Milton Friedman is oft quoted as saying that “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” But experience over the past three years suggests that this might not always be the case. Prices can go up for one of two reasons. Either there is a sudden increase in demand for goods and services relative to available supply, or there is an abrupt downward shift in supply relative to existing demand. Friedman was talking about across-the-board price increases that occur because too much money is chasing too few goods. That is not necessarily the explanation for the current increases in prices we have seen, and that fact poses a policy problem for the Fed.
In 2020 we saw the outbreak of the Covid pandemic, and with it came a huge shock to the supply of labor and sharp dislocations in supply, driven by disruptions in both supply chains and in productive capabilities as people got sick and were unable to work. The dislocations were not evenly distributed across the productive sectors of the economy. In those areas with supply disruptions, prices increased. Some sectors like travel, hospitality, and food services, for example, were especially hard hit and basically shut down. Other sectors were less impacted if they did not engage in activities that required direct personal contact with the public. Companies increased their reliance on technology, and workers were permitted to work from home and to pursue flexible work schedules. At the same time, the federal government implemented offsetting spending and financial support to the economy and citizens, and the Fed expanded its balance sheet to over $8 trillion, monetizing a lot of the federal debt that had been issued. This action clearly expanded the monetary base but was not manifested in a huge corresponding increase in the money supply; nor did it result in an explosion of bank debt, despite the fact that interest rates were cut to near zero. Additionally, the increase in inflation, which began in mid-2020, was not uniformly distributed over all sectors of the economy. The Dallas Fed publishes the components making up the PCE price index each month; and a review shows that of the 177 components, 49 actually showed decreases for the month of January 2022; and this pattern was consistent over the period that inflation was increasing. Additionally, the economy grew at a 6.9% year-over-year rate, and labor markets were tight, putting pressures on prices Unemployment was near its pre-pandemic low at 3.8%, and there were more jobs than unemployed people, resulting in an acceleration of wages.
So, in the period leading up to February 2022, while the increases in prices were due mainly to supply dislocations and recovery of growth, there was also the possibility that the easy-money policy pursued by the Fed and fiscal initiatives may also have contributed an unknown amount to the overall price increases that occurred. It was easy to see the role played by supply dislocations and this helps in part to explain why the Fed argued for some time that it viewed the associated price increases in certain sectors of the economy as transitory.
But then we had the Russian invasion and war in the Ukraine. Within three short weeks, sanctions were imposed upon Russia; Russian funds were frozen in central banks; Russian banks were exiled from the SWIFT payment system; US and other major corporations closed businesses inside Russia; credit card systems like Visa and Mastercard stopped processing payments; the ruble essentially collapsed; and Russian debt is now rated junk and is facing default. In addition to these consequences, Russia’s role as the third largest supplier of oil and natural gas and Ukraine’s role as a major supplier of agricultural products, including corn, wheat, vegetable oils and iron, have resulted in a selective set of supply shocks that have hit several key markets. Oil and natural gas prices have increased; and the price of gasoline, for example, now averages over $4.29 per gallon in the US. Europe has been particularly hard hit, especially Germany, which is extremely dependent on Russia for oil and natural gas. Those supply shocks have already led to price increases in the US and elsewhere, adding to measured inflation pressures.
The Fed is faced with sorting through those shocks and must try to determine how much of the recent inflation pressure is due to true, underlying broad-based inflation and how much is due to external shocks. Relative price increases because of shocks are not the same as broad-based inflation because there is too much money, as envisioned by Friedman. Clearly, with policy rates near zero and with a strong domestic economy, some movement back to normal would be in order. However, to embark upon a long series of rate hikes at a time when markets are experiencing huge shocks of uncertain duration could pose a significant risk to the economy’s expansion. These pressures will not end with the end of the conflict in Ukraine as the sanctions imposed upon Russia are likely to be in place for some while. Think for a minute how many gas stations in the US are at risk if the push to promote electric vehicles persists as one way to cut down on energy dependence upon less trustworthy suppliers. Unless those businesses install charging stations, they will just be convenience stores.
Tighter monetary policy will not cure the supply problems in the energy market, nor will it bring forth more wheat or corn. As the result of the Russia-Ukraine experience, the international order should and will readjust, and some of the relative price changes will become permanent. In the face of this review of the inflation situation, the Fed moved at its March meeting to raise rates by 25 basis points and have signaled that there is a path for interest rates though the end of this year that will bring the median Federal funds rate to 1.9% by the end to 2022 and to 2.8% by the end of 2023, a bit higher than what it views as the equilibrium longer run rate. This suggests not only a fundamental shift in the Fed’s view on how much of the inflation problem is due to temporary supply disruptions. It also suggests the importance of the view, articulated by Chairman Powell that labor markets and the economy are strong and can withstand higher rates going forward, whatever the fallout might be from the Russia-Ukraine situation. Interestingly, the Dow gave up over 450 points it had gained prior to the announcement but recovered about half that loss by the time Chairman Powell’s post-meeting press conference was over, and ended up 518 points on the day.
Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
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