Yulii Zozulia/Ukrinform/Abaca/Sipa USA via AP Images
Bulk carrier Kubrosli Y is loaded with Ukrainian wheat in the port of Odessa, in Ukraine, August 19, 2022, following the disruption in grain shipments caused by the Russian invasion of Ukraine.
This story is part of a Prospect series called The Great Inflation Myths, which takes on the dominant orthodoxies mainstream economists and the Federal Reserve have been espousing about inflation and the need for interest rate hikes to tame it. The series was developed in collaboration with the Political Economy Research Institute (PERI) at the University of Massachusetts Amherst. You can read every piece in the series at prospect.org/
Introduction
After the lockdown-induced recession in 2020, fiscal policy helped restore employment and household income. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, the American Rescue Plan, and other federal actions added about $5 trillion in stimulus over a two-year period. This moved aggregate capacity utilization, as measured by the ratio of actual to potential GDP, to a high level. The increase in overall output has been accompanied by increasingly tight labor markets.
Without massive fiscal stimulus, the recovery would have been much weaker; and without the strong recovery, inflation would have been lower. However, high overall levels of utilization do not necessarily produce high rates of inflation. Aggregate utilization in this expansion is not materially higher than those during the previous expansion, when annual core CPI inflation was near 2 percent and showed much lower volatility. High capacity utilization, by itself, is an incomplete explanation of what is being seen.
A more complete account includes the profound effects of supply reductions. The data show that negative supply shocks significantly affected core CPI inflation. Reduced labor supply has contributed to tight labor markets, and pandemic-induced disruptions to global and domestic manufacturing supply chains have created unexpected shortages. This has created unusual price pressure as the economy began to recover. As if that weren’t enough, the prices of energy and food increased rapidly beginning in 2021, exacerbated by OPEC-engineered reductions in crude oil production and Russia’s war on Ukraine.
There are indications, however, that supply disruptions and their effects have eased over the course of 2022. Money wage growth has declined, even though measures of labor market tautness remain high. Measures of supply chain disruption have eased, and producer and retail prices of manufactured goods are falling.
Improving supply conditions mean that the Fed ought to be cautious in its use of contractionary monetary policy. The importance of supply constraints in this inflationary episode also means that policies to ease them—some of which are easily identified, and likely to be popular—could help prevent Fed overshooting and unnecessary recessions in the future.
Labor Supply Shocks
Two shocks to labor supply have combined to make labor markets very tight as the economy has recovered. First, the labor force participation rate fell markedly from its February 2020 level as the pandemic forced the economy into shutdown and workers left the labor force. Participation has yet to fully recover; COVID-19 risk is the most likely explanation, since nearly all of the change is explained by declines among older workers. If the December participation rate were equal to that in February 2020, there would be an additional 3.2 million people in the labor force.
Improving supply conditions mean that the Fed ought to be cautious in its use of contractionary monetary policy.
Second, labor force growth has been reduced by U.S. immigration restrictions. Deliberate policy decisions to reduce immigration under the prior administration, along with pandemic-related disruptions that have continued to affect immigration processing, have resulted in limited additions to the working-age population. Had immigration continued at the pre-2019 rate, there would have been approximately two million additional working-age immigrants in the United States by the end of 2021. This would have added 1.3 million workers to the labor force. Without these two labor supply shocks, the December 2022 labor force would have been approximately 4.5 million workers larger, nearly a 3 percent increase.
This supply shortfall has had a measurable effect on the ratio of total people unemployed to total job vacancies—a recognized indicator of labor market tautness. In February 2020, the ratio was .8, and in December 2022 it fell to .6. Absent these two shocks, the ratio would have been significantly higher, and labor markets less taut.
The falling unemployment-to-vacancy ratio has been accompanied by higher money wage growth. During the year before the 2020 recession, average hourly earnings grew at an annual rate of 3.1 percent. After fluctuating dramatically in the period between April 2020 and July 2021, average earnings grew more rapidly than in the pre-recession period, increasing at an annualized 5 percent between July 2021 and November 2022. Unfortunately for workers, prices are growing more rapidly than money wages, leading to real wage cuts.
It is important to recognize, however, that even though money wages are rising more rapidly than they were pre-recession, there is no evidence of acceleration in 2022. In fact, the annualized rate of growth of average earnings in the first 11 months of 2022 was 4.6 percent, and in the three months between September and November it was 4.3 percent.
