Effective Inflation Control Requires Supply-Side Policy

After the pandemic-induced recession in 2020, fiscal policy helped raise gross domestic product (GDP) above pre-pandemic levels. But as output and employment have grown, so has inflation. The year-on-year increase in the core consumer price index (CPI)—which measures prices of goods and services other than energy and food, which are usually more volatile—was 6.3 percent in August 2022. And the year-on-year increase in the overall CPI was 8.3 percent in August.¹ Post-recession growth has taken place in an environment in which supply—of labor, manufactured goods, crude oil, natural gas, and food—has been and continues to be significantly disrupted. These negative supply shocks have been major contributors to core inflation and to energy and food inflation.

The Federal Reserve has responded to rising inflation by raising interest rates to reduce demand for goods, services, and labor. If interest rates are raised enough, output and employment will be reduced, price and money wages changes will slow, and, eventually, core price inflation will be reduced.

However, because recent inflation was significantly caused by supply factors, the contractionary monetary policy put in place to curb it will entail real economic loss, especially for those most vulnerable in the labor market—people of color, workers without a college degree, disabled workers, and others. Therefore, it makes sense to look for ways around the supply disruptions that are affecting the current expansion and may constrain growth in the future. There are several steps that could help in the short to medium term, including:

• Expanding the uptake of COVID-19 vaccines to reduce labor and manufacturing supply shocks
• Providing additional support for child and home care to raise labor force participation
• Reducing limits on working-age immigration to increase labor supply
• Intensifying antitrust enforcement to reduce the ability of corporations to raise prices more rapidly than costs
• Increasing the supply of renewable energy and eliminating reliance on fossil fuels to limit energy supply shocks, including by implementing and building on the recently enacted Inflation Reduction Act

Actions such as these are not part of the standard anti-inflation toolkit, but given the changing economic environment, they ought to be included.

After the lockdown-induced recession in 2020, fiscal policy helped restore employment and household income. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, the American Rescue Plan, and other federal actions added about $5 trillion in stimulus over a two-year period. This moved aggregate capacity utilization, as measured by the ratio of actual to potential GDP, to a high level. The increase in overall output has been accompanied by increasingly tight labor markets.

Without massive fiscal stimulus, the recovery would have been much weaker, and without the strong recovery, inflation would have been lower. However, high overall levels of utilization do not always produce high rates of inflation. Utilization rates in this expansion are no higher than those during the previous expansion, when average core CPI inflation was near 2 percent and showed much lower volatility. High-capacity utilization, by itself, is an incomplete explanation of what is being seen.

A more complete account includes the profound effects of supply reductions. The data show that negative supply shocks have significantly affected core CPI inflation. Reduced labor supply has contributed to tight labor markets, and pandemic-induced disruptions to global and domestic manufacturing supply chains have created unexpected shortages. This has created unusual price pressure as the economy has recovered. This pressure has been amplified by shifts in consumer demand to goods in short supply, as well as the exercise of market power by corporations, which has raised price-cost margins.

Core inflation anomalies in the current expansion

Compared with the previous expansion, increases in overall capacity utilization in the economy have produced higher rates of inflation and more volatile price movements. The economic recovery that began in the first quarter of 2020 has been accompanied by very large increases to the core CPI. (see Figure 1) The annual rate of change of core CPI moved upward from 3 percent in January 2020 to 8.5 percent in June 2022. This is an extraordinary change from the previous expansion. Not only is the inflation rate higher but month-to-month variations in the rate are relatively more extreme.

Figure 1

Moreover, higher and more volatile inflation is occurring when overall capacity utilization is no higher than it was during the previous expansion. The ratio of actual GDP to the Congressional Budget Office’s (CBO) estimate of potential GDP shows that, in the aggregate, the economy is close to capacity—that is, it is close to the level of real output that can be produced with normal levels of utilization of labor and capital inputs. However, this ratio is not that different from what occurred in 2019.

