Shocks, Supply Chains, and Unanchored Expectations, Oh No!

The “big” drivers of Inflation (Part II)

In my last post I laid out the gist of the first two “big” macro drivers of inflation, inflation expectations and the output gap. In this post I round out the discussion by getting to the third big player, “shocks.”

Shocks

In the “textbook” description of inflation, the designator, “shocks”—which is short-hand for supply-side shocks—is ordered last in the equation that “models” inflation. The typical inflation equation looks something like this:

Now, the listing of “shocks” after the output gap and inflation expectations in the equation does not imply that the shocks are less important. Rather, the order reflects an assumption that the supply-side shocks are random and, importantly, that such shocks are temporary. How so? Shocks represent a disruption, a clog somewhere in the supply chain, an unexpected shortage of workers, a sudden increase in the cost of inputs, like oil, or something like that. All of which lead to an increase—and typically a rapid increase—in the cost of doing business.

However, in time those disruptions and clogs get sorted out. They are not permanent and it is impossible to predict them in advance. That is why they are called “shocks.” Moreover, they are called “supply-side” shocks to distinguish their effect on inflation from the effect that comes from the output gap (which represents the demand side).   

(As an aside, historically the most common example of a supply-side shock was an “oil price” shock. In particular, the oil-related shocks in 1973 and 1979 motivated this focus on oil prices and remained the standard bearer of “supply-shocks” for macroeconomists thereafter. The supply-chain issues of 2021 may very well update that standard example.) 

Before we walk through the effect of such a shock on inflation . . . what’s up with the tortoise in the inflation equation? The tortoise represents the connection between the output gap and the rate of inflation. In my explanation of that relationship in the last post, I assumed a one-for-one relationship—if the output gap increases by 2 percent, then inflation increases by 2 percent. In reality that isn’t necessarily the case. The tortoise represents whatever that connection may be—I explain this in more detail in a little bit.

Okay, let’s look at how shocks matter for inflation. Consider Table 3, where inflation expectations are “anchored” at 2 percent and there are no supply shocks:

Table 3 represents a default or “typical” business cycle scenario: real GDP increases above potential GDP for a period of time, over which inflation expectations remain anchored at 2 percent and there are no supply-side shocks (i.e., the supply chain is running smoothly and things are relatively calm in energy markets). As a result, inflation rises and falls with the output gap.

Now assume that supply-chain-related turmoil strikes, as shown here in Table 4:

Here I assume there is a supply-side shock that hits in month 2, lingers and then slowly dissipates over the ensuing months. This happens at the same time the output gap increases to 6 percent and then back down again. Hence, we have a demand-driven expansion and we get hit with some sort of supply-side disruption. Sound familiar?

This double-whammy leads to a notable increase in the rate of inflation, a jump from 4 to 9 percent in one time period. High rates of inflation stick around for a couple of months—11 and 8 percent, respectively—before finally abating.

Here, I imagine a scenario of just a few months; in reality such a scenario is likely to play out over a longer period of time. Moreover, it is easy to imagine such a jump would generate headlines. And, it is easy to imagine the confusion this scenario would cause, with pundits, bloggers, twitter-heads, and macroeconomists all disagreeing on exactly what was going on.

Consider also that the longer such a supply-side effect might draw out—and the longer inflation remains high—the Fed’s credibility may be questioned. As discussed in Part I of this inflation discussion, that could trigger a change in inflation expectations. If that was the case you could view the “shock” as becoming “persistent” or “permanent” in the sense that the public loses trust in the Fed and, as result, adjusts expectations upward, like I showed in Table 2 in Part I of this discussion (I’ll return to this possibility at the end of this post).

However, with respect to the shock itself, there is no reason to expect a supply-side disruption to be permanent. In other words, is there some reason to expect businesses to throw up their hands and say “okay, we don’t want profits anymore, we give up on this logistical problem, even though there is strong demand for our product”? That does not make sense; at least, not in a market economy where firms are constantly seeking to stay in business.

My impression of our current situation is something akin to what I show in Table 4. We are experiencing—and certainly experienced in 2021—an unusually strong economic expansion. All the data suggests as much, both real GDP overall and consumption data. With respect to the supply chain issues, imagine for a moment if consumer spending was simmering at a low level—below, say, the recent historical average of 2.2 percent. In that case, shouldn’t we expect the supply-chain issues to be less of a problem; for there to be less “pressure” on prices to increase as a result of those issues? My hunch is, yes.

Let me close this post with a couple of clarifications: on the tortoise and on the potential for a change in inflation expectations.

First, the tortoise in the inflation equation: The tortoise represents a topic at the heart of macroeconomic analysis—how fast or slow do prices change as the economy expands or contracts? If prices are “sluggish” or “sticky” (nomenclature macroeconomists have long used), then the output gap can increase by a lot, but inflation would change by a smaller proportion. The value of the tortoise might be 0.5, revealing a relatively muted relationship; that is, a less than one-for-one relationship (for math enthusiasts out there, the tortoise represents the slope of the inflation equation). Conversely, the relationship could be more than one-for-one—where prices are considered “flexible” and adjust quickly. The tortoise is instead a hare.

Whether the link between inflation and the output gap is the tortoise or the hare is a function of the particulars of our economy—the labor market, regulation, production logistics, the attitudes and strategies of businesses, global competition, consumers reaction to price changes, and so on and so on. Indeed, there is a lot to discuss with respect to the tortoise and the hare. But, since this post is already long enough, and I still need to close with inflation expectations, I leave further discussion on the tortoise and the hare for future posts.

Finally, I think it’s fair to say that I have down-played the importance of the supply chain shocks for our current macroeconomic story (here and in my previous posts). In time, I feel certain the effect of the supply chain shocks on the rate of inflation will abate. However, that does not mean I think the shocks are harmless. To me, the real danger is not the shocks themselves, but that they may force the public to lose faith in the Fed, leading to an unanchoring of expectations. If the public is not patient enough with the Fed, or the Fed tests that patience by not acting with enough force against inflation (by moving to close the output gap), then inflation expectations very well could shoot up in 2022. In that scenario, the rates of inflation that we saw in 2021 will become long-lasting. If so, the Fed will have a bigger challenge on its hands: close the output gap and do it severely enough that inflation expectations will drop back down.

For now, it appears to me that the Fed thinks their planned efforts for 2022 will do the trick, and that scenario I just described won’t come to pass. The Fed is, after all, forecasting a fall in inflation for 2022. However, if the scenario I sketch out in Table 4 lasts a long time—and the public loses patience with the Fed—then an unanchoring could occur. Considering expectations have been more or less anchored to 2 percent inflation for at least two decades, such an occurrence would be historic, something I would call in that case the “Great Unanchoring.” We’ll consider the possibility of a “Great Unanchoring” in future posts. And if it does happen, you heard the term here first!