Streetwise Professor

June 10, 2022

Sic Transit Transitory: Yes. Sic Transit Inflation?: Unfortunately not.

Filed under: Climate Change,Economics,Politics,Regulation — cpirrong @ 6:43 pm

So today inflation as measured by the Consumer Price Index checked in at 8.6 percent annualized. Which is an uptick in the rate rather than the promised easing.

Sic transit transitory.

The Queen of Transitory, Janet Yellen (Jerome Powell being the King) acknowledged as much earlier this week in Congressional testimony, admitting that her prediction had been wrong. Whoopsie!

One wonders about her (and Powell’s and the rest of the herd’s) mental model of inflation, especially under current circumstances. The usual explanation is some version of the Phillips Curve inflation-unemployment tradeoff. Which is stupid because it is just a correlation, and a worthless one at that since it is about as stable as Amber Heard.

But even that idiocy obviously won’t fly here, so Yellen mumbled about COVID and supply chains and Putin and blah blah blah (as well as holding forth on gun control and abortion, which are OBVIOUSLY primary responsibilities of the Treasury Secretary). These explanations are also inadequate.

Insofar as COVID is concerned, arguably the policy response to it (not COVID itself) shifted back supply curves as stores were closed and people stayed home from work. But those restrictions peaked in early-2021 and have been easing then, so can’t explain by themselves accelerating inflation in the subsequent months.

Yes, COVID has had lingering effects on certain sectors that have constrained supply while demand has rebounded. For example, a lot of truckers that left the industry in 2020-2021 haven’t come back. Interestingly, trucking schools shut down during the pandemic, which has constrained the flow of new labor to the market. In industries such as lumber and oil refining, the largely policy-driven collapse in demand in 2020 led to actual disinvestment and a loss of capacity. We saw the impacts of that in the lumber market a year ago, and are seeing it in the markets for refined products now.

But those factors alone cannot explain the recent spikes: demand has to be part of the equation as well.

Also, supply constraints (and supply chain bottlenecks) cannot explain increases in the general price level, especially as measured by broader measures such as the Producer Price Index and the GDP Deflator. Here’s a straightforward example.

Consider computer chips, inadequate supplies of which hit the auto industry hard, and which are blamed as a major culprit for inflation. Yes, the chip supply constraint limited the production of new automobiles, raising the prices of both new and used cars (which are substitutes for new ones). But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.

Put differently, bottlenecks increase prices on one side of the bottleneck relative to the prices on the other side. One cannot attribute a rise in the price level (in which the prices of most if not all goods and services are rising, albeit some more than others) to bottlenecks, at least not directly. Bottlenecks can cause prices to fall too. You can’t just look at the impact on the downstream side.

A more indirect story is that by limiting output (and therefore income) bottlenecks cause real income to be lower, thereby reducing the demand for real money balances. Given the nominal supply of money, the only way to equilibrate the now lower demand for real balances with a given nominal supply is to reduce the real value of the money stock by increasing the price level.

Color me skeptical that this can explain the magnitude of the inflation we’ve seen. (The Fed juicing base money by almost 50 percent in 2021 could have added to this impact.)

I therefore am deeply skeptical that supply constraints, attributable to COVID or otherwise, explain the broad rise in prices that has been accelerating over the past year plus.

What about Putin, Biden’s favorite scapegoat? Well, the Ukraine War doesn’t really explain the timing. Consider diesel prices.

There was a spike in the crack spread right at the time of the invasion in late-February, but that subsided quickly. The subsequent runup, especially the ramp-up in mid-April, is harder to ascribe to the war and almost certainly reflects some demand side factors.

Furthermore, it usually takes some time for upstream shocks to translate into higher prices at the consumer level (e.g., a wheat price shock impacting retail food prices). Meaning that a lot of the impact of a disruption first occurring in March is yet to have been fully felt. Good news all around, eh?

No, I think that the stock explanations that the likes of Yellen, Biden and the media fall back on to explain the accelerating inflation are woefully inadequate. Supply chain (and the effects of COVID thereon) in particular.

The most plausible explanation to me is the fiscal theory of the price level, developed formally some years ago by Thomas Sargent and recently studied deeply by John Cochrane. In a nutshell, the theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus. Holding primary surplus constant, an increase in government obligations requires a price level rise to reduce the real value of outstanding debt by the amount of the new debt. Similarly, given the level of government debt, any reduction in expected future surpluses requires a rise in the price level. (The theory is obviously a lot more complicated: that’s a Cliffs’ Notes version of the Cliffs’ Notes of John’s book.)

The massive COVID-driven fiscal stimuluses of both Trump and Biden dramatically increased the nominal value of US government debt. Moreover, the clear preference of this administration and Congress is to expand government spending (and debt) further (e.g., student debt forgiveness, among other things). (It will be interesting to see what happens to inflation if there is a big shift in Congress in 2022.)

