Can the Fed Really Fix Inflation?

The real remedy for the problem is to increase supply.  

Inflation is the headline issue today.  We see the impact with each trip to the grocery store or every time we fill up our car at the gas station.  

Milton Friedman defines inflation as “a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”  The Covid relief bill and Infrastructure bill resulted in the printing of trillions of dollars.  All this newly printed currency caused, along with supply chain issues, most of the shortages we experience today. 

The traditional tool used to fight inflation was to increase interest rates to reduce demand.  It was the most direct and fastest working remedy.  But today’s conditions look very different from what was going on in the past which means the normal tools might not work this time.  

Here’s what’s different:  

•  We have a record low number of houses for sale or to rent.  In spite of higher mortgage rates there aren’t enough houses for sale (or rent) to increase supply and encourage lower housing prices.
• To expand the supply of houses for rent or sale requires new construction.  But the raw materials needed for construction are supply-chain delayed and are experiencing record high prices.  
• There are nearly two job openings for every person currently seeking work.   Wage rates are increasing at record speed.  In many cases, service levels or hours of operation are being reduced due to the lack of available labor. 
• There are still long lead times and little to no inventory of cars, trucks, tractors, major appliances, and computer chips. 
• There are record shortages of airline pilots, airline crews, and truck drivers.  The shortage is expected to last a decade for pilots and truck drivers. 
• The petroleum supply has been reduced by climate change concerns and the Russia/Ukraine conflict.  Neither will be reversed quickly.
• The Russia/Ukraine conflict has caused a 20% reduction in wheat, grain and edible oil for export.  Droughts in India and the Western US have added to the reduction of global wheat supplies. 
• The reduced availability of Russian fertilizer caused by the war will lower global crop yields which means we can’t expand food supplies for at least a year or more.
• China recently shut down a crucial global manufacturing and container shipping center in Shanghai for two months to fight Covid.  Congestion and back log of manufacturing in Shanghai will ripple through global supply chains and reduce supplies further for a while. 
• Baby Formula is in shortage in the US only.  It is a special unique situation but an indication of how fragile supplies are especially where regulation, food safety, and labor all intersect.  

Milton Friedman has been proven right in that more printed money has created shortages which has led to higher prices. We can either expand the supply of goods or reduce demand to fix this imbalance.  The current policy is to reduce demand.  The same actions to reduce demand will also make it harder to expand supplies.  Prices are less likely to decline without a real supply expansion.  The current actions won’t lead immediately to lower prices for labor, goods and food. The results look a lot more like rationing.

Bottom line?  It feels like inflation, or a world of price instability, will be around a lot longer than most experts think. We live in interesting times.