The New Frontier: Debating Inflation
Last Week’s Interview with Bloomberg and a Notes on the Crises 2021 Theme
For a long time now I’ve been thinking about, and foreseeing, a widespread turn to concerns about inflation. Early on in the pandemic I was concerned that supply chain disruptions coming from the abrupt shift to producing in pandemic conditions would lead to an inadequate fiscal response to the pandemic out of inflation concerns. It turned out that those supply chain disruptions were less dire than many feared- but disconcertingly because workplaces tended to not close and let employees bear the burden in the form of illness and death. Meanwhile, debates over the latest Covid relief packages in congress have not really focused on inflation or the availability of physical resources (I’ll have more to say about the latest relief package in the future). Yet we have seen price increases in commodities whose prices are determined on international chartered exchanges and supply chain disruptions have still led to unprecedented delays in deliveries and accumulating unfilled orders.
This is also a topic I’ve long been interested in, so I was excited to explore it with Joe Weisenthal in an interview for his weekday newsletter. Given that this topic isn’t going away, I want to write about it more regularly in 2021. To do so, we need to break down this big complex concept into its constituent parts. What is “inflation”? How is it measured? How are prices set? How frequently do prices change and how often? I have been working on developing a continuation of my #MonetaryPolicy101 series on this topic but I've had a lot of materials to review and it has been slow-moving work. In the meantime, enjoy this interview which focuses on price changes and “non-price adjustments” to big changes in demand in our current context.
Inflation measures like the CPI remain mild. Yet it's clear that there is a lot of stress happening to global supply chains. During the recent earnings season, retailers talked a lot about delays and shipping logjams hampering their business. And if you read through the latest ISM Manufacturing report -- although it was strong -- basically every comment from a company was about how much of a mess the supply chain is. This raises an interesting question. Why don't more companies just raise prices to balance out supply and demand, rather than allowing backlogs and shortages to emerge? To answer the question, I conducted an email interview with Nathan Tankus, the author of the must-read newsletter Notes On The Crisis. Nathan's work is grounded in MMT, heterodox thought, and does a great job of explaining why prices don't just automatically balance out supply and demand like the textbooks would say.
Below is a lightly edited exchange. Nathan's answers are indented.
To start from a high level: Why don't more companies just raise prices to balance out supply and demand?
Well first it's important to recognize that companies have options besides instantaneously balancing supply and demand. In fact, the first thing that happens when a company receives an additional order is that their order backlog increases. A company doesn't have to respond to that instantly and in fact how quickly the company responds is a strategic choice up to its discretion. Economics, especially economics textbooks, confuse us on this point by focusing on equilibrium. In textbook economics equilibrium, there are zero-order backlogs and output perfectly balances with demand, though we aren't told as such.
There is some more recognition of this "non-price" adjustment in higher level economic studies, but we still know relatively little about the motivations behind it. One of, if not, the first economic surveys to produce evidence on non-price adjustment to changes in demand comes from Alan Blinder's path-breaking book Asking About Prices. In that work we learned that non-price adjustments to demand were very important in practice and that they were most prominent among businesses that felt they had "implicit contracts" with their customers not to raise prices. This is easy to understand when you remember that these demand circumstances are likely temporary and it is unwise to leave customers feeling like you bilked them when you had the chance.
Another element that is surely driving order backlogs right now are the supply-chain linkages across the economy. A company waiting on raw materials has no ability to speed up the process so raising prices to reduce their order backlog will just hurt their cash flow without any benefit to them. In this way bottlenecks and shortages tend to propagate throughout the economy from an initial disruption.
Got it. So obviously in some cases, supply or demand shocks do result in increased prices. Used car prices went up a lot over the last year. Things like airline tickets and hotel rooms seem to fluctuate. Is there any general guide to when an industry or category of good is more likely to see one or the other (price increases or longer lag times) in response to a supply-demand mismatch?
