Last week, US Fed Chair Jay Powell gave testimony to the US Congress on inflation and Fed monetary policy. He spooked financial markets when he appeared to say that the latest data on the economy would probably require further interest-rate hikes and at a faster pace. Powell argued that although the headline inflation rate had fallen back, the ‘core’ inflation rate, which excludes energy and food prices, remained ‘sticky’. Also, the US labour market still seemed exceptionally strong, justifying the need to control the impact of any wage rises. He again suggested that it would be necessary to hike further the Fed’s policy rate (which sets the floor for all other borrowing rates) until wage costs came under control.
Once again, Powell, like other central bank governors, claimed that inflation was being driven by ‘excessive demand’ and also by the risk of rising wages causing a ‘wage-price’ spiral. But there is plenty of evidence that it is not excessive demand or wage-push that has caused the acceleration of inflation. I have offered such evidence in several previous posts. And in a recent post, I recounted a long study by Joseph Stiglitz that offered comprehensive data showing that inflation was caused by supply-side shortages not ‘excessive demand’.
Since then, more evidence has appeared backing up the supply story. One recent paper found that when the economy came out of the COVID pandemic lockdowns and slump there was a shift into buying more goods. However, producers were unable to deal with this surge. “Our main finding is that the shift in consumption demand from services towards goods can explain a large proportion of the rise in U.S. inflation between 2019:Q4 and 2021:Q4. This demand reallocation shock is inflationary due to the costs of increasing production in goods-producing sectors and because such sectors tend to have more flexible prices than those producing services.”
And there is further evidence that the inflationary spike was driven mostly by non-labour costs (raw materials, components and transport) and by sharp rises in profit mark-ups. Wage rises made the least contribution.
The latest US data on wage increases confirm that there is no ‘wage-push’ inflation.
And this is not just in the US. In the Eurozone, it is even more the case that non-labour costs and profits drove inflation rates. The ECB recently published an estimate of the contributions from profits, taxes and labour costs to EZ inflation.
Well, even so, can it be argued that tighter monetary policy ie raising interest rates to increase the cost of borrowing and reducing money supply by selling central banks’ stock of bonds can still get inflation down? Well, not according to the ECB’s own analysis. In a study, the ECB found that an interest-rate hike by 1 percentage point only reduces inflation by about 0.1 to 0.2 percentage points. The ECB also estimates that the largest negative year-on-year effect of rate hikes on GDP will materialise only after nine quarters!
It’s the supply-side that is key to inflation. In particular, over the long term, it is the rate of productivity growth in any economy. If the growth in production per employee slows or even falls, costs per unit of production will rise and that will force companies to try and raise prices. Another recent paper argued that “sector-wide cost shocks and supply bottlenecks” create the conditions for companies with some pricing power to raise prices to protect profit margins. It becomes ‘sellers inflation’.
Productivity growth is key to inflation. Indeed, there is a strong inverse correlation (0.45) between productivity growth and inflation rates over the last two decades.
Powell is now talking of going higher and faster with rates. But the impact of previous hikes have hardly affected inflation. And controlling the money supply does not seem to have much effect on inflation, contrary to the view of the monetarists. The Bank for International Settlement (BIS) is the international association of central banks globally. Its economists are firm monetarists and Austrian school supporters of free markets. In a recent study, the BIS found “a statistically and economically significant correlation across a range of countries between excess money growth in 2020 and average inflation in 2021 and 2020.” John Plender of the Financial Times, another Austrian school pundit, concluded that “you do not have to be an out and out devotee of the quantity theory of money to see that the buoyancy of US house prices and equities last year was substantially about too much money chasing too few assets.”
Note two things here. First, there is causality. As the BIS admits “The debate about the direction of causality in the link between money and inflation has not been fully settled. The observation that money growth today helps to predict inflation tomorrow does not, in and of itself, imply causality.” It could be that “it is income, not money, that causes spending to increase, with the evolution of money balances acting as a signal.” But then the BIS goes onto argue that “causality is neither necessary nor sufficient for money to have useful information content for inflation – which is our focus here.” Really? Surely it matters whether it is economic activity, production and spending growth that drives overall money supply, or vice versa?
Second, Plender notes that increased money supply is associated with rising house prices and stock prices – no mention of the prices of goods and services. And that is the point. Strong money supply growth and low interest rates up to the point of the pandemic did not lead to rising prices and accelerating inflation in the shops. Instead, money supply fuelled a credit boom expressed in a boom in real estate and financial assets.
What is missing from the monetarist argument is that changes in money supply can also mean changes in the velocity of money ie the turnover rate of the existing stock of money. If the velocity of money falls, it means that holders of cash are not spending it on goods and services but hoarding it in deposits or investing in property and financial assets. So as money supply growth accelerated in the first two decades of this century, the velocity of money fell as the cash was used in financial and property speculation.
But note the change since the pandemic. The Fed has been tightening money supply to control inflation. After exploding up in 2020 during the pandemic slump, money supply is now contracting.
