The problem is that the measures the White House is pointing to have almost nothing to do with the kind of exogenous shock that is a true supply disruption.
Fortunately, one does not have to be an econometrician to notice that something is wrong with the Fed’s measure.
W hen inflation took off in President Biden’s first year, the White House blamed it on “supply disruptions,” as did the Fed. At the time, the story had some plausibility. Covid-19 did shut down much activity exogenously, as previously happened, for example, during the Arab oil embargo. If a bolt of lightning upends the supply of a good, then its price will certainly rise.
Early in 2021, there were already a number of other factors to consider. Government spending exploded in President Biden’s first year, and John Cochrane’s fiscal theory of the price level suggested that inflation would soon skyrocket. Simultaneously, the Fed ignored early signs of inflation and kept interest rates far too low. The Biden administration even doubled down on spending later that summer, compounding the fiscal-policy errors. When the Fed finally started responding to the inflation spike, there was a general consensus among economists that the so-called supply-disruption story led to large fiscal- and monetary-policy errors, and Federal Reserve chairman Jay Powell even confessed that referring to inflation as temporary because of supply disruptions was a mistake.
But the supply-disruption story has not only stuck around, it’s getting worse and worse. Why is inflation declining now? Well, as we learned this week when the White House assembled its Council on Supply Chain Resilience, it’s because the terrible supply disruptions that caused inflation in the first place have been defeated by brilliant policies. Indeed, this week, the White House boasted of a whopping 30 steps the Biden administration has taken to reduce inflation. The White House then helpfully presented a chart from the New York Federal Reserve bank that supposedly proves inflation was caused by supply disruptions, which have finally begun to ease. The White House has also pointed to another measure of supply disruption, the Institute for Supply Management’s measure of delivery lags, to explain inflation ups and downs.
The problem is that the measures the White House is pointing to have almost nothing to do with the kind of exogenous shock that is a true supply disruption. To see why, consider a simple thought experiment. Suppose that equity markets skyrocket for some exogenous reason, and every American who owns stocks suddenly feels wealthier. They might all decide it is a good time to purchase a new automobile. But when the massive increase in demand hits the showroom floor, there will quickly be a problem. Dealers and automakers would not have enough cars to meet the new demand, and it might take months for a consumer to get the new car he desires. The increase in delivery lags happened solely because of demand, but the ISM measure would tell us it is a supply disruption.
The Federal Reserve’s measure cited in the White House press release is quite a bit more complicated. It relies on a mix of other statistics, including transportation costs. Each of these measures, of course, also can depend on (and even be driven by) demand factors. Going back to our example, one might imagine that a surge in automobile demand would increase the demand for trucks to deliver the cars, therefore driving up shipping costs.
In a background paper, the authors concede that demand could be a problem, and they propose a statistical method to strip out demand factors. But their method ignores the fact that demand and supply happen simultaneously, and cannot be controlled for so easily, a potential error that Norwegian economist Trygve Haavelmo clarified in the 1940s, later earning him the Nobel prize.
Fortunately, one does not have to be an econometrician steeped in the wisdom of Norwegian economists to notice that something is wrong with Fed’s measure. According to it, supply disruptions were worse in 2022 than during the pandemic! Might that be because the measure is being driven by demand? Of course.
The truth is that the exogenous supply disruption from Covid-19 is a thing of the past, but higher-than-target inflation is not. Attempts by the Fed and others to rewrite history might have some value in the publicity department, but that is as far as the value will ever go.