Compared with the previous expansion, commodities prices have diverged remarkably from the price of services. The core CPI—that is, the CPI less food and energy—has two component indices: the commodities less food and energy subindex, which tracks the prices of tangible goods that households purchase; and the services less energy services subindex, which tracks the prices of trade, transportation, health care, financial, and other services. Prior to the 2020 recession, the commodities price index was essentially flat, and the services price index was moving upward at a relatively steady rate, somewhat less than 2 percent annually. In the post-recession period, the two indices diverged markedly, with commodities prices rising rapidly, especially after 2021. (see Figure 2) This divergence is hard to explain as a result of excess aggregate demand alone.

Figure 2

Explaining the core inflation anomalies

Negative supply shocks have played a major role in raising core CPI inflation: Reductions in labor supply have tightened labor markets, and pandemic-induced disruptions to global and domestic manufacturing supply chains have created unusual and unexpected shortages. As the economy has recovered, these supply shocks have added to price pressures. These effects have been amplified by shifts in consumer demand to goods in short supply and by corporate increases in price-cost margins.

Reductions in labor supply—caused by both the COVID-19 pandemic and abrupt changes in immigration policy—together with sustained employment growth have produced very tight labor markets. The result has been increased money wage growth, with low-wage workers experiencing real wage increases.

Although money wages are growing more rapidly than they were pre-recession—and, as a result, raising costs—there is no evidence of acceleration or a wage-price spiral. In July 2022, with continued strong job gains, employment climbed back above its pre-pandemic high. But the U.S. labor force was approximately equal to its February 2020 level.² This unusual stagnation is the consequence of two factors: First, the labor force participation rate fell markedly from its February 2020 level as the pandemic forced the economy into shutdown and workers left the labor force. Participation has yet to recover, and COVID-19 risk is the most likely explanation. (see Figure 3) If the current participation rate were equal to that in February 2020, there would be an additional 1.8 million people in the labor force.

Figure 3

Second, labor force growth has been reduced by U.S. immigration restrictions. Deliberate policy decisions to reduce immigration under the prior administration, along with pandemic-related disruptions that have continued to affect immigration processing, have resulted in limited additions to the working-age population. Had immigration continued at the pre-2019 rate, there would have been approximately 2 million additional working-age immigrants in the United States by the end of 2021.³

Without these two labor supply shocks, the July 2022 labor force would be approximately 3.5 million workers larger, a 2 percent difference. This supply shortfall has had a measurable effect on the ratio of total people unemployed to total job vacancies—a recognized indicator of labor market tautness.⁴ In the run-up to the 2020 recession, this ratio was declining, reaching a value of 0.8 in February 2020. (see Figure 4) The recession caused massive unemployment, and the unemployed/vacancy rate spiked to nearly 5 in April 2020. As the economy recovered, this ratio declined, falling below 0.8 in July 2021 and reaching 0.5 in July 2022. With 3.5 million additional workers in the labor force, this ratio certainly would have been lower.⁵

Figure 4

The falling unemployment-to-vacancy ratio has been accompanied by increasing money wage growth. During the year before the 2020 recession, average annual earnings growth was about 3.1 percent. After fluctuating dramatically in the period between April 2020 and July 2021, average earnings began to grow more rapidly than in the pre-recession period, averaging about 5 percent annually between July 2021 and June 2022.⁶ With lower labor market pressure, money wage growth would very likely be lower.

It also should be noted that even though money wages are rising more rapidly than they were pre-recession, there is no evidence of acceleration in the past few months. In fact, the annualized rate of growth of average earnings has declined in the first six months of 2022, to 3.8 percent in June.⁷ These data do not point to a 1970s-style wage-price spiral, which can change expectations and make higher rates of inflation a more permanent issue. Moreover, there is nothing in the data that argues for permanently high levels of unemployment and slack labor markets. In 2019, the unemployment rate was identical to the current rate, the unemployment-to-vacancy ratio was 0.8, core inflation was about 2 percent, and real wages were growing at nearly 2 percent.⁸

It is also important to recognize that labor market tightness has delivered both employment and real wage growth to those who are lower in the wage distribution. As economists Joana Duran-French and Ira Regemi have pointed out:

Increasing wages for those earning the least is fundamental to ensuring an equitable economy that leaves no one behind. Wage increases among those who earn the least helps Black, brown, Latinx, and gender and sexual minorities most, as these communities are disproportionately represented in low-wage populations. For example, approximately 60 percent of low-wage earners are women, and wage increases at the bottom of the income distribution are likely to benefit nearly one-third of Black Americans and a quarter of Latinx Americans.⁹

A severe reduction in employment could reduce or reverse these gains.

