Inflation = Nominal Growth – Real Growth

At Full Stack Economics Alan Cole puts the inflation debate in the simplest possible terms: inflation is the difference between the nominal growth and real growth. We have a pretty good idea of the shape of the nominal recovery. Now the hard question: what’s the shape of the real recovery?

The next question is simple: how well can our real economy produce the things people want? We have two problems. The obvious problem is that COVID-related inconveniences have made people less efficient at their jobs. A subtler problem is that COVID-19 made consumer demand less predictable. For example, producers were surprised at the beginning of the pandemic when more people wanted goods delivered, and fewer people wanted in-person services, for reasons of safety or convenience.

Compounding the problem, a lot of people suddenly wanted big durable goods, like at-home exercise bikes, for their homes. But it’s not clear if this increased spending will continue in the future. As our friend Joseph Politano of Apricitas notes in his most recent post, “durable goods are, well, durable,” so once that demand is sated it could easily reverse.

In short, the combination of workplace inefficiency and unexpected shifts in demand has resulted in less total production, contributing to inflation from the supply side, or “real” side, of the “inflation equals nominal minus real” equation.

which is a succinct statement of why I’ve been harping that policy should be focused on increasing production.

He then turns to pondering what will happen regarding inflation. If incomes rise slowly and moderately, we may well have “transitory inflation”. Transitory can either be “happy” or “sad”:

The happy transitory scenario is where we defeat COVID-19’s major inconveniences and get a V-shaped recovery in the real economy. This would mean that scarce items like autos rebound to full production, the efficiencies of the pre-COVID era return, and plentiful production races to return prices back towards normal levels.

In these circumstances, we could see incomes rising strongly even as inflation falls below 2 percent. The price level forms an upside-down V, rising sharply and then declining in the recovery. We might even get a bit of deflation that “makes up” for the bad inflation we suffered earlier. While deflation is an ominous sign if it signals the start of a recession, falling prices produced by rising productivity can be a healthy sign.

In the sad transitory scenario, on the other hand, many COVID inconveniences stay with us forever. This creates unpredictable problems and slows down production, producing an L-shaped recovery. We eventually learn workarounds, but we won’t be as rich as we would have been in a world without the virus. In this scenario, the price level forms an upside-down L, so prices rise sharply and stay at those elevated levels without any “make-up” years of low inflation.

I’m concerned that legislators will perseverate on the pump-priming measures they’ve been using for decades without paying any attention to production and that the Federal Reserve will delay their remediating action which, in general, works against that fiscal policy.

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