I think generally a good place to look is whether more of the product can be produced easily. By definition you can't increase the production of used cars. (Nonetheless, price increases might get big enough to get people to sell a used car they wouldn't otherwise sell). Antiques are a very obvious example here. Commodities are an important example because their transaction prices are based on formal exchange market prices. Bids on exchange markets aren't identical to demand for commodities to be used in production, but they are often related. It takes a very concentrated and/or coordinated degree of supply -- along with large 'buffer stocks' -- to prevent procyclical variations in exchange market prices. This, in and of itself, is related to product characteristics because a product needs to be standardizable for it to be tradeable on international exchange markets.
Hotels, airlines and rental housing are kind of in the category of products that can't be "produced easily" as well. But more than product characteristics, it seems to me that these sectors' price responses are driven by the transition to algorithmic pricing. Airlines, of course, used to have quite stable prices and even when those got more flexible, I think the strong response to demand conditions emerged with algorithmic pricing strategies.
Generally a product that is easily storable, more closely associated with tightly drawn ongoing business relationships, and not standardizable -- and/or very associated with managing a specific brand -- is more likely to lean towards varying delivery times and building up unfilled orders than changing prices in response to demand changes.
So last question and it's a two-parter. Does the logic of non-opportunistic exploitation of disruption apply more to consumer companies than business-to-business operations. In other words, would a supplier of, say, semiconductors to video-game console makers be more comfortable hiking prices than, say, an end-vendor of refrigerators to consumers? Also I know in general, the MMT view is that inflation is the limiting factor when thinking about the constraints on spending and economic activity. How should we think, from a policy perspective, about real-resource constraints that don't show up in price, but rather in delays, shortages or other bottlenecks?
I think business-to-business suppliers are even more likely to not hike prices because of temporary demand changes than consumer companies. The relationship of brand to end consumers is nebulous and fluid. Meanwhile there are all sorts of psychology-inspired tools for managing relationships with end consumers that don't rely on a lack of price changes. It's hard to know when you have a relationship with an end consumer. On the other hand, business-to-business suppliers are having direct conversations and directly managing relationships with other businesses who have employees whose job is to think about those relationships. End consumers may be temporarily ticked off by opportunistic price changes but forget about it over time. A business which mainly supplies another business could lose a significant percentage of their contracts in a slower time period and permanently harm their multi-year sales expectations. I think this is reinforced by the trend in recent years to "value-based pricing" in business-to-business markets where a business may be setting a higher profit mark-up on a specific contract oriented around providing a higher level of "service" and justifying it by the "value" being created for the purchaser.
An opportunistic price increase eats into that projected "value" and isn't worth losing a customer you've invested resources into retaining. Of course, if businesses need to raise prices they will. But I think price increases are more likely to come from cost-changes e.g. the cost of commodities than demand conditions.
As for MMT, I've long been pushing the idea that while inflation is a good first approximation for the constraints on fiscal policy, it is not by any means an exact one. The much more direct and obvious constraint is the state of unfilled orders across industries. Whether or not price increases are happening, shortages are a constraint on conducting additional economic activity. In this respect I think the Op Ed I coauthored with Professor's Scott Fullwiler and Rohan Grey was quite prescient. In it we said:
"Regardless of which policy tool is used in a particular context, demand management in general needs to lean much more heavily on the appearance of bottlenecks in specific industries instead of simply tracking changes in a general price index. The immediate signs of bottlenecks are large and sustained rises in unfilled orders for specific goods and services. Preventing shortages is after all what demand management is first and foremost about and price indices are misleading policy targets when they include factors that are insensitive to demand and would be counterproductive to manage with demand."
The optimistic element of this is that if unfilled orders and bottlenecks are well managed, non-financial regulation can help prevent the opportunistic price increases that do happen and leave further scope for stimulative economic policy when that's warranted.
Anyway, definitely follow Nathan and of course check out his newsletter.