What is Going on With Inflation in the US?
A Tale of Global Markets and Forces Outside of Our Control
Inflation in the US is at an all time high. Not since the OPEC oil crisis in the 1970s has inflation been this elevated. That period was followed by a deep recession as the Federal Reserve hiked interest rates to get things under control.
Today everything from gas to energy to food feels like it is becoming more expensive by the day. The media is constantly writing articles about how likely a recession is given high inflation and the expected Fed response to contain it.
Consumers are angry at paying higher prices and have shown their displeasure in Biden’s approval rating. As inflation has risen, his approval rating has declined to just over 40% from an initial high of 55% at his inauguration.
How can we explain the unusually high inflation we see in the US today?
There are roughly five reasons why inflation is higher today than in the past:
- Pandemic induced supply shock (Global)
- Pandemic induced consumer shift from goods to services (Global)
- Russian invasion of Ukraine and impact on gas and wheat prices (Global)
- Biden’s COVID stimulus package (US specific)
- Lack of Competition in US Industries (US specific)
Three of these are global reasons outside of the United State’s control. Of the last two one is also outside of Biden’s control, and one can be attributed directly to his policies.
Impact of the Pandemic
The COVID-19 pandemic upended supply chains around the world, causing disruption to the global economy. Backlogs at ports and manufacturing shutdowns created a problem for interconnected and specialized production processes.
Most countries today specialize in very specific steps in the production process of all goods. Cars assembled in the US consist of parts from Germany, Mexico, and many other countries.
This is not a bad thing and is actually more efficient, but when a global crisis hits, shocks to one country will reverberate throughout supply chains and impact every other country.
While COVID has slowed down and economies are generally reopened, the impact of previous disruptions and continued lockdowns in China still drive inflation around the world.
The global container index shows the price of shipping around the world. It skyrocketed in 2021 and has started to decline to normal rates but remains elevated from the recent average, putting pressure on end consumer prices.
Beyond COVID-19 supply shocks, the pandemic also create demand side shocks as well. With lockdowns and the virus driving people inside, consumers shifted from purchasing services to buying more physical goods. This created pressure on the prices of goods.
A good deal of inflation can be explained by this shift. While consumer preferences are returning to normal, there is still increased consumption of goods relative to the historical norm, which creates a global price pressure that affects all countries.
The graph below shows yearly growth in spending in the US for services and durable goods since 2018. For much of the last two years, growth in durable goods spending was much higher than the historical norm. By contrast, demand for services declined during the bulk of the pandemic, showing the change in consumer preferences.
This demand shift interacted with the supply backlogs, creating a gap in markets, leading to sky high prices (remember the used car chaos during 2021?).
Only recently has this started to shift back to normal.
The War in Ukraine
The war in Ukraine was an unmitigated act of aggression by Russia. Beyond the implications for the Ukrainian people, it also led to surging gas and wheat prices because Russia is a major global exporter of oil and Ukraine is a major bread basket for the world. This in turn caused energy and food prices to rise around the world as both are set on global markets.
While wheat prices did rise during the pandemic due to global supply and demand shocks, it really rose at the end of February 2022 after Russia invaded Ukraine and disrupted wheat production and exports there.
Similarly, gas prices also sky rocketed post February 2022 when Russia invaded Ukraine. And because the pandemic had decimated US oil production due to purely market forces of declining prices and demand, there was not extant capacity to ramp up production as prices soared.
This is also hampered by the fact that much oil production is controlled by the OPEC cartel that purposely does not increase production when prices are high to keep profits elevated.
US Specific Factors
There are two US specific factors to rising inflation.
The first is the huge stimulus bill passed by the Biden administration to help people navigate the COVID economy. The American Rescue Plan Act was passed in March 2021. At the time people feared the huge bill would lead to excessive inflation as it gave consumers lots of money at a time when the economy was not necessarily performing terribly.
Second, the US faces a wealth of concentration in many industries that leads to monopoly pricing power. As many industries have only a few firms, they are able to set prices for their goods and can pass on cost increases from supply chain shocks directly to consumers.
While there is evidence that this phenomenon has been happening for decades, it can’t specifically explain the recent inflation surge because it is not clear that concentration has gotten materially worse during the pandemic. Basically this is a decades long problem and so cannot be the main underlying cause of inflation in the last couple years.
However, concentration can interact with the global supply chain crisis, providing firms with monopoly power an opportunity to pass on rising costs to consumers or use the pandemic as an excuse to raise prices. There is evidence of this in company earnings calls to investors.
If you want an example of how concentration in the US has hurt consumers recently, take a look at the current baby formula shortage.
Putting it Together
How can we disentangle the impact of the three global factors from the two US specific ones?
One way is to use the historical relationship of inflation in OECD countries to forecast what expected US inflation should be. This should adjust for global factors that are causing inflation to rise everywhere. The difference between actual US inflation and expected inflation based on other countries is the residual that is leftover to be explained by US specific factors.
When we use OECD countries to forecast inflation in the US and take the difference from actual US inflation, we get an excess rate of 2%-4%, which we should also note has been declining recently.
This means that excess stimulus and concentration together are responsible for only around 2% to 4% of inflation. The other 4% to 6% of US inflation is due to global factors outside of anyone’s control.
Of the 2% to 4% attributable to US specific factors, we can roughly say 75% is due to excess stimulus and 25% from concentration. So Biden’s policies are to “blame” for 2% to 3% of US inflation. Notably, even if these effects were removed inflation would still be much higher than historically because of outside forces.
If these outside, global shocks were not there, we might be observing a total inflation rate of around 4% to 5%, which is high but not as shocking as the data seems to suggest.
And of course this ignores the beneficial effects of Biden’s stimulus bill, which helped reduce child poverty, prevented evictions, and had many other positive effects.
It is not clear if the American economy would be in a better place if we hadn’t passed the stimulus package though things would probably be a bit better better if the stimulus bill had been smaller.
Overall, inflation in the US today is not a policy failure of the Biden administration or something anyone could have really prevented. It is mostly due to global shocks like the pandemic and war in Ukraine.
We shouldn’t punish politicians for things they don’t control and should also expect high inflation to continue for some time as the world adjusts to the post pandemic reality.
It should also temper Fed policy on reducing inflation at the risk of a recession since much of inflation is due to global shocks. True excess inflation in the US is much smaller than the headline numbers.
