On Inflation, Economics Has Some Explaining to Do

This would be understandable if economists had only missed by a bit. They didn’t. Inflation at the end of last year was more than double the median projection among economists surveyed eight months earlier and well above the highest forecast.

Economists at both the Federal Reserve and the White House were blindsided. The European Central Bank recently reported that the accuracy of its inflation forecasts “declined significantly during the Covid-19 crisis.”

Economists’ definition of inflation—a rise in the overall price level—is constant but their understanding of its causes goes through regime shifts. Textbooks still link inflation to the money supply, but financial innovation and regulatory changes have made the link between money and spending too unreliable to be useful.

Nowadays, working economists try to predict inflation by comparing the demand for goods and services and their supply as represented by the “output gap”—the difference between actual gross domestic product and potential GDP based on available capital and labor—and by the Phillips curve, according to which wages and prices accelerate when unemployment falls below some natural, sustainable level. Models such as the Fed’s supplement this with measures of past and expected inflation, which influence wage- and price-setting behavior, oil prices and exchange rates.

These models worked reasonably well over the roughly 40 years before the Covid-19 pandemic, but not since. “Economists do not have a satisfactory theory of inflation at this point,” said Harvard University’s

Larry Summers.

The Phillips curve, he said, “has large anomalies.” It can’t explain why some countries experience hyperinflation, or why in the U.S. the price level rose so rapidly between 1933 and 1935 in the presence of a massive output gap, he said.

Mr. Summers is one of the few economists to have warned of inflation early in 2021 (and to have published several NBER papers on the subject). While he’s critical of the Fed’s models, his framework is similar: He thought President

Biden’s

$1.9 trillion stimulus would far exceed the output gap. He said this was a “back of the envelope” model that didn’t yield precise forecasts but, combined with history and judgment, “provided enough information to say overheating was an enormous risk.”

Similar arguments were made by

Olivier Blanchard,

the former chief economist of the International Monetary Fund, who thought strong demand would drive unemployment down to 1.5%, and by

Michael Strain,

head of economic-policy studies at the conservative American Enterprise Institute.

While all of these critics got the direction of inflation right, their analyses can’t explain, at least using prepandemic relationships, the magnitude, i.e., how inflation suddenly shot from around 2% before the pandemic to 8.6% now—6% excluding food and energy. They explain why inflation rose more in the U.S. than Europe, but not why inflation rose so much in Europe.

Alan Detmeister, an economist at UBS and formerly the Fed, ran a statistical exercise earlier this year that found that the output gap, derived from actual GDP and Congressional Budget Office estimates of potential GDP—both adjusted, and unadjusted, for inflation—can explain at most 0.1 percentage point of the rise in inflation since the middle of last year, and the unemployment rate can’t explain any. He did find that worker quits and job vacancies and supplier delivery times can explain about half the rise in inflation.

This supports the widespread anecdotal evidence that supply disruptions and labor shortages due to Covid-19 and the war in Ukraine account for a lot of the rise in inflation. “Normally when you get the strength of demand we got, you would have seen supply respond pretty strongly,” said Mr. Detmeister. “It’s a bit of a reflection of a failure of modeling. We don’t have good measures on the supply side, particularly on a sectoral level.”

Economists have treated the supply side—autos, housing, restaurants, energy, healthcare, finance—as homogenous and elastic: When demand for nursing home beds or cars rise, so does their supply, and prices rise only a little, if at all.

But in the last two years, supply hasn’t been homogenous. Some industries like e-commerce have hired easily, while others like nursing homes have lost workers in droves. Food sold to restaurants didn’t substitute easily for food sold in supermarkets. Supply hasn’t been elastic: Increased demand for cars and houses boosted prices, not output.

Mr. Strain said this doesn’t invalidate output gap models; it means they need better empirical underpinnings. Nor, said Mr. Summers, does it excuse the Fed or the administration: Supply problems and worker shortages should have made them even more wary of pumping so much more stimulus into the economy.

Nonetheless, the evidence suggests high demand and restricted supply are interacting in ways that economists struggle to calibrate. That is a problem, because it suggests inflation may remain unpredictable as the Fed rapidly withdraws stimulus but supply disruptions from Covid and war persist.

Hopefully soon, academics will have some answers. “The rise of U.S. inflation in the summer and fall of 2021 has been substantially larger and faster than in the last few U.S. recoveries,” economists Emi Nakamura and Jón Steinsson at the University of California, Berkeley, noted in December. Analyzing the competing explanations “will be an important focus of research” at the NBER.