But in contrast, the velocity of that money stock is turning up, counteracting the impact of tighter monetary policy. That makes any tight monetary policy ineffective on inflation, but not necessarily on economic growth and employment. Fed policy will not work except to accelerate any slippage into economic recession. Cleveland Fed researchers analyzed the FOMC’s most recent economic projections. Their model projects the FOMC’s current unemployment forecast would bring core PCE inflation down to 2.75% but only by 2025 And a “deep recession would be necessary to achieve” the 2.1% inflation projection that the Fed is aiming for.
And now we have the collapse of SVB as a result of Fed interest-rate hikes. See my post. Indeed, this may force the Fed to pause on its plan to raise interest rates higher and faster. The Fed is being caught in a dilemma: more rate hikes could mean more bank failures and recession; but stopping hikes means that the Fed is toothless in dealing with inflation.
The worst is to come for the so-called global south. If the Fed continues to hike, then the US dollar will regain strength after the recent brief pause (graph below).
Total global debt is now over $300trn, or 345% of their combined GDP, up from $255trn, or 320% of GDP, before the covid-19 pandemic. The more indebted the world becomes, the more sensitive it is to rate rises. To assess the combined effect of borrowing and higher rates, The Economist , estimated the interest bill for firms, households and governments across 58 countries. Together these economies account for more than 90% of global GDP. In 2021 their interest bill stood at a $10.4trn, or 12% of combined GDP. By 2022 it had reached a whopping $13trn, or 14.5%. As much of the debt owed by economies in the Global South is in dollars, an appreciating dollar relative to their own currencies is an extra burden. Developing economies now spend more on external debt service than on the health of their citizens!
So not only is recession on the agenda in the G7 economies, but debt default and slump is already beginning in ‘developing’ economies (e.g. Sri Lanka, Zambia, Pakistan, Egypt).
Michael Roberts Blog 
Thank you sir Excellent write up Best wishes
Thank you for this. I hope that you will be able to write more about the potentially contagious consequences of the SVB failure (further to your other recent post) in view of the highly imperfect ‘resolution’ of the GFC (e.g., Dodd-Frank), and also about the geopolitical consequences of further rate rises (or else, the Fed executing a 180 degree turn if contagion strikes).
In the 1980s the Volcker shock was a proximate cause of the collapse of regimes in central Europe, Africa and Latin America. The question is whether Powell is trying to execute a mini-Volcker shock (knowing that he cannot raise rates to anything approaching Volcker without destroying the system), and if the intention of this is to remind wavering developing nations that they are part of the US imperium. However, there presumably comes a point where the prospect of being in hock to China might seem more appealing (or relatively less unappealing) than being in hock to the US. I note the extent to which mineral rich southern Africa, which did so much for British imperialism, is now turning towards the Sino-Russian bloc, and wonder what the consequences might be for Europe, in terms of paying an escalating premium for US (and Australian) minerals. After all, European prosperity over the last 300 years has been predicated, in large measure, on access to discounted African minerals.
On the “BIS dilemma”: well, this is really just a philosophical question. When you see an endless line of ships full of containers from China clogged in the outdated and dilapidated Californian port during the apex of the pandemic, a liberal can look from essentially two points of view: excess money (printed) and distributed to the masses; or insufficient supply from the logistics sector. They both miss the point, in my opinion.
My opinion on this remains unchanged: this is not a supply-demand issue, but the simple and self-evident fact that the USA — and, by association, the rest of the Global North — is shrinking as a whole except the financial sector. The Global North cannot sustain its valorization process anymore, it will have to scale down. The fact that one side (supply or demand) is or isn’t shrinking faster than the other is immaterial: we’re just talking about a period of latency. [The fact that, due too the Dollar Standard, this period of latency is longer in the USA than the rest of the First World is also immaterial]
The Global South has been sustaining the Dollar Standard since the end of the Cold War. If it collapses (again), it collapses. However, the peoples of the Third World are already accustomed to poverty and crises, so the fall is shorter. Besides, History never repeats: today, they have something they didn’t during 1992-2008: an alternative (China; BRICS; SCO; BRI). Which German tribe would ever imagine that, one day, they would be ruling the Roman world and beyond, during the times of the Roman Empire? One is until one isn’t; that’s how History works.
The inability of capitalism to ignite a new Kondratiev Cycle is really getting dramatic. A series of states in the USA (Iowa, Alabama, Minnesota, Missouri, Ohio, among possibly others) have already passed or are in the process of passing bills lowering work permit age limits to 14 years old. This, combined with other reforms removing women’s rights and the promotion of Christianity and neofascism (alt-right), is related to the greater and deeper structural problem of demographic shrinking in the USA. Up to some years ago, mass immigration from Latin America kept the American demographic bonus at acceptable levels; now Latin America itself is experiencing chronic negative birth rates, and this apparently endless source of cheap and young labor is drying up, cutting off the solitary argument the American Left had against had against the Alt-Right ideological charge.
If capitalism remains unable to start a brand new KC, expect this tendency of the rise of the alt-right (far-right; neofascism) to continue at an accelerated pace, specially in the USA. By 2035-2050, it could well be that virtually every American will start working at 14, and the center-left (social-democrats) — if it still exists by then — will be “fighting” for the return of the minimum 18 year work age, to “the good ol’ times of Barack Obama”, just like they clamor for the return of the “days of Eisenhower” nowadays.