I would also suggest that the big regulation plus big “green” agenda pursued by this administration and Congress are also inimical to growth, and expectations about growth. (I put “green” in quotes because as I’ve written before, a monomaniacal focus on CO2 is not a balanced environmental policy, and is indeed inimical to the environment in many ways.)

The green agenda is particularly pernicious. BIden and others (not just in the US) keep yammering away about the wonderful transition to green energy that will occur. What this really means is a transition to more expensive energy and lower incomes. Sic transit transition? I wish.

Less growth means lower future GDP means less future government revenue means smaller primary surpluses.

Meaning that both from the debt side and the growth/surplus side the COVID and post-COVID years are, according to the fiscal theory of the price level, a recipe for large increases in the price level. We’ve seen just such an increase. The timing works out. The fact that the increase in prices is broad works out.

This administration–of which Yellen is unfortunately an accurate avatar–not only does not believe in the fiscal theory, but finds it an anathema because its implications regarding the need to restrain government spending and to jettison onerous regulations and its cherished CO2 agenda require it to become, well, Reaganites. So what is likely the right model of the current inflation will never be their mental model.

Which means we will not be able to say sic transit inflation anytime soon.

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  1. Professor:

    What of hints — for I cannot find any projections, predictions or estimates — of the Fed’s balance sheet liquidation? I think the FF rate is important, but what of these massive assets that were sopped up, that now overhang the debt market? Powell has only hinted vaguely at them. The fact that Bostic & Brainard are BOTH on board w/ .5% rate increases is scary enough. But the most I’ve heard about the Fed balance sheet is that folks are hoping these debt instruments merely ‘retire’ as they mature. Methinks that is a significant contributor to the bond market, if the Fed is SERIOUS about returning to ‘normal.’ I would think that they need to be sold to show that the Fred is serious. In Civil War military parlance, to keep one’s ‘powder dry,’ for the next assault. And there will ALWAYS be another assault.

    B well. See you next month, if possible.

    VP VVP

    PS Vlad used up his own balance sheet of quotes. So be it.

    Comment by Vlad — June 10, 2022 @ 7:40 pm

  2. Exactly. I don’t think Trump gets a “pass” on inflation. The spending under Trump never went down, and on a marginal basis rapidly increased during Covid. Those were the initial seeds…

    Trump got a raw deal from the press, Democrats, GOPe etc but he was his own worst enemy sometimes. I don’t think he should run again or be the Republican standard bearer.

    Comment by Jeffrey Carter — June 11, 2022 @ 8:41 am

  3. I’m surprised that it took so long for the post-2008 suppression of interest rates, and QE, to move from causing asset price inflation to causing retail price inflation. I suppose the crystallising events include (i) stupid Western governmental reactions to the pandemic – lockdowns, school closures, and so on; (ii) accelerating budgetary incontinence by those same governments, (iii) Ukraine, Shanghai, and whatever comes next.

    I wonder how all this will be affected as the understanding becomes widespread that an awful lot of working age people are going to have been disabled or killed by Long Vaxx and Long Lockdown.

    Comment by dearieme — June 11, 2022 @ 9:02 am

  4. Most interesting prof.
    I was momentarily seduced by
    “theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus.”
    But for many years many governments haven’t even been running a primary surplus. (Italy has, so they should be market darlings, right?)
    So I’m a bit sceptical but not well educated enough to refute the argument.

    One thing I’m confident about: there are enough excuses to go round – Putin, covid, lockdown, China, commodity cycles – to ensure that the egregious errors of government and central banks will be hidden from the public for many years to come.

    Comment by philip — June 12, 2022 @ 5:35 pm

  5. Thanks for sharing Sargent’s Fiscal Theory of the price level. My economics school was thoroughly leftist-Keynesian, so we learnt about Rational Expectations and such but naught after that.

    Would be interested to see the theory tested against the Weimar hyperinflation, the late-sixties and 1970s inflation, and post-bubble Japan.

    More broadly, I’d be wary of applying any type of theory to what we are seeing now. I recently caught up with a high-IQ acquaintance, whose first confession was along the lines of ‘I’ve given up trying to forecast anything.’ And he runs a data science company called something like ‘Prescience’, LOL! Models, theories, intuitions etc built to deal with the behaviour of normal people aren’t going to perform well when faced with the cognitively-challenged freakazoids currently occupying the lever-pulling swivel-chairs.

    Comment by Ex-Global Super-Regulator on Lunch Break — June 13, 2022 @ 4:35 am

  6. “One thing I’m confident about: there are enough excuses to go round – Putin, covid, lockdown, China, commodity cycles”
    Spot on, there are just so many factors. Plus I’d add QE to that list.

    “But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.”
    That’s one of those things that seems incredibly obvious now that I see it, but as a layperson, I hadn’t considered that at all. Very interesting.

