Almost every time I see an expert on macroeconomics interviewed, they suggest that a substantial part of the inflation of the past five years has been on the supply side. That’s wrong; none of it was on the supply side. I would go further; Essentially, none of the inflation of the past fifty years has been supply-side.
To be clear, I’m talking about the total cumulative price increase over a five-year period, or over a fifty-year period. It is true that some of the inflation in 1979 was on the supply side, as well as some of the inflation in 2008 or 2022. There have been individual years in which negative supply shocks drove prices up, but just as many years in which positive supply shocks drove prices up. pushed up. prices down.
Many experts seem to implicitly think that there is some kind of “ratchet effect”, where negative supply shocks push up prices, after which inflation settles back to average levels. That’s not true. When negative supply shocks do not cause inflation to rise above the average, positive supply shocks cause inflation to fall below the average.
Crude oil from West Texas currently trading at just over $70/barrel. The graph below shows real oil prices over the past 80 years (deflated using the CPI):
Adjusted for inflation, oil prices are about the same as they were in the late 2010s, and about the same as they were in the mid-1970s. That means that the nominal oil price has risen at about the same rate as the overall CPI over the past five years, and even over the past fifty years. Oil doesn’t explain long-term inflation at all.
[To be fair, there was a permanent one-time rise in real oil prices during 1973, when the OPEC moved the industry from being a competitive market to a cartel. Since then, it’s been mostly fluctuations round a real price of about $70/barrel.]
When the oil price rises faster than the CPI, this puts upward pressure on the CPI. Technically the Fed could prevent this, but because of its dual mandate it generally allows higher oil prices to pass through to higher consumer prices. When oil prices rise more slowly than the CPI, this puts downward pressure on the CPI. Because oil prices have risen at about the same rate as the CPI over the past five years, and even over the past fifty years, oil shocks have essentially had no impact on the cost of living in the long run. No. The same applies to food price shocks, supply chain shocks and other forms of supply shocks. They are not a factor for long-term inflation.
Why do so many experts insist that supply shocks have played a major role in the unusual inflation of the past five years? It seems they made the following mistake. They rightly noted that negative supply shocks pushed consumer prices higher in 2022, but forgot to note that positive supply shocks had an equally powerful downward effect on inflation in other recent years. In other words, the supply shock part of the problem was actually transitory.
So why wasn’t the headline inflation rate transitory, as many had predicted? The answer is simple. All cumulative inflation since 2019 is demand-side, and demand-side inflation is permanent. PCE inflation has exceeded the Fed’s 2% target by a total of nearly 8% over the past five years. NGDP growth is over 4% per year, totaling about 10%. That’s the whole problem; supply shocks have nothing to do with it. In any case, we have had enough positive supply shocks (mainly immigration) to keep inflation 2% below the level you would expect from the extreme demand stimulus provided. The Fed actually got lucky.