In the name of combating inflation, some economists are calling on the US Federal Reserve to raise interest rates more sharply. Other economists argue that an interest rate shock could push the US economy into recession. With brutal consequences for working people. Behind this debate is the question of whether increased demand is overheating the economy, or whether supply-side factors are fueling inflation? So far, little speaks for this thesis, as our editor Otmar Tibes comments.
America's job market is stronger than it has been for a long time. In June alone, 372,000 new jobs were created, significantly more than expected, and the unemployment rate remains at a historically low level of 3.6 percent. In other words, there is near full employment in the US. Given the many shocks that have occurred over the past few months and years since the outbreak of the pandemic in spring 2020, this is a remarkable achievement. After the outbreak of the pandemic, 22 million people became unemployed. In hardly any other country has the pandemic cost as many jobs as in the USA. Thanks to the CARES laws and the American Rescue Plan (ARP) that was also passed, many jobs could be saved and new jobs created.
But what is usually taken as good news is being taken as bad news these days. Some economists are of the opinion that the strong labor market is responsible for the high inflation in the USA. The inflation rate in the USA is currently 8.9 percent. The rate has not been this high for 40 years. Older citizens may remember the late 1970s when US inflation was spiraling out of control. It is well known that inflation was then driven by a wage-price spiral. Today, so-called "fiscal hawks" are warning the public that such a crisis could happen again. The Federal Reserve (Fed) is therefore now under massive pressure. Already in June it decided to raise interest rates by a whopping 0, 75 percent increase — the largest increase in 28 years. However, it is currently being pushed to raise interest rates even further, even if this is onecould trigger a recession in the US.
Not all economists agree with this, however. They fear that raising interest rates even more could have far worse consequences for the economy than the current inflation. Not only would the government's successes in driving the US economic recovery be undone. A recession could also lead to social upheaval in the USA. Right-wing populists in particular could benefit from such a crisis. In addition, some economists are critical of the warnings of a wage-price spiral. The situation today is different than it was in the 1970s. They therefore consider it unrealistic that such a spiral could occur. They therefore advise taking a closer look at what is really driving inflation in the US.
This question is already being discussed controversially. While “fiscal hawks” and mainstream economists adamantly attribute inflation to macroeconomic imbalances, other economists are a bit more cautious. They miss the empirical evidence of the thesis and are therefore skeptical about it. While it's plausible that demand plays a role, consider the stimulus checks issued as part of the 2021 American Rescue Plan. But even if demand is contributing to inflation, that doesn't rule out the possibility that other factors could also play a role. These do not necessarily have to be on the demand side, but also on the supply side. Finally, after the outbreak of the pandemic, there was a series of supply shocks, in the course of which the profits of companies have also skyrocketed. This is an indicator that inflation is not being fueled solely by the demand side.
The thesis of macroeconomic overheating
Some economists have scoffed at the idea that inflation could be related to corporate earnings. For example, former US Treasury Secretary Larry Summers recently explained that higher profits and higher prices always result from higher demand — that's the way the market economy works. In his opinion, the imbalance between supply and demand is therefore due to the labor market. The fact that this is booming is an indicator that increased demand is meeting lower supply. In this case, it's only logical that prices keep going up, he argues. In a speech in London, he called for the booming job market to “cool down” and “excess” demand to be eliminated. Recommended as a suitable measure to push the unemployment rate above 5 percent in the US for an extended period:
We need five years with unemployment above 5 percent to contain inflation - in other words, we need two years with unemployment at 7.5 percent, or five years with unemployment at 6 percent, or one year with unemployment at 10 percent Percent.
The theory behind this recommendation is that higher prices are always due to higher demand. To put it even more simply, when prices keep going up, people overspend. This type of inflation is what concerns about “overheating” are all about. The capacity of the economy is exceeded by a demand that has become excessive. The resulting inflation must then be combated by increasing unemployment. This is what standard economics textbooks suggest (see Phillips curve). The most effective way to do this is by raising the key interest rate sharply in order to suddenly curb investment on the supply side. Higher interest rates mean that borrowing becomes more expensive. In this way, growth is dampened and unemployment increases.
The earlier such a restructuring crisis begins, the better, believe its proponents. They therefore insist that the Fed raise interest rates as soon as possible. It is to be feared that unions will demand higher wages. At that point at the latest, the situation could turn into a wage-price spiral, they warn. Apparently, this warning has already caught on with some policymakers — like Federal Reserve Chair Jerome Powell or Acting Treasury Secretary Janet Yellen . Both have publicly expressed concern that inflation could lead to higher wages. In the UK, the head of the British central bank, Andrew BaileyTrade unions have even been explicitly asked to moderate their wage demands in the coming months in the name of fighting inflation. Otherwise, policymakers would find it harder to keep inflation in check when the specter of a wage-price spiral becomes a reality.
