The recent surge in inflation has been driven by both demand and supply factors as fiscal stimulus and low rates supported a boost in demand, while lockdowns put significant pressure on supply chains.
A common critique against current monetary policy is it’s a fairly blunt instrument, in part because interest rates only impact the demand side of the economy, not the supply side. Indeed, interest rate policy has no impact on supply chains or labor shortages but does influence the cost of consumption. With the Federal Reserve (Fed) committing to rates being higher for longer yet price pressures remain elevated, investors are considering if further rate increases will eventually bring inflation back down to target?
Analysis conducted by the Federal Reserve Bank of San Francisco1 attempts to capture supply and demand driven contributions to inflation. The study incorporates over 100 different goods and services in the personal consumption expenditure (PCE) index and identifies demand driven categories as those where an unexpected change in price moves in the same direction as the unexpected change in quantity in each month, and supply-driven categories are identified as those where unexpected changes in price and quantity move in opposite directions2.
The analysis yields some interesting takeaways:
- Higher interest rates do contribute to a decline in aggregate demand. In the last three recessions following a period of rising rates, the contribution of demand driven factors declined.
- Supply driven inflation can be quite volatile driven by several factors like supply chains and production capacity.
- The recent surge in inflation has been driven by both demand and supply factors as fiscal stimulus and low rates supported a boost in demand, while lockdowns put significant pressure on supply chains.
Going forward, as we highlight in a recent post, China’s reopening, the recent uptick in Manheim used car prices and elevated wage growth complicates the inflation outlook. The still large contribution of supply factors implies higher prices may not completely subside until labor shortages, production constraints, and shipping delays are fully resolved. Moreover, the elevated contribution of demand factors suggests the Fed may have more work to do.
To be clear, we do expect inflation will continue to decline in the months ahead, however, without a slowdown in growth or recession that forces a decline in demand factors, it seems unlikely inflation can return to 2%. Given this, investors should remain cautious in portfolios, as the Fed may decide it needs to do more to bring down demand in the economy.
1 Shapiro, Adam Hale. 2022. "A Simple Framework to Monitor Inflation," Federal Reserve Bank of San Francisco Working Paper 2020-29.
2 Unexpected changes in price and quantity are derived from a trailing 10-year window for both price and quantity. If the actual values of price and quantity are above or below their predicted values in the same direction, the category is labeled as demand-driven; if the actual values of price and quantity are of opposite signs, the category is labeled as supply-driven. If the actual values is statistically indistinguishable from their predicted values, the category is labeled ambiguous.