Sunday, November 28, 2021

Inflation Explainer

Bari Weiss asked me to write a short post for her substack offering some inflation explanations on the occasion of post-Thanksgiving shopping.  

It’s Black Friday, ‘70s-Style

Black Friday begins tonight, and Americans, after emerging from our collective turkey coma, will dive into our sacred, national ritual: shopping. 

Those who haven’t shopped lately are in for a rude awakening: Many items will be out of stock, delayed or cost a lot more than they used to. Welcome to inflation, back from the 1970s!  

As you look for a deal on a Peloton to work off your pandemic paunch, here is a brief explanation about what’s going on with our economy, why so many things are becoming more expensive, why this hurts all of us, and why the government can’t spend its way out of this mess.

Why are prices rising? 

The news is full of “supply chain” problems. Shipping containers can’t get through our ports. Car-makers can’t get chips to make cars. Railroads look like the 405 at rush hour. 

What’s underlying many of these problems is the fact that businesses can’t find enough workers. There aren’t enough truck drivers, airline pilots, construction workers and warehouse workers in the “supply chain.” Restaurants can’t find waiters and cooks. There are 10 million job openings and only seven million people looking for work. About three million people who were working in March 2020 are no longer working or looking for work.

But supply chains wouldn’t be clogged if people weren’t trying to buy a lot. The fundamental issue is that demand is outstripping supply.

Strawberry prices go up in the fall because the supply is lower; apples are cheap, because they are abundant. Prices of one good relative to another change, and induce us to shop effectively. 

That’s normal.

Inflation is different. Inflation describes all prices and wages going up at the same time, straining supply throughout the economy. That’s the situation right now. Even the Dollar Tree stores just became the buck and a quarter stores, raising all prices 25%.

What’s driving current inflation?

Widespread inflation always comes from people wanting to buy more of everything than the economy can supply. Where did all that demand come from? In its response to the pandemic, the U.S. government created about 2.5 trillion new dollars, and sent checks to people and businesses. It borrowed another $2.5 trillion, and sent more checks to people and businesses. Relative to a $22 trillion economy, and $17 trillion of existing (2020) federal debt, that’s a lot of money. 

People are now spending this money, the economy can’t keep up, and prices are rising. Milton Friedman once joked that the government could easily create inflation by dropping money from helicopters. That’s pretty much what our government did.

(I do not here argue the wisdom of this policy. The government helped a lot of people and businesses to get through the lockdowns. One can quibble that money could have been distributed more thoughtfully, but we’re here to think about inflation, not Covid policy.) 

What’s wrong with inflation?

Prices and wages all rising at the same rate doesn’t sound so bad. But it’s never that simple. Inflation is chaotic! Some prices go up faster than others. You can’t get things you need. Neither can businesses. And wages tend to lag behind prices, so workers lose in real terms, as do those on fixed incomes. 

What was the Fed’s role in all of this?

The Federal Reserve failed at its most basic job: to figure out how much the economy can produce, and to bring demand up to, but not beyond, that supply. To that end, the Fed controls interest rates. If people get a higher interest rate on money in the bank, they will leave it there rather than spend it. But the Fed failed to see inflation coming, and kept interest rates at zero, where they remain. The Fed says it is keeping interest rates low to improve “labor market conditions,” despite the widespread worker shortages and the eruption of inflation.

Will inflation continue? 

It’s hard to say. If the Federal Reserve’s immense staff of economists can be caught off guard, so can you and I. 

That said, there is some momentum to inflation, so further price increases are likely. Higher property prices will feed into higher rents; rising input costs and wages will lead to higher prices; trillions of those extra savings are still waiting to be spent. 

Where inflation goes after that depends on how much more our government continues to print or borrow to send people checks and expand social programs. This doesn’t seem likely to end soon. And if people believe that monetary policy will never return to controlling inflation, and taxes and spending will never come into line so the government can start to repay mounting debts, inflation spirals out of control.

The good news is that long-term interest rates—the kind you pay to borrow for a mortgage or car—have not yet risen, as they tend to do when bond markets expect inflation. Bond markets think inflation will quickly subside. It’s still very cheap to borrow, a bright light for consumers. And low rates make it easier for the government to slow inflation. 

Okay, so what can Washington do about it?

Simple: It has to stop printing and borrowing money. And it has to reassure people who hold our debt that there really is a plan for paying it off. And the Fed has to return to the unglamorous job of curbing inflation, rather than endless “stimulus” and “accommodation.” 