These data certainly do not point to a 1970s-style wage-price spiral, which might change price expectations and make higher rates of inflation a more permanent issue. To the contrary, they indicate moderating wage growth.
Manufacturing Supply Shocks
Along with labor supply shocks, pandemic-related disruptions in the supply of manufactured goods appear to have made a significant contribution to post-recession core inflation and its volatility. Parts of the U.S. economy are highly integrated into global supply chains, which have been repeatedly disrupted by COVID-19 waves and lockdowns. This has reduced domestic availability of intermediate inputs and final goods and produced bottlenecks in cross-border transportation. Domestic production has also been disrupted by labor force shocks. These supply-side problems have had a measurable effect on goods prices.
The U.S. auto industry provides a canonical example of a negative global supply shock. Pandemic-related reduction in the supply of essential semiconductors has denied automakers an essential input. As a consequence, U.S. auto production in May 2022 was about 28 percent below the pre-recession level. This decline in supply has been matched by a dramatic increase in overall vehicle prices. The scarcity of new cars has also driven up the price of used cars. From April 2021 to April 2022, new and used cars’ price increases together added 1.17 percentage points to the overall CPI.
The importance of negative supply shocks to pandemic-era inflation has been supported by statistical analysis. The Federal Reserve Bank of New York has constructed a global supply chain pressure index (SCPI), a statistically weighted combination of several variables that reflect global supply disruptions. Deviations of the index from its mean value are highly correlated with changes in producer and consumer prices over the past 24 years. A statistical decomposition of post-2019 CPI inflation shows that the large increases in the SCPI during spring 2020 and summer 2021 made significant contributions to CPI growth, adding about one percentage point to the inflation total in early 2022.
There is evidence that supply constraints are easing. The SCPI has declined 70 percent between its December 2021 peak and November 2022, although it remains above trend. The San Francisco Fed’s analysis of the sources of core PCE inflation shows that month-to-month and year-on-year supply-driven price increases have trended downward over 2022.
The easing of supply conditions helps explain declines in the producer price index for manufacturing. After rising 41 percent since the beginning of the recovery, the index has declined by 3.6 percent since June. Retail prices of manufactured goods, measured by the core CPI commodities subindex, have likewise declined by a percentage point since September.
OPEC has coordinated reductions in the supply of crude oil, and Russia has limited the supply of natural gas to the EU. The invasion of Ukraine has disrupted the world supply of important grains and foodstuffs. These supply shocks, together with increased demand for energy as the world economy has recovered, have caused world energy and food prices to spike, adding significantly to CPI inflation.
The Contribution of Supply Shocks to Energy Price Inflation
Crude oil. Crude oil prices, which are determined in a world market, rose as the world economy recovered from the effects of the pandemic. The price of West Texas Intermediate crude oil, for instance, increased, in 2010 dollars, from $23.85 per barrel (bbl) in the first quarter of 2020 to $83.03/bbl in the second quarter of 2022. By the fourth quarter, the price had fallen back to $62.34/bbl.
The decision of the OPEC cartel to reduce production beginning in 2020, together with increased worldwide demand and disruption of the oil market caused by Russia’s invasion of Ukraine, caused the large run-up in price. Because OPEC produces about 40 percent of world oil supply, the cartel’s production decisions have a huge effect on world oil supply. In 2020, OPEC reduced production levels, and this was reflected in rising spare production capacity. Prices began to rise soon thereafter, and the worldwide recovery in economic activity raised demand further. The decline in oil prices over the course of 2022 reflects both declining world demand, and an easing of OPEC supply reductions.
Refined products. Rising oil prices have been the principal determinant of rising gasoline prices during the recovery, but data from the U.S. Energy Information Administration (EIA) indicate that refiner markups over crude oil costs—which is the principal variable input cost—have made a substantial contribution to gasoline prices. The difference between oil acquisition costs and the wholesale price of gasoline rose from $0.59 per gallon in April 2020 to $1.29 in March 2022. As crude prices have declined since mid-2022, so have retail gasoline prices.
The difference between input cost and price—or the “crack spread,” in industry jargon—increased in part because refining capacity has decreased by nearly 5 percent since 2020. Refineries also have been operating near capacity, with gasoline imports comprising only a small fraction of supply. This has given refiners increased market power.
