Federal Reserve Chair Jerome Powell testified before Congress last week, as required by the Humphrey–Hawkins Act. He was greeted by Democrats who have yet to revise their views on inflation — views that are politically convenient but divorced from economic reality.
In his opening remarks, Sen. Sherrod Brown (D-Ohio) blamed inflation on pandemic related supply chain issues, Russia’s invasion of Ukraine, avian flu and corporate greed. The message was clear: Raising interest rates will not fix these supply-side issues, so the Fed should not risk damaging labor markets with higher rates.
Sen. Elizabeth Warren (D-Mass.) echoed the opposition. “So far, you haven’t tipped the economy into recession,” she told Powell. “But you haven’t brought inflation entirely under control either. And maybe the reason for that is that other things are also keeping prices high — things you can’t fix with high interest rates: things like price gouging, and supply chain kinks and a war in Ukraine.”
The supply-side inflation narrative isn’t new. It was a plausible explanation 18 months ago. That’s no longer the case. More recent data indicate that inflation is largely demand driven.
The pandemic reduced production and pushed prices higher, but only temporarily. Prices rise above trend when supplies become constrained and return to trend as those constraints ease up.
Production contracted sharply in the first half of 2020. It has since recovered. Real gross domestic product returned to its pre-pandemic level by the end of the first quarter of 2021 and its pre-pandemic trajectory by the end of the second quarter.
Did prices similarly return to trend? No. Prices accelerated. The personal consumption expenditures price index (PCEPI), which had grown at an annualized rate of 3.75 percent in September 2021, climbed to 6.87 percent in October and 7.34 percent in November.
It is no coincidence that Fed officials began changing their tune around this time. Powell stopped using the term “transitory” in November 2021. In December, the Federal Open Market Committee (FOMC) revised its post-meeting statement to acknowledge demand-side factors.
How about the war in Ukraine? The Biden administration likes to refer to Russian President Vladimir Putin’s price hike. But it is a partial explanation, at best.
The surge in prices preceded the invasion by several months. Core PCEPI inflation, which excludes the food and energy prices most affected by the war, grew at an annualized rate of 4.2 percent from January to June 2022. When energy prices declined in the back half of the year, core inflation remained high at 3.9 percent.
Sen. Brown says greedy corporations are raising prices to line their pockets while using higher input costs as cover. But, as economist Joshua Hendrickson explains, a firm with market power “cannot pass along the entire additional cost” (let alone a greater amount) “if it also wants to maximize its profit.” Since the price of a firm’s product rises less than the cost to provide it, the profit margin gets smaller, not larger, as Sen. Brown claims.
The rise in corporate profits can be explained by an increase in demand, though. When demand increases, profit-maximizing firms raise their prices and enjoy greater markups. Workers eventually renegotiate their wages to account for higher prices. But they do so with a lag. Until then, firms realize greater profits.
Higher profit margins have not increased inflation. Rather, both profit margins and inflation have been driven higher by additional spending. Large fiscal expansions in 2020 and 2021, which were accommodated by monetary policy, resulted in much more spending than usual. With all that money sloshing around, and little scope for output to increase, prices soared.
The FOMC could have prevented inflation from rising so high. Had it stabilized demand in 2021, the early price increases associated with the pandemic would have been temporary. Convinced inflation was a supply-side problem, the FOMC failed to cool demand.
That was then. In February 2023, the FOMC dropped references to the pandemic and the ongoing war in Ukraine as a source of “upward pressure on inflation” from its post-meeting press release. Monetary policymakers now recognize that our inflation problem is largely demand driven, and they have the tools to deal with it. Congressional Democrats should follow suit.
William J. Luther is an associate professor of economics at Florida Atlantic University and director of the American Institute for Economic Research’s Sound Money Project. Follow him on Twitter @williamjluther.