State of Play (August 21)

Why is inflation so "low"?

This is the fifth installment of “State of Play. As usual. I start with a few recent tidbits.

Lawrence H. Summers


Consumer spending is strong and looking to rise into Christmas as COVID recedes. PCE inflation has risen at above a 6 percent annual rate since the passage of stimulus. Core PCE is running well above 5. Short-term real rates are as negative as they have ever been….

…..Record labor shortages, product bottlenecks, and liquidity overhangs.  WE HAVE AN INFLATION PROBLEM.

Frances Donald


· Oct 1

The Fed can hike interest rates all it wants, it's not going to make it rain in Brazil, open ports in China, find truck drivers in the UK, change covid-0 policies in Australia. Bet that the Fed will hike rates if you want, but don't bet it will help this supply-driven inflation.

Jason Furman


Oct 1

What about the reverse? The Fed can do ultra-accommodative policy all it wants, it's not going to make it rain in Brazil, open ports in China, find truck drivers in the UK, change covid-0 policies in Australia. Will it help the US supply-driven output/employment shortfall?

More to the point:

George Selgin


Replying to @AdamPosen @Austan_Goolsbee and 2 others

I think the correct formula is that you don't tighten for supply shocks, but you do tighten to keep a limit on demand growth. If there is no commitment to keep demand growth in check, then an adverse supply shock might serve to justify even a disproportionate jump in inflation.

And then there´s Adam Tooze´s take:

Whether we are living through the beginning of a new inflation is uncertain. What is clear is that we are living through a great inflation debate.

Inflation does not suddenly “come out of the woods”. It is “created” by the Fed through its conduct of monetary policy. When faced with supply shocks, its job becomes harder. It has to find, as George Selgin notes, the “correct formula”.

The panel below helps us make sense of what´s going on and how inflation may develop going forward.

On the LHS, we have the Levels Charts. When the Covid19 shock hit, NGDP (or Aggregate Nominal Spending or AD), drops significantly. This brings down RGDP. Obviously, as seen in the RHS Growth Charts, NGDP growth goes strongly negative and one measure of inflation (Core PCE) drops significantly.

Between the two vertical bars, inflation remains low & stable by both measures. Why does the Core PCE measure rises abruptly to the right of the second vertical bar?

Note that at that point, NGDP reaches its prior level path and “hugs” it. At the same time, RGDP flattens out, with supply bottlenecks and more conventional supply shocks (oil, for example) binding.

Note that Core PCE inflation has stopped rising (while the “super core” trimmed PCE has not gone above its level prior to the pandemic). This is the result of George Selgin´s “correct formula”, with the Fed limiting demand growth to remain on its post GR trend level path.

If the Fed continues with that policy, inflation will “shrink” with supply bottlenecks being “relaxed”. At that point, real output will increase and the Fed can nudge NGDP to a higher trend level path at the same time that inflation remains “tame”.

The next chart shows how misguided the views that many have espoused since Spring 2020 that inflation would rise significantly in 2021 & 2022 because money supply growth rose to record rates.

Money supply growth reacted with a very short lag to the abrupt and deep drop in velocity (inverse of money demand). If money supply had not reacted (or reacted much less), the economy would have dived into a deep and long depression.

More recently, money supply growth has dropped to offset the rise in velocity, keeping NGDP growth “on track”.