- Inflation hasn't been influenced by supply-side trends, a think tank expert argues.
- Instead, inflation was mainly caused by fiscal policy and reversed through interest hikes.
Inflation is starting to let up, but supply chain improvements are not the key reason, a senior fellow at the American Institute of Economic Research wrote.
Instead, the Federal Reserve should take the most credit, as its aggressive monetary tightening campaign succeeded in putting the brakes on US demand, Alexander William Salter wrote in an article published by the think tank at the end of December.
His outlook pushes back on a wider narrative that has formed in recent month, which points to mended supply chains and expanding inventories as the lead reasons for today's disinflation.
This interpretation has been regularly touted by Treasury Secretary Janet Yellen, while a Roosevelt Institute paper from September argued that supply-side expansions were driving the majority of price declines.
"There's a gaping hole in this story: The economic theory that underlies it makes predictions that are clearly inconsistent with the data," Salter argues. "While improved productive conditions can sometimes cause prices to grow more slowly, or even fall, they aren't the main reason inflation is slowing now."
Largely, if supply restrictions propel prices higher, solving them should have the opposite effect, he said. But since the pandemic, goods prices have remained elevated even as shipping and energy costs have fallen.
This relationship is so symmetric that a 1% rise in total supply growth should bring the inflation rate down 1%, Salter elaborated. Still, GDP growth, the basic measure of supply, doesn't show this is happening.
"You can't explain an inflation slowdown between 4.5 (PCEPI) and 5.8 (CPI) percentage points based on a mere 1.2 percentage point increase in real GDP growth," he said, referring to third quarter metrics. "Supply-side improvements would need to be around four times as large for the explanation to work."
Instead, the post-pandemic surge in inflation is better explained by the sharp uptick in federal spending seen during COVID, after fiscal policy was expanded to support US households and consumers.
Any disinflation that's followed is the Fed's work, Salter said, and showcases the effectiveness of raising rates 5.25 percentage points in a 16-month timeframe. Paired with the central bank's balance sheet reductions, these efforts helped reduce the nation's money supply, with M2 falling 3.3% from a year prior.
"If this isn't a total demand slowdown, nothing is," Salter wrote.
He added that this argument could reinstate long-standing macroeconomic understandings of inflation, which have come under question as price growth appeared less correlated with demand and employment.
"Our inflationary roller coaster ride has a silver lining: It vindicates the textbook macroeconomics we've been teaching our students since the early 1980's," he said. "The link between total demand growth and inflation remains strong."
But there may still be room for disagreement. For instance, new research recently found that the supply-chain challenges were more persistent than previously understood, and may have played a larger role in price hikes than even supply-side proponents realized.