Temporary Supply Shocks Matter More Than Increased Demand To Inflation Bump

Inflation – the change in overall prices – is back in the news again. After a persistent decline from a year over year high of 9.0% in June 2022 to a recent low of a year over year increase of 3.1% in January 2024, inflation recently has stopped falling. Prices were 3.5% higher in March 2024 than in March 2023. This “not quite falling, not quite rising” pattern of inflation is something that happens even in a very low inflation environment and follows from isolated bumps in prices that have little if anything to do with more demand. Instead, they are related to supply shocks and possibly companies’ market power that keep prices from falling further. This also means that further tightening monetary policy – higher interest rates – will unnecessarily cause economic pain. Fighting climate change through regulations and investments in renewable energy, increasing the supply of housing, enforcing antitrust rules and fighting junk fees will be more productive ways to reduce inflationary pressures, even in the short and medium term.

The basic theory of demand driven inflation goes something like this. Strong hiring lowers unemployment. Low unemployment gives workers more power to ask for higher wages. More jobs and higher wages drive demand higher for a wide range of goods and services. The additional demand translates into higher prices – inflation. The Federal Reserve then supposedly has to slow demand by raising interest rates and reduce inflation since higher interest rates cut economic activity, increase unemployment and lower demand.