Inflation Expectations, Output Gaps, and Supply Chains, Oh My!
The "big" drivers of Inflation (Part 1)
There is no shortage of opinion on the inflation phenomenon of 2021 (see my earlier post showing the data on inflation). Famous experts of all kinds have weighed-in and even debated each other on the subject, such as Nobel Prize-winning economist, Paul Krugman, and macroeconomist and former Treasury Secretary, Lawrence Summers. Krugman has been a well-known economist/columnist for a long time, and Summers has done just about everything, including once kicking the Winklevoss twins out of his office (allegedly). If Krugman and Summers don’t agree, then you might think it must be pretty darn complicated, no? And you’re right, it is.
But, if we take a “big picture” approach to breaking inflation down, we can at least gain a working understanding of what the debate is all about. Of course, understanding inflation is complicated since the number (and the concept) is the manifestation of millions and millions of economic decisions made every day. But, that is what the study of macroeconomics is all about—how we make sense of all of those millions and millions of decisions from a “big picture” vantage point.
In this post that is what I am going to do: focus on the “big picture” drivers of inflation. The macroeconomics profession has, more or less, coalesced on three main drivers: Inflation Expectations, the Output Gap, and supply-side “shocks.” These three drivers all have a unique effect on inflation, but together they are the main culprits for inflation. For a visual, I made this amateur-looking graphic:
Let’s tackle each “big” driver in turn, with the emphasis of this post on the first two. We will finish up with supply-side shocks in a follow-on post.
Inflation Expectations
“Inflation expectations” is a term for what the “public” expects for inflation over the long run. Macroeconomists boil it down to a specific number and this number serves as an “anchor” for inflation over the business cycle. That is, while the current level of inflation may be below or above the “anchoring” value, the public expects inflation to return to this long run value.
So, who is the “public,” and what is the value?
The “public” are investors, more or less. Investors, or financial market participants more broadly (banks, insurance companies, and so on) pay close attention to what inflation is, and what they expect it to be in the future. You could also include in the “public” certain groups, such as human resource departments, or union negotiating teams. And possibly you could broaden that to include “consumers,” in so far as people give thought to the long run picture of inflation (we are more likely to do so when it comes to thinking about our retirement accounts).
What is the value? The evidence from many, many years of comparison across countries and time periods, lead us to believe that expectations are “anchored” by a reputable central bank, such as the Federal Reserve. If the Fed says they are targeting an inflation rate of 2 percent, and all of the above parties believe them, then inflation expectations will settle on 2 percent. If we don’t believe them, then expectations become “unanchored” and all sorts of trouble ensues (more on that later).
The Output Gap
You can think of the output gap as the level of real GDP above or below the level of potential GDP, as mentioned in a previous post. In practice, the gap is defined in terms of percentages, as the difference in the rate of real GDP growth from the long run average expected for the economy.
Or, Output Gap = Current rate of real GDP – Long run average.
If the long run average is 1.8 percent (per the Fed’s forecasts), and the U.S. economy grew at 6.9 percent in 2021 (per the estimate published last week), then the Gap in 2021 = 5.1 percent.
You can also think of the output gap as representing the business cycle—which is the oscillation of real GDP around the long run average. With that in mind, the output gap, too, is a concept that reflects a long-held belief by most macroeconomists—that the business cycle is driven mostly by aggregate demand. The latter means the willingness and ability of households and firms (and the government) to spend money in the near term, or what macroeconomists call the “short run.” It is this force—aggregate demand—that I focused on in a previous post about the abnormally high levels of consumption spending the past year (Inflation and the Hungry Beast).
Moreover, there is a very important and simple relationship between the output gap and the rate of inflation:
When the output gap is positive, the rate of inflation increases.
When the output gap is negative, the rate of inflation decreases.
There is a variety of logic behind those two bullet points, the details of which I won’t go into here (if you’d like to get deeper into it, check out this background from well-known macroeconomist Gregory Mankiw). For our purposes—and for your purposes of understanding the general scope of the current debate surrounding inflation—consider this relationship between the output gap and inflation as the prism through which macroeconomists typically view the topic. To see it a little clearer, consider this hypothetical example:
Say that inflation expectations are currently hovering around 2 percent, and are expected to remain at 2 percent for long time. Also, assume the economy is perfectly “at rest” where real GDP = Potential GDP, meaning the output gap equals zero. And for now, let’s ignore the third leg of the inflation stool, the “shocks” factor.
Given that setup, let’s see how inflation increases over time, on a month-to-month basis, as the output gap increases by 2 percent each period (where the initial time period is “month 0”). This is shown in Table 1:
What we observe in Table 1 is that if inflation expectations are fixed at 2 percent then as we roll through the business cycle expansion and back, inflation increases and decreases accordingly.
(Here I am assuming a one-for-one relationship between the inflation rate and the output gap; in typical models of inflation, that may not be the case, which I discuss in a follow-on post).
Pretty simple, right? Okay, what happens if inflation expectations change, and why might they change? First, expectations may change if the “public” notices inflation increasing and decides that the increase represents a “permanent” change in the nature of inflation. So, the public ratchets up their expectations accordingly.
Let’s modify the example from above and assume the public does so in Month 4, after realizing belatedly what has happened the previous three months. Moreover, as a sort of “catch-up” in anticipation of further inflation, they escalate their expectation by the average increase the previous three months—2 percent. Table 2 captures what happens:
At month 4 the public starts “building in” the rise in inflation caused by the business cycle expansion (the increase in the output gap). As a result, even after the expansion cools off and real GDP is once again equal to potential GDP, the economy now has a permanently higher level of inflation, 8 percent instead of the 2 percent back in month 0.
Why would this happen, versus the case above when inflation expectations were unchanged during the expansion (the latter case shown in Table 1)? The conventional wisdom among monetary economists (the particular brand of macroeconomist that obsess over the Fed and monetary policy) is that inflation expectations will remain unchanged—even as inflation increases along with the output gap—as long as the public trusts the central bank. If we believe the Fed is committed to “price stability” at 2 percent, then our inflation expectations remain “anchored” at 2 percent. That is what happens in the Table 1 example.
In contrast, when I wrote above that the public decides that those increases represent a “permanent” change in the nature of inflation, I mean that the public now views the Fed as asleep at the wheel. If we lose faith in the Fed, then we as the public go rogue, and raise our expectations accordingly. That is what we see in Table 2 above with inflation ending up at 8 percent in month 6.
The “inflation rate-inflation expectations-trust in the Fed” nexus is a useful lens through which we can understand our inflation story for the past 40 years or so. Under the chairmanships of Paul Volcker and Alan Greenspan, the Fed was able to commit to price stability, convince the public of that commitment, and stick to it. And that has been the case ever since (under the subsequent stewardship of Ben Bernanke, Janet Yellen, and Jerome Powell). To be sure, that is a very simplistic summary of that history, but stick that in your brain for now. I anticipate writing more on that nexus in future posts.
Based on this discussion, we can see some of the “big picture” of why inflation increases and decreases; or increases, but then fails to decrease. First and foremost, it is perfectly normal for inflation to increase and decrease over the business cycle—linked as it is to the output gap. Second, inflation may jump up as expectations change, resulting in a permanent higher level.
Okay, so what about “shocks” and the oft-mentioned “supply chain issues” from 2021? That is the missing piece of the “big picture.” I leave that as a cliff-hanger for now, but I will address that final leg of the inflation stool in the next post.