To ease supply constraints, our government has to remove the sand in the gears. The ports are clogged because of countless regulations—like zoning laws that forbid stacking empty containers. Multiply anecdotes like this by tens of thousands throughout the economy and you’ll begin to get a picture of where we are. We need a long-overdue Marie-Kondoing of public affairs.

If inflation is as simple as you say it is, why are politicians singing another tune?

Politicians hate inflation because it means they can’t keep spreading money around. Supply constraints reverse political rhetoric. When a politician says a new program will “create millions of jobs,” those jobs are now a cost, not a benefit, because there aren’t any available workers.

So they offer a string of excuses, just as they did in the 1970s—including lots of talk about “supply shocks” and “bottlenecks” and “transitory” inflation —while hoping it all goes away. 

The Biden administration, having just cancelled the Keystone pipeline, is now begging the Saudis and Russians to turn on the pumps, just as Richard Nixon pleaded with OPEC. The White House is accusing oil companies of colluding to raise prices. They will likely pressure other companies to limit price increases, as presidents from Kennedy to Ford did. This shouldn’t come as a surprise: Every past inflation has sparked a witch hunt for “speculators,” “hoarders,” “middlemen,” “price-gougers,” and other phantasms. Let’s hope the government doesn’t try price controls, as Nixon did, precipitating gas lines and shortages of everything. 

Meanwhile, the administration is re-messaging its spending plans as inflation-fighters. It won’t work. Consider the childcare plan, to take just one example, which they say will lower costs. The government will subsidize childcare while mandating higher wages for staff, more licensing requirements and inspections. Childcare costs will inevitably rise for the country as a whole. One can believe that it’s a good policy, and that it’s worth the cost, but it will make costs higher, not lower. 

Politicians don’t want to face the hard reality that inflation brings, but inflation has a way of forcing change, as it did in 1980. 

So, should I try to buy things on Black Friday and Cyber Monday? 

Only if you really need them. Prices are the neurons that transmit information in the economy. High prices tell you to wait and to let someone who values that Peloton more than you do have it. Most Americans should take this golden opportunity to build up some savings, look for a job or a better job, and enjoy those leftovers.


  1. "Bond markets think inflation will quickly subside."

    Yup, if the FED does what bond markets think it will do. :-)

  2. Thank you professor.

    I wonder about this: "Higher property prices will feed into higher rents". Why would that be? I can easily see why rents would drive house prices. But why should increasing house prices drive rents up?

    My model is that rents clear the market of housing usage, whereas house prices clear the market for housing ownership. Housing usage demand is driven by demographics and purchasing power. Housing usage supply is driven by construction, which is positively correlated with house prices. So high house prices slowly increase supply (with a lag), which decreases rents. Why should it increase rents?

    One could argue that high house prices increase demand for leases, but that doesn't increase demand for housing usage - people who forego buying a home do not thereby increase their demand for places to live.

    1. If I as an apartment building owner see that I can get an inflated price for my building, I may very well sell it to the highest bidder. That buyer is undoubtedly going to have to raise rents in order to get a reasonable return on their investment. I believe this is the point that Mr. Cochrane was making, rather than getting into the relationship between apartment rental costs vs. the private housing market.

    2. I'm just speculating here. In an area where the population is growing there is a continual demand for additional housing -- new houses and new rental units are being constructed to meet the continual demand. With the price of land and construction costs increasing these new houses AND rentals will require higher mortgages and rents respectively. So that's one reason why rents go up. And then if houses are so expensive that the house/rental ratio swings to more rentals, then more rental demand = higher rents. Maybe I'm wrong, but that makes sense to me.

    3. Thank you, Richard. It's a plausible hypothesis, but I don't know if there's any evidence supporting it. For that to happen, rents in your building must be below-market-clearing, and the hike is capped by the market clearing price. So it can only be meaningful in markets where there's a shortage of dwellings at the going price.

    4. Another way for your suggestion to work is if landlords are very irrational.

    5. If property values go up, my landlord's tax burden goes up and so does my rent.

      As for Richard's theory here is one point of evidence: At my last rental, property value went up, Landlord was not allowed to increase rent enough, so he sold. The rents became below market clearing when the landlord decides to take the rental unit off the market. This drives up rent prices.

      Price-to-Rent ratio is a popular statistic, and there is a tendency for rents to jump to catch up when the ratio is high.

    6. Landlord to tenant: I'm raising rents.
      Tenant: I don't want to pay a higher rent.
      Landlord: You don't have to pay my rent. Go buy a house.
      Tenant: I can't. Houses have to high a price.
      Landlord: Rent someone else's apartment.
      Tenant: Every apartment I want costs as much or more as this one.