Notably, pandemic-related disruptions in the supply of manufactured goods appear to have made a significant contribution to post-recession core inflation and its volatility. Parts of the U.S. economy are highly integrated into global supply chains, which have been repeatedly disrupted by COVID-19 waves and lockdowns.¹⁰ This has reduced domestic availability of intermediate inputs and final goods and produced bottlenecks in cross-border transportation. These supply-side problems have had a measurable effect on prices.

The U.S. auto industry provides a canonical example of a negative global supply shock. Pandemic-related reduction in the supply of essential semiconductors has denied automakers an essential input.¹¹ As a consequence, U.S. auto production in May 2022 was about 28 percent below the pre-recession level. This decline in supply has been matched by a dramatic increase in overall vehicle prices. (see Figure 5) The scarcity of new cars has also driven up the price of used cars. From April 2021 to April 2022, new and used cars’ price increases together added 1.17 percentage points to the overall CPI.¹²

Figure 5

The importance of negative supply shocks to pandemic-era inflation has been confirmed by statistical analysis. The Federal Reserve Bank of New York has constructed a global supply chain pressure index (SCPI), a statistically weighted combination of several variables that reflect global supply disruptions.¹³ Deviations of the index from its mean value are highly correlated with changes in producer and consumer prices over the past 24 years.¹⁴ A statistical decomposition of post-2019 CPI inflation shows that the large increases in the SCPI during spring 2020 and summer 2021 made significant contributions to CPI growth, adding about 1 percentage point to the inflation total in early 2022.¹⁵

The co-movement of the U.S. SCPI—which measures global supply chain impacts affecting the United States specifically—with core CPI inflation is illustrated in Figure 6. As can be seen from the figure, directional changes of the U.S. SCPI generally match directional movements in core CPI.¹⁶ It also is worth noting that the U.S. SCPI increased strongly during the last quarter of 2021, when the United States and the rest of the world were hit by the delta COVID-19 variant. This global supply shock, together with domestic COVID-19 effects, may have contributed to the burst of core inflation during this quarter.

Figure 6

Pandemic-induced changes in consumption behavior also added to commodities price inflation. Because of COVID-19 waves and lockdowns, U.S. households changed their expenditure patterns. Real expenditures on durable and nondurable goods rose significantly above pre-recession levels during the first year of the recovery and moved sharply upward again during the first half of 2021. (see Figure 7) Econometric analysis confirms that, controlling for the increases in household disposable income produced by expansionary fiscal policy, changes in consumer behavior account for about half of the increases in durables spending.

Figure 7

These upward shifts in real demand for commodities, which were also roughly coincident with supply shocks, were accompanied by bursts of inflation in early 2020 and early 2021. (see Figure 8) There was a subsequent burst in late 2021, which came after durables demand had stabilized. That burst was coincident with the delta COVID-19 wave.

Figure 8

There has been lively discussion about the effect of corporate pricing decisions on inflation. For example, researchers at the Roosevelt Institute have shown, using firm-level accounting data, that average markups for publicly traded firms jumped measurably in 2021.¹⁷ Increasing mark-ups will raise prices, ceteris paribus. When mark-ups are constant, prices will change in proportion to costs. But when markups are increasing, because of temporary or permanent increases in market power, the percentage change in price will exceed the percentage change in costs.

These insights are consistent with what can be seen in a business cycle framework, using national income data. Estimated markups for the nonfinancial corporate (NFC) sector are graphed in Figure 9.¹⁸ The figure includes data for two business cycles.¹⁹ In both the 2009 and 2020 recoveries, markups rose as the expansion got under way. This is consistent with previous business cycles; markups typically increase at the beginning of a recovery.