    Comment by HibernoFrog — June 14, 2022 @ 2:07 am

  7. So here in the UK, everyone is shitting themselves over where interest rates go next.

    The Bank of England had one job, which was to keep inflation at around 2%. It’s currently at about 9%. Andrew Bailey, having failed at the FCA by making it entirely ineffective and woke, is clearly working his old magic at Threadneedle Street! A seat in the Lords and a string of incompetence-reward sinecures draw nearer by the day for the buffoon!

    Traditionally (well, until the mid-1990s I’d say) it was always said that interest rates needed to be around inflation rate plus 5%. That was RPI inflation, so as we’re now on CPI inflation – adopted because it’s lower – maybe it should be inflation rate plus 6%.

    That implies sterling rates need to be about 15%. Sterling rates are in fact at 1%.

    The implication is that rates need to increase 15-fold. Unless…is it possible that compared to then, people and economies are now so indebted that the old RPI+5% formula no longer works? Can RPI minus 8% now be high enough to squeeze inflation out?

    Comment by Green As Grass — June 14, 2022 @ 10:01 am

  8. Craig, I think your example of diesel cracks might not be quite on the money. It’s certainly true that diesel cracks have been on an uptrend as we came out of the various lockdowns and demand, for now, continues to be strong; however there has been a dramatic change in the supply side from Russia. In April and May many Russian refiners were forced to reduce runs due to a lack of export options (and the bottlenecks weren’t always diesel). Add in the self-sanctioning by many EU companies (if not the EU itself) and pretty soon diesel (and Jet) were pretty hard to find. Effectively the available pool of refining capacity was reduced as Russian products went out of fashion and that supply side disruption continues to have quite an effect of European markets. And Eurpoean markets set the price at the margin as Europe is the big short for distillates as you know. It’s posssible but not a given that diesel cracks do reduce as supply increases – Russian barrels will come out one way or another – but as I think you’ve said elsewhere the best cure for high prices is high prices…

    Comment by John Spencer — June 14, 2022 @ 11:51 am

  9. @Green,

    Re. formulae, rules of thumb, models, etc, for determining economic policy – see my comment above.

    Comment by Ex-Global Super-Regulator on Lunch Break — June 14, 2022 @ 9:46 pm

  10. @Green As Grass. Yes, once upon a time the Taylor Rule (and similar rules), well, ruled. But central bankers thought that all changed post-Crisis. And here we are.

    Failing upwards is the hallmark of this era.

    Comment by cpirrong — June 17, 2022 @ 9:14 am

  11. @Ex-Global Super-Regulator on Lunch Break. Glad to be of help. Cochrane has a paper forthcoming in the J. Econ. Perspectives that studies historical episodes, including the end of hyperinflations, from the perspective of Fiscal Theory.. Haven’t had a chance to read it since John just posted it last night. I’ll read over the weekend and give my thoughts.

    Comment by cpirrong — June 17, 2022 @ 9:17 am

  12. @dearieme. You and me both. I’ll find the link to my old post describing when I asked Bernanke that question in May, 2009. He was right . . . for a time. But his successor thought that the factors that made extraordinary monetary policies non-inflationary would last forever. This was a category error.

    Comment by cpirrong — June 17, 2022 @ 9:19 am

  13. what? no mention of evil oil companies – and shipping companies – price gouging? Bozo O’Biden has mentioned it as frequently as he can.

    Bernie the Jerk Sanders has just touted a – windfall profits tax!!!!!!!! And there is legislation proposed in Congress recently for a – windfall profits tax!!!!

    Do they no remember 1980, when a windfall profits tax was enacted???? And it didn’t work????

    Or, apparently, the modus operandi is to “do something” – no matter how stupid, and they don’t care if it’s stupid – they “did something.”

    Comment by elmer — June 17, 2022 @ 9:26 am

  14. @13 Elmer — and they don’t pay a price.

    Comment by Pat Frank — June 17, 2022 @ 3:02 pm

  15. @Pat Frank

    some of them do – they get voted out

    but the fact that NanXi Piglosi and Bernie the Jerk Sanders and Schmuck Schumer and others can stay in office for so long, or that the Brainless Bartender AOC or the incest queen, Ilhan Omar, an their ilk, can get elected in the first place —— well, there’s something horribly wrong with that

    Comment by elmer — June 17, 2022 @ 8:13 pm

  16. The alarming thing about interest rate prospects in the UK is that last time they were used to control inflation they went to 15%, but at that time most people were on floating rates. Nowadays almost nobody’s on a floating rate and many are on 5-year fixes. My mortgage is fixed for five years at 0.99%. Hiking rates does nothing to me.

    So last time, rates had to go to 15% – on almost all mortgages – to take demand out of the economy to suppress inflation. Don’t they now have to go higher than that, given that there is only a handful of floating-rate mortgages through which the demand destruction can take place?

    Or does this mean that interest rates as a tool to control inflation may have lost their utility, as everyone has proofed their mortgage against rate rises via lengthy rate fixes?

    Comment by Green as Grass — June 20, 2022 @ 5:09 am

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