    7. I'm in commercial real estate not residential, but I think they behave similarly. In my market, lots of new construction, which is costing a lot more than older buildings did. The owners still wish to get a normal return from their investment, hence they ask more rent from new tenants. This, in turn, pulls up rates in older buildings. The value of commercial real estate is tied to the rents and rate of return, therefore properties sell for more and tax assessments rise, which is yet another cost increase for tenants (most of these are NNN leases, so tenant pays the taxes).

  3. My father, who grew up in the Great Depression and spent his young adulthood in Europe during WW2 is saying from his (inflating) copper lined grave "John is right"!

  4. Look for a job...could be a pleasant experience for many.

    These are the best labor markets in 55 years for the bottom third of the US labor force.

    Is there a way to tame inflation, but keep tight labor markets?

    Is the only way to beat inflation to stagnate wages?

  5. "The Fed controls interest rates. If people get a higher interest rate on money in the bank, they will leave it there rather than spend it".

    But, how long do they keep their money in the bank? Won't they spend their money in the end? I think we will have inflatin eventually enen if Fed raises interest rate.
    Please correct me if I am wrong.

  6. Your analysis depends on the fiscal impact of inflation. Yet you ignore two important features of the the tax system - the taxation of nominal capital gains and inventory profits. Might it be that inflation, even leading to higher interest rates improves the fiscal picture?

    1. Unknown,

      Only if real GDP rises with inflation. If inflation rises and Real GDP falls (stagflation) then the fiscal situation gets worse, not better.

      Do you see the conflict in John's statments?

      "Okay, so what can Washington do about it?"
      "Simple: It has to stop ...borrowing money."

      And also,

      "To that end, the Fed controls interest rates. If people get a higher interest rate on money in the bank, they will leave it there rather than spend it."

      For every person wanting a higher interest rate on the money that they lend, someone else must borrow at that higher interest rate.

      And so who is the borrower at the higher interest rate?

      "Politicians don’t want to face the hard reality that inflation brings, but inflation has a way of forcing change, as it did in 1980."

      The change in Federal Reserve happened in 1979 (Paul Volcker becomes Fed chairman).

      The change in the CPI (OER replaces housing prices) happened in 1983.

      Prudhoe Bay oil production began in 1977.

      The only thing that happened around 1980 was Ronald Reagan becoming president and enacting tax cuts that had the side effect of running up the federal debt and by virtue INCREASING government expenditures on the interest payments it was making on it's debt.

      John has the stop borrowing part correct. But that didn't begin happening until about 1996-2000.

    2. Reagan tax cuts caused huge increase in productivity and economic growth as well as a big positive change in investment efficiency. They were clearly the best economic move in the last century.

    3. Stan,

      I don't think so. Again, the big improvements in productivity came in the early 1990's as cold war government defense spending was being curtailed and welfare spending was reduced.

      And if you recall correctly, a lot of those tax cuts were reversed, though the number of tax brackets never went back to the 1985 level (15 brackets). There are now 7 tax brackets (there were two in 1989 and five in 1993).

      1985: Top tax rate = 50%
      1989: Top tax rate = 28%
      1993: Top tax rate = 39.6%

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      People/Corporations do not pay rates. We had pretty high rates in the '50s and '60s. We also had a lot more write-offs.

  7. as out RBA head has shown people could not buy services in the pandemic so they changed to goods. This has produced the problems we see today.
    When spending resumes on services rather than goods some of the inflationary problems will go.

  8. This:

    "In July 1996, the Federal Reserve broke the metronomic routine of its closed-door policy-making meetings to hold an unusual debate. The Fed’s powerful chairman, Alan Greenspan, saw a chance for the first time in decades to drive annual inflation all the way down to zero, achieving the price stability he had long regarded as the central bank’s primary mission."

    "But Janet L. Yellen, then a relatively new and little-known Fed governor, talked Mr. Greenspan to a standstill that day, arguing that a little inflation was a good thing."

    And since that time:

    Employment to population ratio lower than it was in 1996
    Inflation higher than it was in 1996

    Economic policy making has gone into "Full Retard" mode.

  9. Hard to see how the federal government simply borrowing to spend on something else can be inflationary; after all, the borrowed money comes from someone who has deferred current consumption. The inflationary problem comes about because the Federal Reserve buys up these treasury bonds as well as other assets like corporate bonds and injects additional cash into the economy. The fed should stick to the original guidance, only buying bonds and commercial assets at painful levels of interest.

