(Un)intuitive Inflation

Today’s inflation report showed that inflation is still elevated. Surprisingly, what might be keeping it elevated seems unintuitive – and even many economists don’t understand the mechanism.

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Introduction

Today, on May 10, the inflation report for April came out. It showed a very slight cooling in the rate, with the Consumer Price Index (CPI) at 4.9% and Core CPI¹ at 5.5%. It is still higher than the 2% target. In other inflation news, last week, on May 3, the Federal Reserve Bank in the US announced another 0.25% increase of the Federal Funds Rate (i.e. interest rate) to a target range of 5.00% to 5.25%.² In his speech after the release of the announcement, Federal Reserve Chairman Jerome Powell pointed out a few interesting components that may be influencing inflation, including supply issues and  ‘greedflation’.

At Nominal News, we recently discussed how recent research shows that supply chain issues that occurred during the pandemic are probably impacting inflation to this day. However, many people assume that since supply issues (including input prices) eased, supply chains can no longer impact the inflation rate. Recently, when talking about supply chain issues on Twitter, even economics professors challenged the assertion that supply chain issues can continue to influence the current inflation rate. 

We will explain why COVID pandemic supply chain issues can influence inflation today (even if the supply chain issues are easing) and show that, even in economics, knowledge can dramatically change, making our previous intuition incorrect.

Inflation Mechanism

‘Typical’ Intuition

Inflation is a ‘rate-of-change’ measure. It looks at how much prices have grown over a period of time. Theoretically, therefore, many have argued that the level of prices (i.e. the actual price) should not matter. For example, suppose you’re selling an item for $10 and the cost to make it was $5 (50% profit margin). Suppose now the cost goes up to $7 due to supply chain issues. In response, you will increase the price of the item to $14 to keep the 50% profit margin. If we were to measure inflation purely on the item the consumer bought, we would have 40% inflation since the price went from $10 to $14. If there are no additional supply chain issues, prices should remain at this level – $7 production cost, $14 price of the final good. Therefore, the inflation rate going forward will be 0%. 

This is the typical intuition that the price or cost level by itself does not matter for inflation (i.e. inflation is 0% going forward after the initial increase in item cost). It’s only the change in the levels that matters. However, this intuition is not necessarily correct. The main modeling approach used by many economists and various central banks actually implies that the level of the real marginal cost (the cost to produce one additional unit in real terms, rather than nominal terms)³ does matter for inflation rate. Let me elaborate.

Real Marginal Costs

First, we need to explain real marginal costs before we dive into the importance of price levels. Real marginal costs matter for inflation in New Keynesian Models. Models that are New Keynesian, unlike other models, such as Neo-Classical ones, usually have prices and/or wages that are ‘sticky’ – prices do not adjust immediately to market developments. This assumption is based on what is observed in the world. If we go to shops or restaurants, prices do not change every day, even though the underlying commodity price does change everyday. For example, wheat prices change every day, but your local bakery does not alter the price of bread everyday. 

However, firms (including restaurants) do change their prices occasionally in response to changes in their underlying costs. Typically, once the underlying costs change by some amount, and firms have lower profits, they decide to alter their price. When choosing a price, what are they trying to achieve? Naturally, firms want to make a profit. To do so, they must charge a price that is higher than their marginal cost. The marginal cost is simply the cost necessary to produce another unit of whatever the firm does – for a car manufacturer, this could be the cost of making 1 more car. Note – this is not an average cost, which would be the total cost divided by the number of all cars produced.

Therefore, when firms decide on a price it can be expressed as a desired mark-up (the profit margin the firm wants) plus the nominal marginal cost. Since firms do not change prices on a daily basis, whenever they do change their price, they must make an assumption about their marginal costs going forward, until their next planned price change. Between price changes, firms profit margins will actually decline – the price is fixed at the beginning of the period, but marginal costs grow during that period. Thus, when setting a price, if they assume nominal marginal costs to be higher in the future, they must set an even higher price today.⁴ 

Example – Normal Times

Now let’s illustrate how a level change in real marginal cost can permanently increase the inflation rate. We will use a simplified model, where 1 worker works for a firm and produces some product. 

Suppose a worker works 10 hours to make 1 unit of the product. The firm pays the worker $100. Let’s also assume that the price level (the value of the goods the worker consumes – like a basket of groceries) in this economy is coincidentally also $100. This means the worker can afford to get 1 unit of consumption (or 1 basket of groceries). This is the worker’s real wage.