The fear of a wage-price spiral is unfounded
Historically, the expression "wage-price spiral" is closely linked to the 1970s. It stands for a development in which wage and price increases mutually support each other. If companies raise their prices, for example, unions have to push through higher wages in response. Otherwise they cannot protect the real (inflation-adjusted) wages of their members. In return, companies raise their prices, since rising wage costs also mean smaller profits. Alternately, this leads to ever stronger inflation dynamics. In the 1970s, when inflation started with a rise in oil prices, such a spiral accelerated the upward movement in prices until it eventually spiraled out of control.
Against this background, policymakers came to the conclusion that inflation had to be stopped by a shock hike in key interest rates. Paul Volcker raised interest rates by an incredible 20 percent, triggering the famous Volcker shock. After this rigorous measure, an era of recession began. In the course of this, factories were swept clean and trade unions were disempowered. During the Reagan years, striking unions were fought down (eg, the 1981 air traffic controllers' strike) to break their bargaining power. In the end, the disempowered workforce acted as a shock absorber for inflation.
In general, however, the disempowerment of the trade unions has not had a particularly positive effect on the US economy. For decades wages grew only slowly or stagnated. The economy as a whole has also grown relatively slowly. The great recession that followed the financial crisis would certainly have been less severe if workers had had more bargaining power. However, a whole series of conscious political decisions prevented this from happening. The number of union members has been declining for years: while in 1983 a good 20 percent of employees in the USA were unionized, today it is just under 11 percent. 59 million people are also freelancers. The collective power of workers is therefore relatively weak.
This, in turn, affects the current situation. If trade unions are not in a position to push through large wage increases at short intervals, then they cannot reinforce the upward trend in prices either. The fear of a wage-price spiral is therefore unfounded. It has nothing to do with the real balance of power in the USA. However, if trade unions are generally too weak to push through wage increases, then the incentive for companies to raise prices at every suitable opportunity is also high. If they increase the prices, then their profits also increase. And higher wins mean some people are getting more money. With Larry Summers you could also say: that's how the market economy works. The suspicion that the current situation is being exploited to generate higher profits,
There is a lack of empirical evidence that the US economy is overheating
However, the theory of overheating is far from over. It is not claimed that today's inflation is being driven by a wage-price spiral, but by macroeconomic imbalances. Aggregate demand is said to be exceeding the US economy's ability to produce the goods demanded. But how can you verify this thesis? In a short article , US economist Josh Bivens made an interesting comparison that may help us answer this question. In it, he compared real gross domestic product (GDP) to the GDP estimated by the Congressional Budget Office and found that real GDP has been underthe level of potential US GDP. This is an amazing result. Because it means that today's US economy should actually be able to meet current demand without any problems.
The thesis of macroeconomic overheating is strongly challenged by the result of this study. A macroeconomic imbalance between supply and demand can only be identified if the supply-side capacity of production has already been exceeded. However, as Josh Bivens' comparison shows, these production capacities in the USA have not yet been exhausted. Even on the contrary. At the moment there is more room for improvement in production capacities, which is why demand could theoretically increase even further without fear of a sudden increase in inflation. It is therefore questionable to speak of a macroeconomic imbalance. Rather, the empirical evidence suggests that aggregate demand is lower than supply.
The question of what drives inflation in the US is made more complex by this finding. Because if inflation isn't caused by one cause, then there must be other - that is, multiple - causes of inflation. But which ones? Josh Bivens has also grappled with this question. He points out that inflation is related to several factors, all of which stem from the pandemic. One of these factors also has to do with GDP. Because although GDP corresponds to the supply-side capacity of the economy, its composition has changedchanged significantly after the rapid reopening of the economy in spring 2021. Demand-side spending has shifted on an historic scale: while spending on personal services (restaurants, hotels, gyms) fell sharply, spending on goods (cars, furniture, clothing) rose significantly. People who haven't eaten out or traveled because of the pandemic have preferred to buy cars, TVs and other durable goods.
Simultaneously with the increased demand for goods, global supply chains have also stalled in recent months, mainly due to port closures. Disabled ports and shipping facilities have a major impact on commodity prices, as evidenced by specific costs. The US Bureau of Labor Statistics (BLS) reports that the price index for transport and storage services rose by an impressive 16.6 percent last year. That's a cost that goes into nearly all goods in the United States. The pandemic could therefore have created a situation in which enough goods can be offered, but many goods prices have risen due to rising transport and storage costs. Only by passing the increased costs on to their customers they could protect their profits. Otherwise they would have been stuck with the additional costs, which makes no business sense.
Corporate profits have contributed disproportionately to inflation
How all of this has affected US consumer prices is again worth investigating. Interestingly, Josh Bivens has also done such research. He recently analyzed the composition of US prices – again with interesting results. Typically, prices are made up of three components: labor costs, ancillary costs, and profit margins. In the USA, very precise data is available on the individual components for the goods and services sector (Nonfinancial Corporate Sector), which makes it easier to examine them in detail. Overall, the nonfinancial corporate sector accounts for 75 percent of the entire private sector. That covers a large part of the US economy.