Notice how it seems the Fed and the White House are going to try a different tactic from the one used in 2008.
In 2008, the Federal Government practically reacted immediately and energetically: it tried to save (bail out) everyone, no matter the cost.
Now, apparently, they are going to at least experiment the reverse of 2008: they are going to shut down the relatively smaller fish — even preventively, if necessary — so they can avoid the so-called “systemic crisis”, i.e. save the bigger fish. They’re going to guarantee the bank deposits in order to avoid a social unrest but that’s it (officially). This tactic resembles the way firefighters contain forest fires, where they purposefully devastate a strip of the forest so that the fire doesn’t have enough fuel to burn the whole forest down.
The problem is: capitalism works completely differently from a forest.
“In 2008, the Federal Government practically reacted immediately and energetically: it tried to save (bail out) everyone, no matter the cost”
The history of the 2008-09 bailout is a bit more complex as the govt did not attempt to bail out everyone. Anybody remember Lehman Bros or Countrywide or Washington Mutual? What the US did do, among other things, was underwrite takeovers, counterparties, etc. Made some money out of it too, with its own versions of the special investment vehicles.
And the reaction wasn’t that immediate–as the Bush administration’s initial bailout program was defeated, if I recall correctly.
Regarding SVB, well that’s where the govt has intervened quickly, with the FDIC creating the SV Bridge Bank and guaranteeing all deposits regardless of size. Biden says the investors won’t be protected– but that mean’s equity investors.
If you hold the bank’s commercial paper, you’re going to have a problem in the secondary markets, but the Fed’s machinery that underwrote the commercial paper markets in 2008 can always be revived.
Yes, during the final months of George Walker Bush’s reign (October-January 2008-2009), he refused — and the Congress blocked when he capitulated — to bail out the system.
It cost him and his party the election of his successor.
Obama, who easily defeated his adversary in 2008 with Chicago financial elite money, immediately bailed out the system. It was his second action as POTUS: the first one was the alleged closing of the Guantanamo Bay prison, which he signed in his very first day at office (a candy for the masses before the rescuing of the capitalists?).
The guarantee of bank deposits up to a given amount is standard practice around the world — even Third World countries do that. What the FDIC did means absolutely nothing. The guarantee of the uninsured deposits was a clear slap in the face of the working class Americans, but, in the greater scheme of things, the deposits are not the problem: it is what happens between banks that are.
https://infrastructurereportcard.org/
With respect I don’t believe a correlation coefficient of 0.45 is strong as you suggest for the data shown in the graph “US annual productivity growth and inflation 1948-2023”. On the contrary I believe r is at best marginal as visual examination of the data presented shows. I don’t like to nit pick as I appreciate the work you do for these blogs but in this case I feel this misinterpretation somewhat weakens the strength of your argument.
Mike reasonable point. Yes the scatter shows that there are probably other factors behind inflation. I am working on a more convincing model with my colleague mino carchedi
Great I’d like to see the results
Agree with Mike (doubt 0.45 and interested to see. new model) And thank you for this post
Now that the dust has settled a little bit more, we can come up with clearer observations:
It seems the situation is even graver than we initially thought. The bankruptcy of the SVB is really systemic, and much more structural than it seems. It has already dawned to the American capitalist class that the Fed cannot rise the interest rates, ever.
The only question that presents to us now is this: will the USA have its Brezhnev Moment or its Hitler Moment? If the first happens, then the American elite and its “political class” (managerial class; middle class) will be resignated to what it is — just a declining financial superpower — and go back to lower its base interest rate ad eternum, until its fate finally comes. If it is the second, then the USA will go all by declaring WWIII against Russia and China, mobilizing whatever it has left in order to try to win — without, somehow, triggering a nuclear war, because that would also end capitalism — and “reset” the game again, in the hope of triggering some kind of Deus ex machina war economy that could trigger a new economic miracle.
A third option would be to simply hope for a miracle to happen and a KC starts out of the blue, from the mind of some historically great genius who happens to be born and raised in the USA. The problem with this option is that it is out of control of any government or the capitalist class; i.e. it is not a policy.
P.S.: the NYT et al published some articles yesterday about how most of the green capitalism companies of the USA broke with the failure of the SVB (the subliminal message was: please support the bail out of the bank, dear readers). However, if that’s true — that the entire base of America’s green capitalism went down with SVB — then that would be a huge blow to the ecocapitalists (the “Greens”).
To the third point, we could see that media spend how much articles to explain AI, such as the “Chat GPT” , is a how huge progress in technology. I must say they were very useful. However, they have a problem like other information technology that caused the last CK in the 1990s, while the number of consumers did not increase, these technologies would destroy more jobs than they create. If those developed countries could not agree that in this world, all people, no matter whether he is rich or poor, white or black, have the equal right to have a decent life. The size of the consumer market only would be smaller and smaller, and the gap between the rich and the poor would be much larger in the future.