Tyler Griffin ‘24, Jan-Peter Kaufmann ‘24, Griffin Lewis ‘24 and Candida Ogu ‘24
In March 2022, two years after the eruption of the COVID-19 pandemic, U.S. inflation had risen to 6.9%, significantly elevated from the Federal Reserve’s 2.0% target rate. As the central bank of the U.S., it is the responsibility of the Federal Reserve to promote maximum employment and preserve price stability. In response to elevated price levels, measured by personal consumption expenditure (PCE) price indexes, the Fed decided to increase interest rates to combat rising inflation at its FOMC meeting in March 2022. Over the next 16 months, the Fed paused interest rate hikes only once and raised the federal funds rate by 525 bps (5.25%) in total, the steepest increase in history.
Despite a 22-year-high interest rate environment, inflation is still adjusting to the Fed’s contractionary policy. Headline PCE, reflecting a weighted market basket of all goods and services that Americans consume, stayed at 3.0%, and core PCE, an index that excludes food and energy prices, remained at 3.5% in October 2023. Naturally, the question arises as to why price levels are still elevated and whether the Fed’s contractionary policy is effective in promoting price stability.
According to macroeconomic theory, elevated interest rates cause inflation to fall. If interest rates are high, saving becomes more lucrative and disincentivizes consumption spending. Furthermore, borrowing becomes more expensive and decreases investment spending, as households are less likely to take on new mortgages and businesses new debt. Therefore, increasing interest rates lowers aggregate demand, which in return reduces output growth and decreases inflation. However, interest rates target the demand side of the economy, not its supply side.
Evidence suggests that supply factors have significantly contributed towards current inflation. In the last three years, the global economy experienced supply bottlenecks due to production interruptions, shipping delays, and overall rising geopolitical tensions. These are particularly noticeable in energy and food prices, affected by Russia’s invasion of Ukraine and international sanctions that followed. Additionally, the COVID-19 pandemic significantly interrupted the production of computer chips despite a rapidly growing demand, which has affected a broad range of downstream industries, particularly the motor vehicle industry.
Although major supply bottlenecks explain more than half of observed PCE inflation, its other parts remain unaccounted for. Russian-American economist, Abba Lerner, described another supply side-oriented inflationary phenomenon that applies to the current state of the U.S. economy. Seller’s Inflation describes how sectorized supply shocks can trickle vertically across the entire economy and cause elevated aggregate price levels. This is possible when the industries that remain unaffected from the shock are consolidated enough to allow its few remaining competitors to exercise monopolistic pricing power. As consumers hold imperfect information about pricing dynamics in each industry, firms who hold a significant share of their respective markets can increase prices to boost corporate profits.
Economists like Isabella Weber and Evan Wasner proposed a three-stage analysis of Seller’s Inflation in the current U.S. economy. At the impulse stage, price shocks occur that lead to initial price increases in affected sectors. If the stock is significant enough, it is propelled by upstream and downstream markets, leading to industry-wide price spikes to protect profit margins. However, this propagation can also lead to amplification, where corporations in other industries feel safe to increase their prices to boost their profit margins due to their relative market power and the public’s initial acceptance of increasing price levels. The last stage describes the conflict that occurs when employees attempt to protect their real wages from rising price levels.
This three-stage dynamic can be observed in the U.S. economy over the last few years. The COVID-19 pandemic represented an impulse that caused prolonged production interruption and frequent supply chain backlogs, particularly affecting computer chips due to global demand’s reliance on Southeast Asian markets. Furthermore, the War in Ukraine created a supply shock on global commodity prices, as both countries have been crucial exporters of energy resources and food products. The initial shock is well observed in the growing gap between headline and core PCE figures at the beginning of the war: headline increased from 6.3% before the war to 7.1% in June 2022, while core decreased from 5.4% to 5.2%.
As sectorized price increases in the motor vehicle industry contributed to 15.0% of PCE inflation by March 2022, despite a much smaller weight of 5.1% in its calculation, it is evident that this impulse amplified throughout the industry. Similar trends can be observed for food prices, particularly in Europe, where prices of substitute products have soared since the outbreak of the war. However, we can also witness an amplification effect in the U.S. Economy. Corporate profits have soared since the reopening of the economy and profit margins have expanded rapidly, illustrated by an above 70% mark-up premium on the marginal cost of certain products, significantly elevated from normal profit margins between 20% to 30%. Furthermore, the historically strong performance of the stock market coming out of the pandemic represented boosted profit margins as well.
Lastly, the U.S. economy has also seen an increase in nominal wages. While real wages have declined in recent years, nominal wages have started to increase significantly. In November 2023, the autoworkers union secured a nominal wage increase of 25% over the next four and a half years. Furthermore, 25 states are planning on increasing their current minimum wages during 2024. The evidence is overwhelming that employees have begun to worry about elevated price levels and protecting their real wages.
As the Fed sets out to fulfill its mission to stabilize price levels in the U.S. economy, it is questionable how effective interest rate hikes are to combat supply side factors, particularly Sellers’ Inflation. Although the Fed may succeed in bringing down inflation to 2%, it will come at a cost, such as the erosion of real wages persisting for the foreseeable future. With the rising development in the current global economy, the Federal Reserve will need to reevaluate their monetary policy and come up with a more nuanced approach to address the complexities of Seller’s Inflation.