invasion of Ukraine, the first major war in Europe in 75 years
  • Monetary stimulus on a massive scale, unprecedented since World War II

Like tossing that boulder into a small pond, the effect is chaotic disruption of all important trends. The chart for almost every economic measure, whether demand-side, supply-side, or monetary, shows whiplash.

For example, here is the chart of Personal Consumption – a decent proxy for Demand.

Here is the chart for Crude Oil.

Here is the money supply (M2).

And government expenditures –

The Big Picture is a carnage of dislocation. All the normal trends and relationships are broken. Beginning one fine day in March 2016, Consumer Demand shifted violently down, then violently up, and always and especially “sideways”– i.e., consumers, in lockdown, or working remotely, unable to pursue many normal activities, or simply becoming cautious as the pandemic spread uncertainty everywhere, altered their buying patterns dramatically. As has been widely noted, there was a major displacement of spending away from the consumption of services, and in favor of the consumption of goods (durable and nondurable).


In dollar terms, over a 30 month period, consumer spending on services fell about $1.5 trillion from the trend line while purchases of durable and nondurable goods increased by about the same amount.

What all this amounts to is a recipe for putting the supply chains that serve our economy under extreme, but temporary stress.

Consider the implications of the shift to goods over services.

Many services are entirely performed in a defined location (e.g., restaurants, hair salons, healthcare) – where there really is no physical supply chain as such (although the service providers may be hampered by supply problems for the goods used in performing the service). Many other services have migrated online (e.g., banking, or streaming media).

“Goods,” however, are physical objects – boxes of cereal, automobiles, microchips – that must be assembled or manufactured (from other physical inputs, with their own supply chains), inventoried, packaged, trans-shipped (often from a great distance), delivered to the end customer, tracked and cared for all along the way. When one speaks of supply chains, one is speaking about the “goods” side of the ledger. Greater spending on goods rather than services puts a much heavier burden on real supply chains. Suddenly injecting a trillion dollars of additional demand for all sorts of physical products ripples through these tightly-coupled networks. Small glitches can derail or delay the process of “fulfillment.” For want of a nail, etc. –

In addition, there is the information deficit created by the shocks described above. Physical supply chains rely on accurate information flow from customers to manufacturers and vice versa (and all the intermediate parties). But the chaotic nature of the past 30 months has disrupted this process. It has blown up the forecasting models that customers use to place orders and manufacturers use to prepare for them. The auto industry is a case in point, where the initial impact of the pandemic triggered classic defensive responses from the car companies, which quickly cut back orders to many parts suppliers on the assumption that the auto industry was about to enter a severe recession. When the opposite happened – consumer demand quickly surged above pre-pandemic levels – the automakers were unable to restock the parts they had canceled. The drastic losses in revenue they suffered, especially from the inability to procure semiconductor components, have been well documented. (More on that in an upcoming column).

Sheer complexity is another problem. Physical supply chains have ramified enormously, in scale and geographical dispersion (i.e., globalization). The example of the moment is the semiconductor industry, which comprises a vast eco-system with tens of thousands of critical or near-critical suppliers, reaching across the entire world. A White House report recently underscored the boggling intricacy of the supply network that underlies the digital economy.

  • “The Semiconductor Industry Association notes that one of its members has over 16,000 suppliers, more than half outside the United States, and that a semiconductor may cross international borders as many as 70 times before reaching its final destination.”

Then there is “science” – specifically, the science of modern logistics management, as it is taught in leading universities and disseminated through international standards bodies. Doctrines of “lean manufacturing” and “just-in-time inventory management” have been widely adopted, and they have squeezed the margin of safety out of the system in pursuit of mere efficiency. All across the manufacturing world, traditional “shock absorbers” (e.g., physical inventory) have been stripped down to bare minimum levels.

All this leads to the crisis which is now driving the price trends in the global economy. The New York Federal Reserve has recently developed a measure of supply chain stress. That stress level has exploded.

This is the primary cause of the inflation today: the supply constraints.

Inflation is not being driven by “excess demand” in any permanent sense (once the stimulus check are spent). At this point, it is certainly not being driven by growth in the money supply(which has fallen now back to levels below the long term average).

[Two large questions related to the monetary causality theory are to be noted:

  • the efficacy, or more generally, the wisdom of aggressive money supply expansion in response to the pandemic crisis in the Spring of 2020
  • the nature of the lag between the money supply expansion, or now, its return to normal levels, and the effect on prices

Those issues will be sidestepped for now, with this passing comment: whatever the merits of the expansive policies in 2020 – and I think they were well-justified by their chief objective, properly realized, i.e., the avoidance of a severe recession at the time – the growth of M2 has been declining rapidly for at least 18 months, which means it is approaching the point where it should begin to show a deflationary effect.]

As to the Expectations theory of inflation, which the Fed seems to be hanging its hat on for now, that is also a large topic for another day – but available measures inflation expectations are not showing the surge in public concern for future inflation – the dreaded “de-anchoring” – that the theory looks for as the root cause of price instability.

And finally, as for the Corporate Greed theory, this too finds no real support in the realm of factuality (although it has plenty of political voltage in some precincts).

Good News & Bad News

“It’s the Supply Chain” – has become the answer to everything, it seems. But it really is the answer to the question of what is driving “inflation” right now. Supply chain stress comes in many forms – shortages, bottlenecks, dislocations geopolitical (Ukraine), medical (China’s Covid-Zero policy and the shutdowns), and more pedestrian cases, like –

  • “One of the world’s most legendary companies has run out of trademarks – that little blue oval emblem that reads “Ford.” Reports say that their supplier cannot deliver the right number of blue emblems like the ones that Ford puts on the back of its F-150 trucks…The average car has over 30,000 parts. The F-150 comes with six engine options, seven trim levels, and so many options that some estimates say there are over 20 million possible configurations. But, that little badge, that nameplate, that trademark, has to be there. Reports say that Ford thought about alternatives like laser etching or retrofitting the trucks when the badges become available. Doubtless some people would have bought the car without the Ford badge affixed. Many or perhaps most would just wait. With all of the supply chain issues, we have really hit the end of the road with this one.”

It’s a great little vignette, but then, it’s not so little.

  • “Ford on Monday said it expects to have about 40,000 to 45,000 vehicles in inventory at the end of the third quarter that couldn’t be shipped to dealers because they were awaiting needed parts. Many of these vehicles are high-margin trucks and SUVs and the shortages primarily involved parts other than semiconductors, the company said.”

The Good News is that supply constraints of this sort are almost alway self-correcting. Businesses and consumers don’t sit in limbo. They respond, build new capacity, fix transportation problems, expedite shipments, increase supply; customers defer purchases, find substitutes, wait it out or work around, innovate. The market mechanism does actually function, even if imperfectly and with a lag. The shocks suffered in the last two years have been severe, but the supply chains are beginning to clear. (More on the specifics in a future column.)

The Bad News is that policy makers seem to have panicked (along with the media, who gave up hope almost immediately). I thought for a while that Jerome Powell had the backbone to stand against the chorus of bad advice he was getting from so many quarters, and allow the system to find its footing again. But the pressure to “Do Something” has prevailed. We have now entered the chapter of “performative monetary policy” – taking measures which everyone knows will (1) have no positive effect on supply chain problems – there is nothing the Fed can do to speed up the delivery of those blue oval logos – but (2) may well cause real economic havoc. Fighting inflation by “reducing demand” – which, perversely, means raising prices (like on your mortgage), and throwing millions out of work (as Volcker did) – is one of those ideas John Maynard Keynes warned us about

  • “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

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