What If Inflation Today Is Out of the Fed’s Control?

(Bloomberg Opinion) -- If any pollster ends up surveying the least popular words of 2021, “transitory” and supply chain” might make the list just behind “inflation.” What makes our situation so frustrating isn’t just that we haven’t seen a string of monthly price increases like this one in decades. It’s also that the type of inflation we are experiencing is particularly painful.

Think back to the basic explanation of inflation: It’s “too much money chasing too few goods.” That’s slightly too simple: It would be more precise to say that it’s “too much spending chasing too few goods and services.” When prices rise because people are spending more, that’s demand-driven inflation. When they rise because of shortages or setbacks to productivity, it’s supply driven. And, of course, prices can rise for both reasons.

One type of inflation can also lead to the other. Some commentators have worried that broken supply chains may alter people’s expectations about inflation in a self-fulfilling way. If you think prices are going to be higher soon, you might spend more right now.  Discussion of this possibility, though, can leave the misleading impression that it would be a cause for gratitude to just have a supply-driven one.

For a textbook example of demand-side inflation, imagine that a central bank makes a surprise announcement it is going to manage interest rates and undertake asset purchases so as to engineer a doubling of total spending throughout the economy over the next year. If people believe it will hit that target, they should expect that in a year’s time, prices, including wages, will be about double what they are now.

This inflation would transfer money from lenders to borrowers (including most mortgage holders). The real value of a fixed debt will drop in half. Inflation would also raise the effective burden of capital-gains taxes as investors pay taxes on assets that look twice as valuable but aren’t. Restaurants would have to order new menus. And the transition could be rough.

At the end of the process, though, the real value of most people’s wages should be roughly the same as before: They will have twice the take-home pay, but each dollar will go half as far as before.

Supply-side inflation works differently. The economy sees the same amount of dollars spent, but they’re spent on fewer things at higher prices. Companies still have to change their prices as supply conditions fluctuate. But borrowers don’t come out ahead. Wages do not, even over time, adjust so that they are the same in real value. Taxes on capital won’t rise, but only because asset values won’t either. All of the inflation represents a reduction in economic activity. It’s pure loss for the economy overall.

To make matters worse, the central bank can’t do anything about it. If it wants to avoid the dislocations of our hypothetical demand-side inflation, all it has to do is call off its plan to double spending.

If, on the other hand, prices are higher because ports aren’t operating efficiently, what is it to do? Engineering increased spending will raise prices further. Reining it in will reduce output further. Neither loosening nor tightening money will get cargo moving through the ports any faster. The supply issues have to be tackled directly.

This year’s inflation reflects both supply and demand, but supply appears to predominate. Total spending has grown, but it is only a little over its expected level.

With that in mind, the comparison to the last prolonged inflation in the U.S. gives us both good and bad news. Inflation today isn’t nearly as high as it was in the late 1970s — it hit double digits three years in a row from 1979 to 1981 — and market projections of inflation remain well below the rates it hit back then.

But while the 1970s saw two supply shocks in the form of oil embargos (in 1973-74 and 1979-80), most of that decade’s inflation reflected the Federal Reserve’s loose-money policies. The inflation we have been going through this year has mostly been much more based on supply issues — and so, in that respect, it’s worse. For years, the Fed has seemed like our most competent policy maker. But the reforms that have to take place to ease the current supply-driven inflation are out of its hands.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is a senior editor at National Review and a visiting fellow at the American Enterprise Institute.

©2021 Bloomberg L.P.