Two brief quotes before tomorrow's post

 

From Randal K. Quarles, Vice Chair for Supervision, Board of Governors of the Federal Reserve System, October 18, 2018:

Traditionally, as taught in Econ 101, inflation provides a signal on whether the economy is operating above or below its potential level. If inflation moves up in a sustained manner, not just because of temporary shocks, then the economy is likely operating above its productive capacity, as firms have the leeway to raise prices given the strength of demand. Likewise, if inflation moves down persistently, then the economy is likely operating with some slack, as firms restrain prices to sell their products in the face of weak demand.

 

From Scott Sumner, Ralph G. Hawtrey Chair of Monetary Policy at the Mercatus Center, November 12, 2018:

So, as you may know, the Fed does inflation targeting at about two percent, but it's really more complicated than that because there's different kinds of inflation. There's supply side inflation, which is created by shocks like sudden increases in oil prices, and then demand side inflation caused by overspending in the economy. It's really demand side inflation that the Fed is concerned about. There's not much they can do about supply side inflation.

 

Quarles distinguishes between temporary and sustained inflation, notes that economic shocks are ordinarily temporary, and points out that sustained inflation is likely due to something other than a shock.

Sumner distinguishes between supply side inflation (created by shocks) and demand side inflation (caused by overspending). He points out that the Fed's money management only works on demand side inflation.

Tomorrow, I identify supply side inflation that is caused by a permanent shock, not a temporary one, though "shock" is not really the right word to describe it.

"Inflation" isn't a good word to use, either. When we focus on inflation, we're assuming inflation is the problem. But inflation really isn't the problem.

In addition to overspending and sudden, temporary cost shocks, I identify subtle but relentless cost pressure as a cause of inflation. This pressure is a problem which can result in a "sustained" inflation.

The overspending that Sumner mentions has only one likely outcome, inflation, because "the economy is likely operating above its productive capacity" as Quarles says.

But a supply-side cost shock has two possible types of outcome. One is inflation, resulting from overspending if the Fed allows it. The other is a slowing of economic growth as rising costs eat into profit, if the Fed refuses to permit overspending and inflation.

Like a temporary cost shock, continuing cost pressure may result in either inflation or the slowing of economic growth, depending on the Fed's response.

But a key point is often missed by people who focus on inflation: If continuing cost pressure is the problem, and the Fed doesn't allow a continuing inflation adequate to relieve the pressure, then the result will be a continuing slowdown of economic growth.

Suppressing inflation solves the inflation problem, but it doesn't solve the problem of continuing cost pressure. We must solve the problem of continuing cost pressure, so that we can prevent both inflation and long-term decline.