    1. WP Kelpfroth

      "Hard to see how the federal government simply borrowing to spend on something else can be inflationary, the borrowed money comes from someone who has deferred current consumption...."

      Well let's see...

      1. When the government borrows, it spends twice, once on the initial expenditure and a second time on the interest payments. Set the interest rate on government bonds at 100% and how much "deferred" consumption do you get?

      2. The interest payments ultimately come from the taxpayer who both consumes and produces goods included in the CPI. High enough taxes can reduce both consumption AND production.

      3. The services that the government provides (system of courts, defense of nation, etc.) are not treated as part of the consumer price index. And so all government "services" have an inflationary bias in that those services are not measured within the CPI.

  10. One can look at inflation or deflation on a more basic level - a mismatch between people wanting stuff and stuff available (which is impacted by the number of producers). Beginning a generation or so ago, some hundreds of millions of young Chinese, willing to work cheap, moved from farm to city factory in China, just as China was integrating into the world economy. The world had the luxury of many more producers, producing much more stuff - so even misguided government policies, here and there, could not create much inflation. All those new workers are now aging out of the workforce, with few to replace them. Inflation is our lot with even the best of governance.
    (For an interesting take on cycles of inflation tied to population increases and collapses, over the centuries, see historian David Hackett Fischer's "The Great Wave".)

  11. Yes, the inflation we are experiencing is due to more aggregate demand than supply; but, that is because we had a major disruption to the supply chain.

    The consumer demand has recovered from the initial shock of February-April 2020 (; but production still lags behind ( and Capacity Utilization Consumer demand has normalized; production has not, and is still struggling.

    The problem is not the Fed and money supply; the problem is the damage to the physical structure of the economy – people/labor displaced and productive capacity shut down. During the initial shock of 2020, container ships were taken out of service and placed in “mothballed” temporary storage. That resulted in empty trailers, containers, and chasses placed in storage – but we don’t have enough capacity to handle those numbers of inactive equipment, resulting in them being placed wherever the companies can find space. Now all that has to be placed back in service, piece-by-piece, to return to some sense of normalcy. Not to mention the people, who were let go, returning to work; and the many smaller businesses along that supply chain returning to operation.

    As I said to you originally, which you did not print, our supply chain operates as queuing theory -- waiting/processing lines, or queues. One line is for processing (moving goods) and also for moving empty containers once they are off-loaded; and one line is a waiting line for reserve capacity (extra containers, trucks, storage space, etc.) that is needed to fill gaps in the processing line or take capacity out of the processing line when it is not needed and thereby make the processing line flow more efficiently. The whole system operates on flow -- keep the processing line flowing. In normal operation the processing line capacity (the movement of goods) far exceeds the waiting/reserve line capacity. The waiting/reserve queue does not have the capacity to hold all the trucks, trailers, containers, chasses, and especially the container ships that were taken out of service. The flow of goods has been disrupted.

    So we have an imbalance in the supply chain; which results in an imbalance between aggregate supply and demand, the inability of supply to get back to normal in order to meet the normalized demand which has returned. The rise in prices reflects how different businesses enterprises, large and small, can deal with the imbalances to keep their operations going, or exist in a standby state until normalcy returns.

    1. Vic,

      "..the problem is the damage to the physical structure of the economy – people/labor displaced and productive capacity shut down"

      I can't speak for other countries, but the largest job losses in the U. S. occurred in the travel and entertainment industries, education, and health care, all which have little to do with "supply chain" problems.
      March 2020 - 16.13 million employed
      April 2020 - 8.69 million employed
      March 2020 - 24.57 million employed
      April 2020 - 21.72 million employed
      March 2020 - 150.84 million employed
      April 2020 - 130.16 million employed

      Regarding trucking and freight carrying:
      March 2020 - 1.51 million employed
      April 2020 - 1.43 million employed

    2. We seem to have lost all proportion in what a shock to our economy we experienced this past year.

      Just in April 2020 alone, near the beginning of the pandemic when we had a national lockdown, we lost [net] over 20 million jobs, and over 6 million people dropped out of the labor force of near 165 million (about 8 million total dropped out of the labor force and we have recovered around 5 million of that), and the unemployment rate rose, just in that month, over 10% (from 4.4% to 14.7%), for the worst month in U.S. history, even nothing during the Great Depression came close to that.

      The month before, March 2020, when the international economy shut down, there was a sell-off of U.S. treasuries to raise cash. The Fed stepped in to the tune of over $1 trillion per day; described by the NY Fed’s John Williams “a staggering amount” to provide liquidity to support the market activity.