Figure 9

However, the increase in markups in the 2020 recovery has been higher than those in the 2009 recovery. During the 2009 recovery, the average of the trough value and the subsequent seven quarters was 7.6 percent. During this recovery, the average was 8.7 percent. That is, in this recovery, rising markups increased NFC prices by about 1 percentage point more than they did in the previous recovery. These data, together with the other data cited above, show that prices grew proportionally more than costs during this recovery. That, by definition, has added to price inflation and to corporate profits. Corporate exercise of market power has had a measurable effect.

Core inflation summary

The data show that negative supply shocks have significantly raised core CPI inflation, reduced labor supply has contributed to tight labor markets, and pandemic-induced disruptions to global and domestic manufacturing supply chains have created unexpected shortages. This has created unusual price pressure as the economy has recovered, which has been amplified by shifts in consumer demand to goods in short supply and by corporate increases in price-cost margins.

The prices of energy and food increased rapidly beginning in 2021. From August 2021 to August 2022, energy added 1.7 percentage points to CPI year on year, and food added 1.5 percentage points. This is a large fraction of the overall 8.3 percent increase. It is also a dramatic change from the pre-recession period. During 2019, energy contributed 0.25 percentage points, and food contributed 0.24 percentage points to CPI growth.²⁰

The movements in energy prices have been driven by increases in worldwide demand, OPEC-coordinated reductions in supply, and disruptions caused by Russia’s invasion of Ukraine, while U.S. food price movements have been caused by drought, increased input costs, and supply shocks related to the invasion of Ukraine.

Energy increases

Crude oil

Crude oil prices, which are determined in a world market, rose as the world economy recovered from the effects of the pandemic. The price of West Texas Intermediate crude oil, for instance, increased, in 2010 dollars, from $23.85 per barrel (bbl) in the first quarter of 2020 to $83.03/bbl in the second quarter of 2022.²¹ The decision of the OPEC cartel to reduce production beginning in 2020, together with increased worldwide demand and disruption of the oil market caused by Russia’s invasion of Ukraine, caused the large run-up in price.

Because OPEC produces about 40 percent of world oil supply, the cartel’s production decisions have a huge effect on world oil supply. In 2020, OPEC reduced production levels, and this was reflected in rising spare production capacity. (see Figure 10) Prices began to rise soon thereafter, and the worldwide recovery in economic activity raised demand further. Meanwhile, the invasion of Ukraine created expectations that world oil supply would be reduced still more, boosting crude prices. It appears, however, that the effects of the Ukraine invasion may dissipate rather quickly. Despite sanctions in the West, China and India have taken the place of Europe as buyers of Russian oil. This means that overall supply may be essentially unchanged by the sanctions.

Figure 10

Refined product prices

Rising oil prices have been the principal determinant of rising gasoline prices during the recovery, but data from the U.S. Energy Information Agency (EIA) indicate that refiner markups over crude oil costs—which is the principal variable input cost—have made a substantial contribution to gasoline prices. The difference between oil acquisition costs and the wholesale price of gasoline rose from around $0.45 per gallon during 2021 to $1.39 in June 2022.

This difference—or the “crack spread,” in industry jargon—has risen because refining capacity has decreased by nearly 5 percent since 2020. At present, refineries are operating near capacity with gasoline imports comprising only a small fraction of supply. This has given refiners increased market power.²²

Despite the rising cost of gasoline and its influence on inflation expectations, current household expenditures on gasoline as a share of disposable income are not unusually high. As the EIA has noted, “Gasoline expenditures averaged 2.6% of disposable personal income in the first quarter of 2022. This percentage is between the 2.4% average over the March 2015 to March 2020 period and the peak of 4.2% in 2008.”²³ The expenditure share is, of course, dramatically higher than it was in 2020, when the effects of the pandemic briefly created a negative price for crude.

