Correcting Statements on Inflation and Inequality
Federal Reserve Governor Waller made a surprisingly wrong statement regarding how prices respond to supply shocks.
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With the return of “Correcting Economic Understanding”, we dive into two separate issues: a surprising statement by Federal Reserve Governor Waller; and why a commonly touted solution to inequality won't do much to fix the issue.
1. Misunderstanding Economic Theory
On January 16, 2024, Federal Reserve Governor Christopher Waller participated in an interview with David Wessel of the Brookings Institution. In the interview, there was an intriguing statement made by Governor Waller regarding how prices react to supply shocks. From the transcript:
Christopher Waller: …it's just a simple macroeconomics point of view. If you're going to increase the spending in the debt [sic] by $6 trillion in a matter of two years, and then say that has no effect on demand, that seems just impossible to me. It isn't the only thing that contributed to the inflation, but it certainly has had to have had an impact. The reason I say that is, you know, people have been talking a lot about, oh, all the last six months shows this was all supply, all supply, all supply. Well, if these are temporary supply shocks, when they unwind, the price level should go back down to where it was. It's not. Go to Fred. Pull up CPI. Take the log. Look at that thing. The level of inflation is permanently higher. That doesn't happen with supply shocks. That comes from demand. And this was a permanent increase in demand and permanent increase in debt. So I think there clearly was in fact a fairly...
Long-time readers of Nominal News may already sense the problem with Governor Waller’s statement. Let’s revisit the argument.
Governor Waller’s Idea
The key issue with the above statement lies in the following part:
Well, if these are temporary supply shocks, when they unwind, the price level should go back down to where it was.
Governor Waller states that supply shocks cannot permanently increase the price level. To put it bluntly, this idea is wrong.
First, let’s explain Governor Waller’s idea. The price level is a hypothetical average price of a basket of goods and services. This basket of goods is typically how we measure inflation. To simplify, let’s imagine we go to the store and buy a basket of groceries for $100. Next year, we will buy the exact same basket of groceries for $110. The price level is now $110 and inflation over the year was 10%, as we spent $10 more on the same basket of goods. According to Governor Waller, if the cause of the inflation (the price level moving from $100 to $110) was driven by a supply shock, then once the supply shock dissipates we should expect the prices to fall back to $100 for this basket of goods. This would actually imply deflation - a drop in price levels – and not disinflation – a drop in the rate of inflation (i.e. the pace of price increase is lower).
What Economics Tell Us
The idea espoused by Governor Waller is incorrect. The price level will not drop back after the supply shock dissipates – it will remain permanently elevated. The main problem is that Governor Waller is not thinking in terms of relative prices – that is in terms of buying real goods or services. Let’s see it numerically.
Let’s take the $100 price of the grocery basket and assume $60 of is the cost of paying grocery store workers (labor) and $40 to a supplier. For simplicity, we will ignore profits. A supply shock increases the supplier’s price from $40 to $50. Thus, this grocery basket will now need to cost $110 ($60 to labor + $50 to the supplier). But, in relative prices, the grocery store workers (labor) are now worse off. Previously they could afford 60% of the basket ($60/$100), but now they can only afford 55% of it ($60/$110). The grocery store workers are worse off and took a pay cut in real terms, as they can afford fewer actual goods than before (55% of the basket vs 60%).
Thus, the grocery store workers will re-negotiate their salary and get back to their previous relative price level of 60%. This means they need to be paid 60% of $110, which is $66. Suppose in the meantime the supply shock disappears, and the supplier no longer needs to charge $50, but can go back to “charging $40”. The problem, however, is that the supplier also does not want to be relatively poorer than they were prior to the shock. After all, why would they reduce their income. If the supplier were to charge $40, with the price level at $110, the supplier would be able to purchase 36% of the basket ($40/$110), when in the past the supplier was used to purchasing 40% ($40/$100). So the supplier won’t drop back their prices from $50 to $40, but rather to $44. Now, we have a new equilibrium, where grocery store workers get paid $66 and the supplier is paid $44, and the price level is $110. Everyone is back to the same level of relative prices as before – workers have 60% and suppliers have 40%.
[We covered a more detailed example demonstrating how a supply shock can also permanently increase the inflation rate.]
