INFLATION AND MONETARY POLICY: FITTING THE CURE TO THE DISEASE
Inflation has been on everyone’s mind these days. But inflation remains one of those unusual phenomena that we observe regularly without fully understanding its cause. We can see how muddled market pundits and politicians can be about it. Some say that it is caused by shortages in materials and/or labor. Others say that it comes from excess demand being unleashed as pandemic restrictions are being eased. Still others blame easy money policy or excessive government spending. So which is it? And why can’t we agree on its cause?
My view is that “inflation” is a lot like “heart disease,” in that it’s a word or phrase that has a single result but multiple causes. Heart disease can lead to heart attacks, which occur when a part of the heart muscle does not receive enough blood flow. The outcome is the common element, but there are many different reasons for having heart disease. Common causes are high blood pressure, high cholesterol and smoking. Preventing heart disease means controlling all of these underlying issues. Controlling your blood pressure and ignoring your cholesterol is not a winning strategy. So while we tend to think of heart disease as a single type of illness, it has multiple causes and preventive strategies.
Central bankers may also look at inflation in this way. Inflation is always a rise in goods and services, but the underlying cause can be different. The way of dealing with each cause would be different too. Publicly, central bankers have stated that current inflation is “transitory” or temporary, which sets this inflation experience apart from others. At the San Francisco Fed, Mahedy and Shapiro (2017) broke Personal Consumption Expenditure (PCE) core inflation down into two components. One was labeled “cyclical” and grouped indicators of PCE core that are sensitive to employment and the business cycle, and therefore to monetary policy. The second component was labeled “acyclical” and grouped those inflation indicators that are affected by idiosyncratic events and are less sensitive to monetary policy. The latter was also broken down into health care and non-health care related indicators. The original paper studied how inflation had stayed stubbornly low for such a long period. Mahedy and Shapiro found that it was the health-related acyclical components that were lower than average and had been that way since the implementation of the Affordable Care Act and Medicare reforms in 2010.
But the current attribution of these cyclical/acyclical inflation indicators may also show why the Fed is largely dismissive of tightening monetary policy to prevent the recent spike in inflation. Figure 01 below attributes the components of PCE core inflation from January 2007 to June 2021.
FIGURE 01 - PCE CORE INFLATION ATTRIBUTION
(January 2007 - June 2021)
Sources: San Francisco Fed, First Quadrant, L.P.
We can see that while the cyclical component of inflation has been rising in 2021, the spike in inflation is largely due to the acyclical components, particularly the non-health related indicators. Since acyclical indicators of inflation tend to move based upon their own idiosyncratic supply/demand issues, tightening monetary policy is unlikely to bring that part of inflation down unless the Fed were to induce another recession just as the recovery is gathering steam. That is, monetary policy is not necessarily an effective way to prevent the current bout of acyclical inflation from accelerating, just as lowering your blood pressure will not necessarily prevent heart disease if you have high cholesterol.
But the cyclical component is also rising. If that trend continues, then we may start to see a move towards higher interest rates. With the cyclical part of inflation accounting for 33% of total PCE core inflation, that day is likely still some time in the future. Otherwise, the cure could be worse than the disease.
Mahedy, T. and Shapiro A. (2017) “What’s Down with Inflation?” FRBSF Economic Letter 2017-35.
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