What Is Driving the Inflation?

By Shlomo Maital   


  Just hours ago, the US Labor Department released June inflation figures.  Consumer prices rose by 5.4% in June (annual, over June 2020), the biggest monthly rise in prices since August 2008.   Used car and truck prices comprised about one-third of the total Consumer Price Index rise.  In other words, without the ‘used car’ effect, the CPI would have risen by 3.6%.   Without food and energy (core inflation),  the CPI would have risen by 4.5% (highest since Sept. 1991).  

   Consumers think inflation will continue to be around 5% for the coming year.  Economists mainly disagree.  And they are wrong.

    How should we react to this?

    The main driving force of rising prices is suppy-side.  Chip shortages and the pandemic cut vehicle production.  So people buy used cars.  That’s supply-side.   Reluctance to rejoin the labor force causes wages to rise – that is supply-side.  Nearly all the proximate causes of the inflation are on the cost and supply side (Supply curves are cost curves, economists explain).

    We had supply-side inflation in 1973/4  and in 1979/80.  It was driven by higher oil prices.  It led to ‘stagflation’ – higher prices, and stagnating economies.  Inflation plus recession.  It will not have this impact this time.  Because —  demand is also recovering and in some cases, booming, as people play ‘catch up’ with their consumption.  So contracting supply curves and expanding demand curves both generate higher prices. 

      There is a real danger in all of this.  We know how to manipulate demand – taxes, interest rates, govt. spending.  We do NOT know the first thing about how to influence suppy curves, which in the end are driven by productivity.   If you try to treat supply-side inflation with demand-curve tools, you get recession or slower growth.    

       There is growing pressure on central banks to tighten their interest rate policy, to battle inflation.  This will choke demand and slow the recovery.  Big mistake. 

        Let’s learn from history.  In the US,  the recovery from the 2008 financial crisis was very slow, because the Obama Administration buckled under Republican pressure and shut down expansionary spending far too soon.  Biden, as Vice-President at the time, was part of this policy.  He studies history.  He knows that was a mistake.  And I believe, he will not repeat it.  The Biden Administration has administered massive, but responsible, stimulus to the US economy and it is working.  He needs to continue this policy, and not be deterred by the inflation hawks.

     There is another risk.  Inflation psychosis.  As people see prices rising, they rush to buy stuff, and this adds fuel to the fire.  I don’t think this is likely.  Over the coming year, supply chains will be re-established, ports and shipping will become much smoother, the Trump-era tariffs will start to come down (they already have), and gradually, the supply-side inflation will abate, while the demand-side expansion will continue apace, as it should. 

     In 1981, under President Reagan,  a massive tax cut (two of them, actually) was motivated on supply-side grounds – pamper the rich, they will invest the money they get to keep, supply curves will expand.  It didn’t happen.  They spent the tax cut. And that fueled a demand-side Keynesian expansion that lasted for a decade and got Reagan re-elected in 1984 in a landslide. 

      Let’s face it.  Demand curves are docile, subject to policy.  Supply curves?  They are like wild mustangs.   Keep demand growing, let the global economy boom (as it is),  let China pull Asia with its 8.4% GDP growth, and let the IMF be right with its global GDP growth forecast of 6%.