Inflationary Tension
The above example is a simple illustration of how inflation persists when all market participants (workers, firms, investors, suppliers, etc.) want to maintain their relative prices (maintaining real purchasing power). In the above example, if workers did not demand higher wages, but took a real pay cut (i.e. kept their wages at $60), then once the supply shock disappears, prices would drop back to the same price level of $100, just as Governor Waller stated. But that would require workers to take real pay cuts temporarily.
Interestingly, raising interest rates by Central Banks aims to do exactly that. By increasing interest rates, the economy slows, fewer jobs are created and more firms go out of business. This reduces demand for workers, making their wage negotiation position weaker since they have fewer alternatives. Thus, in our example, workers would not be able to demand the $66, but instead would have to settle for a lower wage. This would reduce inflation mechanically in our example.
Why the Confusion
Given Governor Waller is a voting member on the Federal Open Market Committee (i.e. he votes on the interest rate changes), how come his statement here is so wrong? I don’t know. However, Governor Waller is not the first to not fully appreciate how temporary supply shocks can permanently fuel inflation.
Another reason that may have caused Governor Waller’s confusion is that he may have been thinking of very narrow supply shocks. Supply shocks often occur in very specific industries. For example, in 2023, due to avian flu, egg prices jumped up by 220%. After the avian flu resolved, the price level of eggs reverted back. The reason this particular shock did not have a lasting impact on inflation (or even the level of egg prices) is that eggs are a very small part – only 0.1% – of the inflation basket. Thus, even such large jumps in egg prices would not result in workers and other market participants renegotiating their wages and prices to restore their relative price position.
The Covid supply shock was much larger as it impacted many industries that represented large parts of the economy. This supply shock seriously altered relative prices.
Summarizing, my criticism of Governor Waller’s comments is not on the point of whether the elevated inflation of 2022-2023 was caused by supply shocks or not (we at Nominal News believe that it was predominantly supply driven), but on the idea of whether large temporary supply shocks can cause permanent increases to the price level. That, on the other hand, is definitely true and not up for debate.
2. Tackling Inequality
Changing topics, I've recently encountered a few writers on Substack discussing inequality, whether it is a concerning issue and what are some ways we can reduce income inequality.
One mentioned idea, that has long been suggested in various political circles, is linking pay of CEOs and other executives in a firm to be no greater than a multiple of the incomes of the lowest paid worker.
CEO pay has grown exorbitantly over the years and is an easily noticeable example of the large income discrepancies in societies. Without opining on whether large CEO pay is justified, the proposed solution of limiting CEO pay as a multiple of the income of the lowest paid worker won't make much, if any, dent in inequality. Why? For two reasons.
Within firm and across firm inequality
The first reason is that most income inequality is not due to income dispersion within a firm, but across firms. Many firms today have long since outsourced certain functions needed for the operations of the firm. Things like building maintenance, security, catering, even phone help lines are no longer directly controlled by many firms. Firms do not hire workers for these roles, but rather hire other firms to do this for them.
But due to this outsourcing of services, there is increased inequality between firms (known as across firm inequality), since we now have firms that specialize in high income jobs (hedge fund managers) and firms that specialize in low income jobs (physical building security for the hedge fund). Thus, even if we were to link the pay of a hedge fund CEO to the lowest pay (a hedge fund analyst) in their firm, the CEO’s pay would still be an exorbitantly large number. Since income inequality is primarily across firms and not within firms, this solution will have limited impacts on overall levels of income inequality.
Lucas Critique – how firms will adapt
The second reason the proposed solution won't work is that it ignores the fact that firms and CEOs will respond to this policy change. CEOs and firms would further outsource jobs that are low income to other firms in order to satisfy the requirements of the policy. This will simply shift the ‘within firm’ inequality to ‘across firm’ inequality.
The proposed solution will have little, if any impact, on income inequality. Given the potential for only very small benefits, the risks of firms further outsourcing certain jobs purely to maintain CEO pay, might have unforeseen consequences. Whether the policy is worth pursuing is unclear to me, but we should not expect it to alter the inequality dynamics.
Interesting Reads from the Week
- describes why it appears that the Federal Reserve is too focused on the past and not on current inflation.
- goes over the plane manufacturing oligopoly between Airbus and Boeing.
- explains how accounting, depreciation treatment and other financial constraints can impact overall levels of housing construction.
Photo by Pixabay.
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