Demand Must Be Destroyed

There is a narrative out there that when prices are high, we can happily resolve the issue by producing more. After all, inflation occurs when too much money is chasing too few goods. So increasing supply is an intuitive solution. But it’s largely incorrect.

The premise ignores the cost of increasing supply. Unless unutilized capacity is already in place, the production of more goods and services requires additional capital investment (plant and equipment) and variable expenses (hourly labor, raw materials). In other words, the effort to increase supply concurrently increases demand and is counter-productive.

As mentioned earlier, this isn’t true in all cases. Companies with unused capacity or inventory might be able to add supply without incurring extra expenses. Or, the excess expense might be minimal in relation to the increased supply. However, this might prove to be temporary, if achievable, and difficult to anticipate in advance for a broad economy.

The Federal Reserve has some idea of broad capacity utilization and labor slack throughout the economy, but generally the idea you can grow out from under inflation is unrealistic and risks entrenching inflationary expectations.

A more realistic and unequivocal resolution to high inflation is to destroy demand by slashing fiscal budgets and tightening monetary conditions. Lower government spending and higher cost of borrowing are blunt instruments that, if used with vigor, will undoubtedly destroy animal spirits. By definition, the economy must slow if demand is to be reduced.

There is no precision to any of this. The Federal Reserve doesn’t really know how little is too little and how fast is too fast when it comes to monetary policy. So we get policy rolled out in increments. Try a little of this and a little of that to see what works. Today, the problem is the Fed is so far behind that this incremental approach – and the soft landing they hope for – is like fighting a forest fire with a garden hose.

Again, while this is part art and part science, one way to illustrate inflation’s lead is the gap between the Federal Funds rate and CPI. The chart below shows this gap is at its widest point ever. To get prices under control, the line likely needs to migrate far above zero (a point at which the Fed Funds is greater than CPI) to effectively choke inflation. Look at what Volcker had to do in the early 1980s to get inflation under control. What do you think Powell needs to do to get inflation back to his stated 2% target?

My point is simple:

1: Supply increases will only partially mitigate inflation at best, and stoke further inflation at worst.

2: Demand destruction is the simplest way to control inflation, and the Fed is so far from its target that economic conditions are likely to worsen beyond what most anticipate.

Bonus point: When will this be over? Problems like these aren’t resolved quickly. It will likely drag on for months. There won’t be a checkered flag to mark the end, but a steepening yield curve after several Fed Funds rate decreases (in the face of demand erosion and thus inflation declines) will be a positive sign. I think the big question at that point will be whether higher inflation will return once demand returns.

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