Write to Greg Ip at [email protected]

This would be understandable if economists had only missed by a bit. They didn’t. Inflation at the end of last year was more than double the median projection among economists surveyed eight months earlier and well above the highest forecast.

Economists at both the Federal Reserve and the White House were blindsided. The European Central Bank recently reported that the accuracy of its inflation forecasts “declined significantly during the Covid-19 crisis.”

Economists’ definition of inflation—a rise in the overall price level—is constant but their understanding of its causes goes through regime shifts. Textbooks still link inflation to the money supply, but financial innovation and regulatory changes have made the link between money and spending too unreliable to be useful.

Nowadays, working economists try to predict inflation by comparing the demand for goods and services and their supply as represented by the “output gap”—the difference between actual gross domestic product and potential GDP based on available capital and labor—and by the Phillips curve, according to which wages and prices accelerate when unemployment falls below some natural, sustainable level. Models such as the Fed’s supplement this with measures of past and expected inflation, which influence wage- and price-setting behavior, oil prices and exchange rates.

These models worked reasonably well over the roughly 40 years before the Covid-19 pandemic, but not since. “Economists do not have a satisfactory theory of inflation at this point,” said Harvard University’s

Larry Summers.

The Phillips curve, he said, “has large anomalies.” It can’t explain why some countries experience hyperinflation, or why in the U.S. the price level rose so rapidly between 1933 and 1935 in the presence of a massive output gap, he said.

Mr. Summers is one of the few economists to have warned of inflation early in 2021 (and to have published several NBER papers on the subject). While he’s critical of the Fed’s models, his framework is similar: He thought President

Biden’s

$1.9 trillion stimulus would far exceed the output gap. He said this was a “back of the envelope” model that didn’t yield precise forecasts but, combined with history and judgment, “provided enough information to say overheating was an enormous risk.”

Similar arguments were made by

Olivier Blanchard,

the former chief economist of the International Monetary Fund, who thought strong demand would drive unemployment down to 1.5%, and by

Michael Strain,

head of economic-policy studies at the conservative American Enterprise Institute.

While all of these critics got the direction of inflation right, their analyses can’t explain, at least using prepandemic relationships, the magnitude, i.e., how inflation suddenly shot from around 2% before the pandemic to 8.6% now—6% excluding food and energy. They explain why inflation rose more in the U.S. than Europe, but not why inflation rose so much in Europe.

Alan Detmeister, an economist at UBS and formerly the Fed, ran a statistical exercise earlier this year that found that the output gap, derived from actual GDP and Congressional Budget Office estimates of potential GDP—both adjusted, and unadjusted, for inflation—can explain at most 0.1 percentage point of the rise in inflation since the middle of last year, and the unemployment rate can’t explain any. He did find that worker quits and job vacancies and supplier delivery times can explain about half the rise in inflation.

This supports the widespread anecdotal evidence that supply disruptions and labor shortages due to Covid-19 and the war in Ukraine account for a lot of the rise in inflation. “Normally when you get the strength of demand we got, you would have seen supply respond pretty strongly,” said Mr. Detmeister. “It’s a bit of a reflection of a failure of modeling. We don’t have good measures on the supply side, particularly on a sectoral level.”

Economists have treated the supply side—autos, housing, restaurants, energy, healthcare, finance—as homogenous and elastic: When demand for nursing home beds or cars rise, so does their supply, and prices rise only a little, if at all.

But in the last two years, supply hasn’t been homogenous. Some industries like e-commerce have hired easily, while others like nursing homes have lost workers in droves. Food sold to restaurants didn’t substitute easily for food sold in supermarkets. Supply hasn’t been elastic: Increased demand for cars and houses boosted prices, not output.

Mr. Strain said this doesn’t invalidate output gap models; it means they need better empirical underpinnings. Nor, said Mr. Summers, does it excuse the Fed or the administration: Supply problems and worker shortages should have made them even more wary of pumping so much more stimulus into the economy.

Nonetheless, the evidence suggests high demand and restricted supply are interacting in ways that economists struggle to calibrate. That is a problem, because it suggests inflation may remain unpredictable as the Fed rapidly withdraws stimulus but supply disruptions from Covid and war persist.

Hopefully soon, academics will have some answers. “The rise of U.S. inflation in the summer and fall of 2021 has been substantially larger and faster than in the last few U.S. recoveries,” economists Emi Nakamura and Jón Steinsson at the University of California, Berkeley, noted in December. Analyzing the competing explanations “will be an important focus of research” at the NBER.

Write to Greg Ip at [email protected]