The Sources of Inflation Have Shifted. The Fed Needs to Take Note.
Over the past year, the sources of inflation have shifted dramatically: rather than rapid income growth, the main driver now is a lull in productivity growth — a problem the Fed’s interest rate hikes can’t do anything to solve and that is probably temporary anyway.
Jerome Powell, chairman of the US Federal Reserve, at the spring meetings of the International Monetary Fund (IMF) and World Bank in Washington, DC, US, on April 14, 2023. (Samuel Corum / Bloomberg via Getty Images)
There’s a simple but underemphasized point about inflation — inflation in general and the post-COVID inflation we’ve been experiencing in particular — that’s worth noting as we head toward the Federal Reserve’s next meeting in early May.
By definition, inflation is the difference between two numbers: the growth rate of real output per hour worked, and growth rate of nominal output per hour worked, and each of these tells us something different about the state of the economy.
Real output per hour is none other than the familiar concept of labor productivity, whose growth rate at any given moment tends to fluctuate around an underlying pace determined largely by the trend of technology. Nominal output per hour is the average amount of money businesses charge for the output of one hour’s labor. Its level is determined by the level of wages and profit markups.
In a classic demand-driven inflation, price rises are caused by the growth of this latter, nominal metric: high levels of demand create a seller’s market in which workers, as sellers of labor, have greater bargaining power vis-à-vis employers, and firms, as sellers of goods and services, have greater pricing power with respect to their customers. We might call this type of inflation excess-income inflation, because it’s caused by nominal incomes earned in the course of production rising faster than productivity.
An inflation-fighting strategy based on compressing aggregate demand — through higher interest rates or government spending cuts — thus makes the most sense when excess-income inflation dominates.
The Other Kind of Inflation
But what’s less often appreciated is the second kind of inflation, which can occur even without any acceleration in unit wages or profits. If the number of hours required to produce a given amount of output rises for some reason, or if its rate of decline falls — that is, if labor productivity growth falters — price inflation will rise even if wage and profit growth remain steady. We can call this type of inflation productivity-shortfall inflation.
For example, if the economy is experiencing annual productivity growth of 1.5 percent and nominal output per hour is rising by 3.5 percent per year, the inflation rate will be 2 percent. If something then causes productivity growth to fall to 0.5 percent, then — even without any change in the growth rate of wages or profits — inflation will rise from 2 percent to 3 percent.
The idea here is that the prices of goods can rise not just because the inputs that go into them (e.g., labor) have gotten more expensive, but also because the actual quantity of inputs required to physically produce the goods has increased.
Why does this matter? The answer has to do with the very different prognoses implied by these two separate inflation types. Perhaps the most important difference relates to the nightmare scenario that central bankers are always most acutely on guard against, in which inflation doesn’t just experience a onetime jump but keeps rising and rising indefinitely. This “accelerationist” scenario can only occur due to excess-income inflation: a self-propelling upward spiral of wages and prices is, in theory, a danger, but a self-propelling downward spiral of labor productivity is not.
So it’s worth looking separately at the contributions to inflation coming from these two different sources, which I attempt to do in the charts below.
First, I calculate benchmarks: what the growth rates of labor productivity and nominal hourly output would be if the inflation rate were at the Federal Reserve’s 2 percent target and productivity growth were at its trend rate as estimated by the Congressional Budget Office (CBO).
Then I calculate how much extra inflation is caused by nominal hourly output rising faster than its benchmark rate (this is the contribution of excess-income inflation) and how much is caused by real labor productivity rising more slowly than its benchmark (this is the contribution of productivity-shortfall inflation). The sum of these two measures is by definition equal to the actual amount of “excess” (above–2 percent) inflation. (All inflation data are shown as four-quarter growth rates.)
What these charts show is that up through the end of 2021, above–2 percent inflation was mostly driven by excess income growth. But since then, excess-income inflation has dramatically declined. From its peak in the fourth quarter of 2021 to the fourth quarter of 2022 (the most recent for which we have data), the contribution of excess income growth to the excess-inflation rate fell from five percentage points to one percentage point.
Thus, the bulk of excess inflation is now caused not by too much demand growth but by productivity growth lagging behind its trend rate — a problem that higher interest rates simply cannot solve.
Avoiding the Worst
Now, it’s possible, in theory, that the recent shortfall of productivity growth relative to its trend rate will turn out to be permanent: in other words, trend productivity growth might have actually declined, but the CBO hasn’t picked up on it yet. If that’s the case, the rate of nominal hourly-income growth compatible with 2 percent inflation will be less than what I’ve assumed in making the above charts, and this could conceivably justify a long-run policy aiming for a lower rate of nominal hourly-income growth.
But so far, economists who study productivity dynamics have generally concluded — however tentatively, given the capricious nature of productivity — that the recent slowdown is probably temporary and that the most likely scenario for productivity is a gradual return to pre-COVID trends.
Labor productivity is hard to measure accurately in real time, so it’s understandable that the Fed would be hesitant to rely too much on any analysis that depends heavily on those numbers. But the fact remains that any Fed policy aiming to push inflation down to 2 percent in the face of productivity growth rates that are significantly — but temporarily — below their trend will require a compression of nominal income growth that will not only be severe and painful. It will be entirely unnecessary.