The result of his study is extremely revealing: Since spring 2020, prices in the goods and services sector have risen at an annual rate of 6.1 percent. A significant increase from the 1.8 percent price growth that characterized 2007-2019. The figure below now shows that more than half (53.9 percent) of this increase is due to higher profit margins. Labor costs only contributed 7.9 percent to this increase. That's not normal, as Josh Bivens notes. Because from 1979 to 2019, profits contributed an average of just 11 percent to price increases, while labor costs accounted for over 60 percent. Also, utility costs - a good indicator of broken supply chains - have driven prices more than usual,
This finding is clear. Corporate profits have contributed disproportionately to US inflation. It is therefore not only the case that many companies have increased their prices due to increased costs. Rather, companies have also expanded their profit margins to increase their profits. With noticeable consequences, as can be seen from the development of monthly inflation rates in 2021. In the second quarter, inflation in the US rose from 2.6 percent to 4.2 percentleaps and bounds. This correlates with the surge in higher profit margins. In fact, in the same quarter, they rose to an all-time high of 19 percent, as can be seen in the second figure below. Therefore, it can be said that the upward movement of prices at the beginning of 2021 was significantly strengthened by companies. In other words, business owners have seized the opportunity to take advantage of inflation.
Because this has led and still leads to undesired effects, political measures would be required to prevent corresponding price increases. Economically, it can be toxic when companies drive prices to take advantage of ever-increasing profits. One could also speak of a profit-price spiral. Political efforts to limit such price increases would therefore not only be appropriate, but even necessary. Temporary excess profit taxes could be an effective means of doing thisbe. They reduce the incentive for companies to use their pricing power to raise prices excessively. In particularly sensitive areas - for example in the energy sector - price caps could also be introduced. Price caps are a very effective way of fighting inflation because they prevent cost increases and temporarily limit the free pricing power of companies. If one wanted to combat the inflation of energy prices in the USA directly, gas price caps would be the most appropriate means of doing so. Incidentally, this also applies to European gas prices.
Causes and effects of inflation in the US
However, as Josh Bivens specifically notes, US inflation was not caused by corporate earnings. In fact, corporate earnings have “only” fueled inflation. The root cause of inflation goes back to the pandemic. This is supported by the empirical fact that price shocks occur in almost allcountries have occurred after the outbreak of the pandemic. The historic shift in demand towards durable goods (cars, televisions, furniture, etc.) is definitely a consequence of the pandemic. This shift has given companies tremendous pricing power over their customers. At the same time, however, port closures have also caused supply chain problems, which in turn have led to skyrocketing costs. However, as already explained above, companies have not used the rise in prices as an opportunity merely to protect their profits. They have also taken them as an opportunity to increase their profits. In 2021, these three factors finally caused inflation to rise sharply. And they still have an effect today.
But on the contrary. Due to the zero-Covid strategy, several lockdowns have been imposed in China in recent months , which have again led to supply chain problems . A two-month lockdown was recently ordered in the port city of Shanghai . The port there is one of the most important transshipment points in the world. The disruptions to port operations there are therefore also having an impact on prices in the USA. Added to this is the outbreak of war in Ukraine. This has further aggravated the situation in 2022. Since the outbreak of war, several price shocks have occurred in the US, affecting the cost of living in particular. In the meantime, therefore, there is even a cost-of-living crisiswarned. Compared to May, food prices rose by 1 percent in June and by as much as 12.2 percent over the past 12 months. Food and energy costs have been particularly affected by the war in Ukraine because Russia's war of aggression has disrupted world supplies of oil, wheat, corn and other commodities. Although some of these prices currently appear to be falling again (e.g. petrol), the situation remains tense.
Overall, the combination of these factors provides a much more plausible explanation for the sharp rise in US inflation than the thesis of macroeconomic overheating. The current fear that inflation will be fueled by an overly strong labor market is also not really convincing. Classically, it is indeed the case that wage costs rise and profit margins shrink as soon as the labor market booms. However, the fact that exactly the opposite has happened in the upswing in the USA to date diametrically contradicts this thesis. Currently, the level of profit margins is still at a historically high level, as can be seen from the figure below. In the third quarter of 2020, profit margins skyrocketed for the first time. Today they are slightly below the level of a year ago. However, they are still historically high compared to pre-pandemic levels.
Also, the strong labor market in the USA has not yet led to excessive wage growth. It is true that nominal wages have grown faster than usual compared to the last two decades. Nevertheless, they have remained below the level of inflation. This means that wage costs have dampened rather than reinforced the upward movement in prices. Especially in the last two months (May to June 2022), wage growth in the US has continued to slow. Extrapolated for the year, it has fallen to an average of 3.8 percent. That's a level that's perfectly consistent with the Fed's overall inflation target of 2 percent. Basically, nominal wages can rise by about 3.5 to 4 percent per year if the Fed targets inflation at 2 percent. 1 During the recovery to date, wage growth in the US has rarely risen above 4 percent. It has therefore not been a determining factor for inflation. Conversely, inflation has proven to be a key factor in driving down real wages. Real wages have recently fallen by 1 percent (June 2022) and even by 3.1 percent compared to the previous year, as can be seen in this publication of the BLS. Accordingly, one can find that inflation has a regressive effect on real wages, which again comes as no great surprise since inflation by definition means a loss of purchasing power.
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