Natural gas

The United States is a net exporter of natural gas, but an unusually cold winter has left stocks at below-normal levels, contributing to increasing prices. In addition, increased demand for U.S. liquid natural gas exports, caused by the war in Ukraine and Russian restrictions on exports to the European Union, has raised price pressure. As a result, domestic natural gas prices are more than double the level of a year ago.²⁴ These natural gas price increases have, likewise, raised the price of nitrogen-based fertilizer, which is made from natural gas.

Food price increases

World food prices have risen rapidly over the past year. The global economic recovery has raised demand, and supply has been disrupted by the war in Ukraine, the reduced supply of agricultural inputs, and extreme weather. While the world food price index has declined from its peak value in March, the year-on-year increase in July 2022 was 13.1 percent.²⁵

The Russian invasion interfered with Ukrainian exports of crops such as wheat, corn, barley, and sunflower oil. Ukraine has a 10 to 15 percent share of global trade in those three grains and an 80 percent share of world trade in sunflower oil, raising prices for all these commodities in world markets.²⁶

In addition, the world price of several important agricultural inputs has been raised by supply disruptions. The prices of three main fertilizers used in U.S. crop production—phosphate (phosphorus), potash (potassium), and urea (nitrogen)—have risen rapidly since 2020.²⁷ Export restrictions on all three fertilizers, imposed by Russia, China, and other countries since 2021, have reduced world trade for each by 20 percent.²⁸ Moreover, rising fuel prices have increased farm operating costs.

Drought, too, has reduced agricultural output in many parts of the world, including parts of the United States. This has affected the production and stocks of feed crops, such as hay, and livestock such as cattle.²⁹

Energy and food inflation summary

The post-pandemic recovery has taken place in an environment of reduced energy and food supplies. OPEC, which supplies about 40 percent of crude worldwide, reduced production beginning in 2020. Domestic weather has reduced natural gas inventories in the United States, causing natural gas prices to rise. Additionally, reductions in refining capacity since 2020 have increased the market power of U.S. refiners, and gasoline prices have risen more rapidly than the cost of crude oil. And as previously noted, the invasion of Ukraine decreased supply of fertilizers and drought disrupted food supplies, which has contributed to the rapid growth in food prices.

As in the case of core prices, supply limitations are playing an important role in both energy and food inflation.

The current price inflation comes from multiple sources, but the Federal Reserve Board has only the blunt tool of demand reduction to deal with it. The Fed has begun raising interest rates to reduce demand for goods, services, and labor. If rates are raised enough, output and employment will be reduced, price and money wages changes will slow, and, eventually, core price inflation will be reduced. However, the Fed’s attempt to reach its 2 percent inflation target could produce a very large reduction in demand, leading to big losses in output and employment.

In these circumstances, it makes sense to explore ways to address the supply disruptions that are affecting the current expansion and may constrain growth in the future. Fortunately, the Biden administration has taken several steps to resolve supply problems. It has made a major effort to reduce the transportation bottlenecks at West Coast ports, the primary destination for containerized shipments from Asia. Moreover, it is releasing crude oil from the Strategic Petroleum Reserve (SPR) to counter crude price increases and is entering into forward contracts to refill the SPR to encourage increased domestic shale oil production.³⁰ Recently the U.S. Department of Commerce released a strategy for a $50 billion semiconductor investment, funded by the CHIPS and Science Act, designed to increase domestic production of both advanced and mature semiconductors.³¹

In addition, there are several other steps that could help in the short to medium term, including:

• Expanding the uptake of COVID-19 vaccines to reduce labor and manufacturing supply shocks: The COVID-19 pandemic continues, and new variants may lead to another wave of infections. The negative effects on labor supply, the operation of the economy, and the functioning of the global manufacturing supply chain also continue. Since vaccination is the most effective method of slowing the spread of the virus, increased vaccine uptake can help resolve supply limitations as well. There is a need for additional federal funding to maintain the COVID-19 relief effort, improve public health infrastructure, and support continuing research and development of vaccines to provide immunity against new variants.³²

• Providing additional support for child and home care to raise labor force participation: When employable adults must care for children or relatives, their rate of labor force participation declines. However, when employable adults have access to quality, affordable child or home care, which is complementary to the income rewards of working, their participation rates rise.³³ Since reduced participation is contributing to the current inflation surge, increased child and home care support would clearly be helpful.