Let’s assume the firm wants a 10% profit. Therefore, since their cost to produce is $100 (the workers wage), the firm will charge $110 for their goods tomorrow. Since this is the only firm in this model, the price level tomorrow will also be $110. Since the firm produced the same amount of goods (just 1 unit), the move of the price from $110 to $100 is inflation – in this case 10%. 

What happens next? The worker now sees that the price level is $110, but their salary was $100. This means they can only consume 0.91 of the consumption basket. That would mean their real wage went down. Naturally, the worker still wants to consume 1 unit of the consumption basket and thus demands a wage of $110. The firm’s costs are now $110. Repeating the cycle, the firm wants a 10% profit, so it will raise its price to $121. This is again another 10% increase in the price level, meaning a 10% inflation rate is maintained. This is how inflation persists in normal times.

Example – Supply Shock

Let’s go back to the beginning. Suppose something made production harder – the worker now needs 11 hours of work instead of 10 hours to make the product. This is a real cost change, as it now takes more time to make the product. Since the worker is working longer, they will not want $100, but say $110. In real terms, they will now be able to consume 1.1 consumption baskets since the price level was $100. 

The firm’s costs are now $110 instead of $100. The real marginal cost is higher. The firm still wants the 10% profit, so it will charge a price of $121 tomorrow. Since the price level went to $121 from $100, inflation was 21%. What happens next? The worker now still wants to get 1.1 units of consumption. So the worker will demand $133, since $133/$121 is 1.1. But since the firm’s costs are $133 and they want a 10% profit, they will now charge $146! So the price moves from $121 to $146 - a 21% inflation rate! Thus, a one time shock to the real marginal cost increases the inflation rate permanently from 10% to 21%! 

What Impacts Real Marginal Cost

Since real marginal costs are important, what do they depend on? Firstly, real marginal are difficult if not impossible to measure directly. Real marginal costs can fluctuate dramatically since the production of one more unit of a good depends on the current commodity prices, energy prices, transportation costs, etc. For example, if a firm wants to produce an additional unit, they might have to pay workers overtime, which is higher than standard pay. This would make the real marginal cost even higher. 

Moreover, real marginal costs are also impacted by wages. And this fact can further amplify inflation, as it generates a ‘cost-price spiral’ (note – this is not simply a ‘wage-price’ spiral, which is commonly talked about in the media). How does this occur?

When the real marginal cost permanently goes up, there is a higher rate of inflation than before, as described in the supply shock example above. Now, suppose employees choose not to push for higher wages (in the above example, it’s as if the worker kept their wage at $100). Then, in real terms, since wages did not go up, but prices increased, the cost of a worker for the firm is lower in real terms (and workers are worse off since their real wages fell). But since the real cost of workers is lower, the real marginal cost will fall. This will result in the real marginal cost falling – potentially even falling all the way back to the value it had prior to the shock that increased it. In this way, the inflation rate drops back to a lower rate that we had previously. However, workers typically do demand higher wages in response to inflation, as in the example above. Therefore, the inflation rate will stay elevated!

Restoring the Previous Inflation Rate

In order for the inflation rate to fall to the previous rate, real marginal cost needs to drop to the previous level. This could be done via two ways:

1. The original source of the cost increase could revert back.

2. Other real costs would need to fall such as other production inputs or real wages.

One of the issues with figuring out whether the first channel can occur is that not only do we not exactly know what the real marginal cost is, but also we do not know specifically what causes it to change. However, many COVID pandemic factors increased – factory closures, shipping delays, and limited raw material access. Some of these issues still persist today, such as the computer chip shortage. If these supply issues are temporary, albeit lengthy, then inflation will naturally revert to normal in the future. If it is permanent, then the only solution is via the second channel.

The second channel can occur through central banks raising interest rates, which impacts the real marginal cost. By increasing interest rates, the economy slows down, bringing down wages via unemployment and therefore, reducing real marginal cost. Naturally, this is a less preferred resolution to the inflation issue. It is worth noting that the current interest rate might be sufficient to bring about this change based on calculations made by Pascal Michaillat (we recommend his substack!).

Another way the second channel might occur is via technological change, reducing the real marginal cost by making production cheaper. However, this is likely to take time.

Other Notes on Inflation

Jerome Powell on Wages

In his speech, Jerome Powell briefly discussed wages:

...I do not think that wages are the principal driver of inflation. You're asking me a very specific question. I think there are many things. I think wages and prices tend to move together. And it's very hard to say what's causing what. But, you know, I've never said that, you know, that it -- that wages are really the principal driver because I don't think that's really right.

