Originally published on RealClearPolicy.com
Inflation has slowed to below 5% during the last year through April according to the latest core personal consumption expenditure price index which excludes wartime volatility in the energy and food sectors. And core month-to-month changes of late (0.3%) are even lower.
The Federal Reserve Open Market Committee (Fed) is succeeding in reducing inflation despite being armed only with a hammer, ill-suited to today’s multiple sources of inflation. It must carefully calibrate use of the hammer to avoid a global recession, which would disrupt the transcendent national goal of sustaining U.S. and European public opposition to Putin’s invasion of Ukraine. That primacy imposes a novel constraint for an institution playing a weak hand, lacking precision tools. The Fed should resist pressure to decelerate inflation quickly, risking triggering a recession. Economic growth can be sustained with the present gradual glide path toward its 2% inflation goal.
Progress on Inflation
The Fed has succeeded in dampening inflation expectations, avoiding a replay of the 1970’s inflation. Consumer and investment demand is slowing and supply chains easing with investment up. The housing sector is slowing. Federal budget deficits are dwindling, easing demand. And while the recovery has tighten labor markets with wages rising, median earnings expectations a year ahead have remained steady at a moderate 3% rise reports the New York Fed. Finally, the risk of a China supply shock is subsiding. Chinese government pandemic policies are behind today’s episodic economic shutdowns hampering production there. Yet, those policies are simultaneously depressing Chinese consumer income and demand.
Set against these events is the Fed’s history where, despite the best of intentions, “soft landing” is an oxymoron. Experts have grown fearful of a Fed-induced recession, with odds rising because the Fed lacks the best tools to ameliorate the major sources of today’s inflation – supply side snarls and rising corporate profit margins.
Sources of Inflation
A new analysis of data from the U.S. Commerce Department finds that rising profit margins accounted for a majority (53.9%) of inflation in unit prices in the nonfinancial sector during 2020 and 2021. This jump created the widest profit margins in 70 years. The next largest source was rising non-labor input costs, reflecting snarled supply chains. The final source was rising labor costs responsible for just 7.9% of the increase in unit costs. The sources of today’s inflation are a sharp departure from the historic pattern over the past four-decades (1979 to 2019) of price stability when profits were a notably smaller factor (11.4%) than labor and non-labor production costs.
Economic Policy Institute data indicate that the U.S. is experiencing a profit-price spiral, not a wage price spiral. Indeed, by lagging prices, wages have moderated inflation. The data do affirm that pandemic supply side issues have also significantly contributed to inflation. But they also have created a puzzle: the pandemic caused an ahistorical pattern of corporate pricing behavior, rising margins creating today’s profit-price spiral.
Supply Side Inflation
U.S. and foreign enterprises are responding as economists would expect in unsnarling global supply chains, complemented by remarkable medical science moderating inflation by keeping assembly lines, ports and vessels manned. Other federal agencies – not the Fed – have the nuanced tools required to slow inflation by reinforcing these market forces. That includes countering Putin’s decision to weaponize food and energy. Disruptions in Europe have caused global oil and natural gas prices to spike. And Putin’s threats, blockades and theft of Ukraine fertilizer, barley, wheat, and sunflower oil exports have also fostered volatility and shortages in food markets, despite U.N. Food and Agriculture Organization reassurances.
Widening margins since 2020 are puzzling. True, generalized pandemic inflation has created a permissive environment where rising prices face less consumer opprobrium than in normal times, and where competitors are less inclined to undercut. Even so, widening margins also suggest some measure of market pricing power. Producer markets have become more concentrated. And the Biden administration has responded to these trends and new data by initiating market behavior investigations, including of the meat packing industry. Other targets are airlines and infant formula. Global shippers are a fourth target – their behavior since 2019 enabled by U.S. deregulation that stripped oversight from the Federal Maritime Commission. The ensuing industry consolidation has left only three entities dominating 80% of global shipments, up from 29% in 2011. Rates since 2019 have leapt to $22,500 from $4,000 for containers transporting Chinese goods to the west coast, tripling industry profits.
The Fed Agenda
The Fed must be cognizant of four realities. First, that meeting its 2% inflation target rests mostly in the hands of Putin and OPEC. Second, ill-equipped to address major source of today’s inflation, there is a risk it will misplay its weak hand and empower Putin by creating a global recession. Third, it can dampen inflation by jawboning enterprises to moderate prices while encouraging investments that unsnarl supply chains. And fourth, other federal agencies – not the Fed – have the nuanced, precision micro-policy tools best suited for the inflation fight – exemplified by the administration’s steps unsnarling production bottlenecks, stimulating baby formula supply, boosting farm production and to not sanction Russian food and fertilizer exports.
It is likely that moderating inflation will shrink profit margins and end the profit price spiral. Even so, the pandemic episode over the last two years justifies the Biden administration’s review of antitrust policy. Ascendant since the 1980s has been the notion that consumer welfare rather than market concentration is the superior metric for judging market power abuse. Yet, market concentration has increased, investment has declined and excess profits tend not to be competitively whittled away by new (nonexistent) market entrants. Bolstered with compelling lessons and data from Europe, replacing the consumer welfare standard with evidence-based guardrails analytically centered on market concentration variables is warranted.
A Pyrrhic Fed Victory
Inflation is not subsiding quickly. Chairman Jerome Powell is aware that supply constraints insensitive to tight money are mostly responsible. Yet, he and his colleagues may respond to critics by engineering a global recession. In spreading dismay among NATO voters, that overreaction would disrupt U.S. national interest in sustaining broad opposition to the Ukraine invasion. It would accomplish what Putin’s military can’t. The Fed would salvage Putin’s war while fulfilling his conviction that liberal democracies are fickle and feckless – incentivizing and emboldening authoritarians for decades to come.
Cool heads are required at the Fed.