Supply or demand? The Fed is trying to figure out what’s driving inflation

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(Bloomberg) – Strong demand for goods and services could start to overtake supply constraints – from the pandemic and the war in Ukraine – as the driver of U.S. prices, according to new gauges built by economists of the Federal Reserve.

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On the face of it, this would suggest that inflation is more likely to persist even as the disruptions caused by the pandemic and war fade away, strengthening the case for tougher Fed policy to counter it.

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But the new research contains evidence that also goes the other way, illustrating how difficult it is to disentangle the impacts of supply and demand on prices.

« It’s kind of the age-old economic problem, » said Mark Zandi, chief economist at Moody’s Analytics in West Chester, Pennsylvania. « That really matters in terms of current monetary policy, because if you think it’s more supply-driven than demand-driven, you might be more supportive of the idea that the Fed should be cautious. »

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To disentangle the different drivers of inflation, Fed economists focused on the relationship between the prices of individual goods and services and the quantities of those things that consumers bought.

In categories where prices and quantities rise together, inflation is classified as primarily demand-driven. Where prices rise and quantities fall, inflation is said to be supply-induced.

Generally, the demand-driven variety is considered more persistent than the supply-driven one. But the new research shows that the conclusion isn’t really that clear cut.

‘Against the Wind’

The Fed’s preferred measure of so-called core inflation, which excludes the food and energy categories, is expected to drop to 5% when October data is released on Thursday.

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The number stood at 5.1% in September – and that month, for the first time since inflation took off in the summer of 2021, demand-led price pressures outweighed those induced by the supply in the annual figure, according to the distribution of the San Francisco Fed using the price-quantity approach.

A major caveat: there is still a large ‘ambiguous’ category of goods and services that do not fit neatly into the supply or demand buckets, accounting for about a fifth of the total. This means that demand is still less than half of overall underlying inflation in the breakdown.

Another problem: It is not necessarily true that demand-driven inflation requires a tougher central bank response in the form of higher interest rates. It depends on whether the effects can be expected to fade quickly – an additional element Boston Fed economists have been looking at.

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« Persistent demand shocks would require much more leaning against the wind than transient demand shocks, » said Viacheslav Sheremirov, an economist at the Boston Fed, who recently published a paper building on San’s research. Francis.

Once inflation in a given category of goods or services has been identified as either demand- or supply-driven, Sheremirov’s study attempted to take it a step further by labeling it temporary or persistent.

« I actually find a non-trivial persistent demand component, and compared to historical data, that’s not usual, » he said in an interview. « Usually most of the demand component comes from transient sources. »

Effects on housing?

In the San Francisco Fed’s breakdown, housing plays an important role on the demand side, in part simply because of its outsized weight in monthly household budgets. But research from the Boston Fed found that it’s not so easy to classify housing as a persistent source of demand-driven inflation.

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Instead, he identified other categories of services – particularly those related to travel, such as airline tickets and hotel accommodation – as the most persistent contributors to the inflation induced by the crisis. request.

This is consistent with a rush to spend savings accumulated during shutdowns when service industries reopen – although by June 2022, when the Boston Fed’s analysis stalled, the effect was starting to wear off. fade.

Zandi, for its part, does a similar exercise on prices and quantities. His work suggests that the impact of demand pressures peaked in the spring and summer of 2021 – after the passage of the US bailout and the rollout of vaccines fueled spending as the economy reopened – and that supply shocks are what propelled inflation to four-decade highs since then.

As these supply-side pressures also start to fade, inflation could once again become more demand-driven. But that will coincide with a much lower headline inflation rate: forecasters see it falling below 3% by the end of next year.

« If nothing changes, then in six months or in 12 months inflation will be more on the demand side than on the supply side, » Zandi said. « But then inflation will be much lower, and that won’t be a problem. It’s a problem now – and the reason it’s a problem now is because of supply.