• Reducing limits on working-age immigration to increase labor supply: Immigration of working-age adults fell sharply after 2019, measurably reducing labor force growth. Additionally, about half of working-age immigrants have college degrees, and the sharp drop in immigration deprived the labor force of these skilled workers. Increased immigration rates would help resolve labor shortages in several sectors of the economy.

• Intensifying antitrust enforcement to reduce the market power of corporations: It is now widely understood that the market power of corporations has increased significantly in recent decades.³⁴ This has allowed price-cost margins to widen and profits to rise above competitive levels. However, the evidence from this recession and recovery demonstrates that supply shocks create novel opportunities to exercise market power and raise margins—perhaps by providing cover for price increases. A more vigorous approach to antitrust enforcement, which would increase entry of new competitors, would reduce market power and should reduce the inflationary effects of future supply shocks.

• Increasing the supply of renewable energy and eliminating reliance on fossil fuels to limit energy supply shocks: Increasing the supply of renewable energy and eliminating reliance on fossil fuels would help reduce the risk of energy-related inflation shocks. Supply conditions in the world market for oil are heavily influenced by OPEC, which controls spare production capacity. U.S. capacity is limited because domestic producers are unwilling to invest.³⁵ Increased supply of renewable energy, however, would allow substitution away from fossil fuel, diminishing the effect of increased demand on energy prices. Moreover, the frequency of extreme weather events, which lower crop and livestock yields, will only rise unless carbon emissions are better controlled. Droughts have contributed to current high food prices, and preventing increased frequency and severity is extraordinarily important.

In addition, empirical work has shown that as temperatures trend upward, labor force participation and productivity both decline. Outdoor work, in sectors such as agriculture and construction, is affected most intensely. Model estimates show that the effective U.S. labor supply will be reduced as average temperatures increase by 1.5 degrees Celsius or more above preindustrial levels.³⁶ As recent events have shown, relatively small reductions in labor supply can impact inflation.

Two recently passed pieces of legislation, which are among the most consequential contributions to industrial policy in decades, will make important contributions to eliminating reliance on fossil fuels. Initiatives in the CHIPS and Science Act will support renewable energy research along with much-needed initiatives to facilitate incorporation of scientific discoveries into manufacturing products and processes.³⁷ Initiatives in the Inflation Reduction Act, likewise, will dramatically increase renewable supply by providing subsidies for clean energy production and domestic manufacture of clean energy technologies. The Inflation Reduction Act also includes important support for incentivizing household purchases of electric vehicles, solar panels, and other clean technology.³⁸ By increasing the supply of renewable energy and reducing the demand for fossil fuels, these two bills will help mitigate climate change.

These and other initiatives in the CHIPS Act and Inflation Reduction Act take important steps toward limiting destructive climate change. They will also deliver the nontrivial benefit of reducing the inflation constraint on economic growth. When additional climate policy actions are considered, inflation-reducing effects should be included in the decision-making calculus.

The current inflation owes a lot to supply conditions that have been anything but normal. COVID-19 has thoroughly disrupted manufacturing and reduced labor supply. Crude oil markets have been strongly affected by OPEC’s 2020 decision to lower production. Food supplies have been hit both by Russia’s invasion of Ukraine and by extreme weather. Moreover, corporations with market power have exercised it freely during the recovery.

These supply problems are unlikely to resolve themselves quickly or completely. COVID-19 continues to disrupt markets for labor, products, and services. OPEC continues to have a dominant role setting world crude oil prices. Climate change continues to produce extreme weather. And domestic corporations continue to exercise monopoly power whenever they see the chance.

This changed economic landscape calls for a broader approach to inflation policy. Relying exclusively on Fed demand management is far too passive. Things will greatly improve if economic policy addresses the supply issues brought into high relief during this recovery. The policy measures discussed above provide a reasonable starting point. Adopting them will relax the inflation constraint on output and employment growth. Moreover, they will provide important benefits to public health, families, and climate. There is much to be gained from a change in approach.