Natural gas. The United States is a net exporter of natural gas, but an unusually cold winter in 2021 left stocks at below-normal levels, contributing to increasing prices. In addition, increased demand for U.S. liquid natural gas exports, caused by the war in Ukraine and Russian restrictions on exports to the European Union, has raised price pressure. Domestic spot prices doubled between the beginning of 2022 and the third quarter. They have since returned to winter 2021 levels.
The Contribution of Supply Shocks to Food Price Inflation
The rapid rise in domestic food prices has been affected by developments in world markets. While the world food price index is down from its peak value in March, the November index is 38 percent above its 2020 average, and 8 percent above its 2021 average.
Supply disruptions have played a significant role in these price increases. The price of nitrogen-based fertilizer, which is made from natural gas, has risen sharply because Russia, a major exporter, has reduced supply and the price of natural gas has jumped. The Russian invasion interfered with Ukrainian exports of crops such as wheat, corn, barley, and sunflower oil. Ukraine has a 10 to 15 percent share of global trade in those three grains and an 80 percent share of world trade in sunflower oil, raising prices for all these commodities in world markets. In addition, extreme weather has reduced yields in producing regions.
The Limitations of Monetary Policy
The principal policy response to inflation has come from the Federal Reserve, which is raising interest rates to reduce demand for goods, services, and labor. The Fed is using demand reduction because that is the only tool it has to fulfill its price stability mandate. If interest rates are raised enough, output and employment will be reduced, price and money wages changes will slow, and eventually, core price inflation will be reduced.
There is good reason for the Fed to be very cautious about further interest rate increases. Core inflation on an annualized basis has trended down since June, reaching 2.4 percent in November. Declines in commodities prices, reflecting supply chain improvements, have contributed to this result. Moderating money wage growth has also played a role. Energy prices have lent a hand to the overall CPI. It is not possible to guarantee that these inflation-positive developments will continue. But it is certain that further demand reduction will cause more economic loss—which will not be equally distributed across the population. Some people will lose jobs and income, and others will not.
It should be clear that we need to take a more comprehensive approach to inflation policy. Some clearly identified supply constraints have played a big role in producing this bout of inflation. We need to relax them. Otherwise, we will continue to bear the risk of unnecessary, policy-induced recessions in an economy capable of continued growth, high employment, and rising real wages.
There are steps that could help in the short to medium term. We could, for instance, make it easier for people to join the labor market. Some of the decline in labor force participation by those most vulnerable to COVID-19 may have been unavoidable. But if we remedied the failure of the U.S. to provide an adequate level of support for child and home care—which would make it easier for people to enter the labor market—labor force participation would increase. Other countries manage it; we could do the same.
We could make it easier for workers to stay in the labor market, by doing a better job of dealing with the ongoing COVID-19 pandemic. More could be done to assure broader uptake of existing vaccines, support new vaccines to deal with mutations of the virus, and develop new treatments for those infected.
We also could reverse the ludicrous unforced error of disrupting working-age immigration. That would restore an important source of labor, half of which is college-educated, from which our economy has historically benefited.
We might also be able to mitigate the impact of large oil price increases, which have played a starring role in more than one inflationary episode. The administration has innovated here. In response to the latest OPEC-induced oil price spike, the U.S. and other IEA members have engaged in a form of open-market operations in the oil market, selling about 1.33 million barrels per day of oil from the Strategic Petroleum Reserve and other sources over the course of six months. This amounts to more than 1 percent of world daily consumption of oil.
According to Treasury calculations, this increase in supply reduced domestic gasoline prices in the range of 17 to 42 cents per gallon. Not nothing, but not enough. However, a larger SPR, and a more targeted selling strategy within the U.S., could supply U.S. refiners with crude at below-cartel prices that would be passed on to consumers. In the longer term, of course, the transition to clean energy will effectively end cartel-generated inflation.
None of these steps would be easy political lifts at the current moment. But that shouldn’t stop progressives from advocating these or similar inflation-mitigating supply policies. Reasonable measures that do not require putting people out of work could prove to be quite attractive if explained effectively.
The author thanks Suzanne Bergeron for helpful comments on an earlier version of this article. This article reflects the views of the author, and not necessarily those of the Center for American Progress.
