How Much Of The Inflation Is Excessive?

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[If you only read one post today, read my new article on inflation, Fireman and Arsonists. I regard it as the most important post I’ll do this year.]

I am amused when I see people debating whether the current inflation is supply or demand driven, as if this is some sort of factual question.

To a hard-core inflation hawk that favors of policy of 2% inflation come hell or high water, all excessive inflation is demand driven, by definition.

In contrast, let’s say you favor 5.5% NGDP growth because you want an inflation rate high enough to keep us out of a liquidity trap. (Recall those economists who wanted to raise the inflation target to 4%.) If 5.5% NGDP growth is the baseline, then nominal spending growth since late 2019 has been roughly appropriate, and all of the current high inflation is supply driven.

When people debate whether inflation is caused by supply or demand factors they believe they are debating something about the nature of the universe, whereas they are actually debating what sort of monetary policy would have been appropriate over the past 2 years.

When I started blogging in early 2009, I assumed a trend rate of NGDP growth of roughly 5%, representing 2% inflation and 3% RGDP growth. But then the trend rate of RGDP growth began slowing, mostly due to slower population growth, but also slower productivity growth. Because the Fed insists on a 2% inflation target, I began suggesting a 4% NGDP growth figure as being roughly consistent with the Fed’s policy preferences.

But even 4% may now be too high. RGDP growth over the past 15 years has averaged only 1.63%, despite a falling unemployment rate. Even worse, population growth has plummeted during that period, so the next 15 years are likely to be even slower. If the Fed is serious about 2% inflation (and I’m having my doubts) then 3.5% NGDP growth is the baseline to evaluate monetary policy.

On the other hand, under their current asymmetric FAIT policy it seems like they are correcting inflation undershoots but not overshoots, implying more than 2% inflation on average. So let’s just stay with 4% NGDP growth as roughly representing the Fed’s dual mandate of 2% inflation (with occasional overshoots) and 1.5% RGDP growth.

Since the 4th quarter of 2019, NGDP growth has averaged about 5.26%, pushing the level roughly 3% above trend over the past 2 1/4 years (or even more if you use the 3.5% trend line benchmark.) So a significant portion of the inflation is demand driven.

The Fed’s preferred PCE price index has averaged 4% inflation since January 2020. So there’s a total of roughly 5% excess inflation over the past 2 1/4 years. From my perspective, it makes sense to view the recent higher than normal inflation as being roughly half supply driven and half demand driven, with the caveat that the overshooting (of both NGDP and PCE) will get even worse over the next 6 months.