This suggests that the Federal Reserve is on the same page as we are, emphasizing that wage growth does not cause inflation.

Jerome Powell on ‘Greedflation’

Lastly, there has been a lot of talk about 'greedflation' lately. This is the idea that the current inflation is being driven by firms increasing their profit margins – or their markups.

This is a new concept that has been suggested as an explanation for the current elevated inflation. To evaluate it, therefore, it is important to establish the link in which firms are able to exert higher prices that would result in inflation. Moreover, the link would also have to be able explain why it happened in this inflationary surge but not previously.

Overall, the discussion around 'greedflation' hasn't explained how this could occur. However, as discussed by Ivan Werning – standard economic theory does predict that higher (desired) profit margins do increase inflation. This is actually predicted by the model we described – inflation depends on the desired mark plus real marginal cost. We would now have to determine whether desired mark-ups went up during this inflationary period. This is easier said than done.

Interestingly, Jerome Powell discussed 'greedflation' also:

So higher profits and higher margins are what happens when you have an imbalance between supply and demand, too much demand, not enough supply. And we've been in a situation in many parts of the economy where supply has been fixed or not flexible enough. And so, you know, the way the market clears is through higher prices. So to get, I think, as goods pipelines have gotten, you know, back to normal so that we don't have the long waits and the shortages and that kind of thing, I think you will see inflation come down. And you'll see -- you'll see corporate margins coming down as a result of the return of full competition where there's enough supply to meet demand. And then it's -- then you're really back to full competition. That's -- that would be the dynamic I would expect.

Although he does not explain exactly why there are higher profits, he does mention lack of competition. One way this could occur is the following. Suppose there is a serious supply shock such as COVID that reduces supply of a lot of intermediate inputs (for example, engines are intermediate goods in the production of cars, which is a final good). This could be caused by factory shutdowns due to lockdowns or major shipping delays as ports were closed. This supply shock does not necessarily have to impact all firms equally. That is, larger firms (car manufacturers), through the importance and connections might be able to guarantee that they are first to receive any items or parts they need (the engines). This would mean many other firms would have very limited, if any production of the final good. Therefore, the market for final goods (cars) would no longer be competitive, but dominated by a few firms – an oligopoly or monopoly would form. Even if the supply shock is temporary but very persistent, these larger firms would be able to charge higher prices, since they are the only ones providing goods to the market. Until supply normalizes, the elevated mark-up charged by these firms would remain.

This is a theory, however, and would need to be empirically tested. Regardless, it is important to have a model in order to be able to speak to how profits could impact inflation, beyond simply correlations.

Conclusion

Inflation is a tricky topic. This is especially so when it came from a unique situation of the COVID pandemic. Even many economists are not fully aware of all the intricacies and latest research on how inflation can occur. This is why it is important to have a model, as it allows us to examine what could be causing inflation and testing whether that is the case – similar to a doctor diagnosis.

The current inflationary period has been very unusual – raising interest rates has so far not slowed down the economy by as much as many have thought. Inflation has persisted. However, these patterns that we have observed so far, appear to fit the idea that supply issues have increased real marginal costs, and that since these supply issues are very persistent, inflation would remain elevated at the levels we are observing. We will see how this supply driven inflation model does in the next few quarters.

Cover photo by Alexander Isreb.

If you enjoyed this article, you may also enjoy the following ones:

Wages and Inflation – to what extent do wages cause inflation?

Causes of Current Inflation – what was behind the inflationary surge during the Covid pandemic?

Inflation and Expectations - how should we think about the recent inflationary spike and what needs to happen for it to come down.

High Profile Layoffs - how the recent layoffs in the tech sector will affect the wider economy.

1. Core CPI is the CPI index without the volatile food and energy component. For full definitions please see this post.

2. The reason the interest rate is a target range and not a specific number is because of how central banks achieve the interest rate. Since they do it via conducting transactions in the market, setting a precise rate is impossible, as it is determined by supply and demand forces.

3. When economists measure things in real terms, they mean how many actual goods you can get. The exact same loaf of bread, whether it costs $10 or $5 has the exact same value in real terms, even though nominally it is different.

4. As an example: if your real marginal cost is $10 and you’d like a 10% mark-up, you’d set a price of $11. However, if the cost next week will be $11, then you would want the price to be $12.10. Since you do not change the price regularly, you will need to set a price that is some form of average between $11 and $12.10. Therefore, the price you choose today is higher, and your profit margins will be elevated for a period of time.