      Now if that alone does not impress you for what a shock we experienced, let me relate this: during that lockdown of about three weeks, the complete Los Angeles freeway system was wide open without any hitch, and I have lived in Southern California for over forty years.

      I think you have to ask yourself about the full ramifications of a sudden shock of that magnitude to the physical economy to include the international activity.

    3. Two things need to happen to rid the economy of this inflation.
      (1) The shock to the economy was due to the pandemic. We have to either conquer the pandemic, or learn to live with it. Then we will return to some sense of normalcy.
      (2) And then, the economy will normalize along with prices, and we will probably be at a new and higher price level for our large economy and without the inflationary pressures.

      The analogy you could make to understand a shock to the economy would be when we came out of war time periods into post-war, more normal, periods – like after World War I when we experienced a short (18-month) depression or the short, but sharp, recession we had in 1946/1947 right after World War II. 1946 was the second worse calendar year in our entire history, right after 1932 during the Great Depression.

      Normally when we have a big shock to our economy after coming out of a big war we can have a deflation (1921 and 1922) or inflation (1946 and 1947). When we shutdown the economies world-wide from February to April 2020, our Federal Reserve along with the fiscal stimulus of the federal government, pumped enormous amounts of money (well into the trillions of dollars) into various aspects of the economy to keep it somewhat afloat, putting a bottom on the recession, in order to avoid a deflation. We perceive a deflation to be worse than an inflation, because of the negative consequences on investing for the future. One moral hazard of that is that asset prices have not corrected and have spiraled upward.

      Whether all that funding that went into the economy to keep it afloat will result in long-lasting inflation will depend on raising our productivity levels as we go forward. We have had very poor rates of productivity, as measured by the Real GDP, since 2001, skipping the pandemic year of 2020 – yearly averaging 1.98%; and only 2.41% if you leave out the recession years, well below our historic yearly averages of well over 3% per year (3.77% since 1790 and 3.03% since 1947; and 4.53% during the ten years of the 1960s). This is also true for labor productivity (output per hour), in which the rate of labor productivity has been in a downward trend since 2005. So what it will take to turn things around, we will just have to see; but, there is plenty of room for corrective action. There is no need for us to return to the inflation of the 1970s – this is not a similar situation.

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  13. Excellent. All needed to say in short statement. Inflation perverts the ethic towards work. Simply, why do I have to work hard if at the end, inflation limits my expenses. I will buy less and less because salaries never grows st the same path as inflation does...

  14. Dear Professor, If you are correct that demand is outpacing supply, then why isn't GDP higher? Last quarter it was only up 3.2%. NIPA Profits are higher compared to nominal GDP. Both are at all time highs. Profits relative to GDP are also at an all-time high. GDP accounts and trailing 12-month earnings per share give the impression that reported corporate profits are going to be very impressive for the foreseeable future. But all of these numbers are comparative and not

  15. It’s going to be so sweet when you eat your words in 6 months. Oil prices are already dropping. The real estate bubble will pop. Workers will flow back into the workforce as they have in Europe when enough unvaxxed folks die off. The chips are getting produced, cars will fly off the assembly lines, the bottlenecks in the ports are already getting unclogged. Biden will meet with the Saudis and oil prices will drop. What will you talk about then? Biden mumbling? Looking forward to it.

    What a Grump!

    1. And will you "eat your words" if inflation is still running high come 6.1.22? Will you do so publically?

  16. I've always been curious why the Fed is given a pass like 'didn't see it coming' (or similar comment). Why are their actions not considered willful? All that can be had at their fingertips and have no insight into any of it. Ignorance is not an excuse. Maybe to a lesser degree stupidity. But, likely, done for the benefit of a few.

  17. Its more like truck drivers have a hard time getting into the port, but not a shortage of truckers. Its a night mare to go in and out of the LA port...

  18. AS soon as I saw the pipeline canceled and gas prices rising, I knew that inflation was triggered by a fundamental increase in baseline costs of transport and manufacturing. Add mismanagement in DC and you have the seventies back! We are so screwed.

  19. Where can I find information on inflation-linked bonds? With stupid low money market rates vs. substantial inflation, it seems like "cash" is a sure loser; I'm in equities now, but I'd love to find options for parking cash.

    1. I - bonds. US Treasury Dept ------ "Treasury Direct." Paying 71/2 % now until April '22 whe it may be adjusted in line with inflation.

  20. Some points here I had never considered before. Lots to think about. Hope inflation slows or returns to normal soon. Thanks for sharing!


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