(Bloomberg) -- Federal Reserve Chair Jerome Powell is dusting off the supply and demand curves every student learns about in economics to explain what the US central bank is doing to bring inflation under control.
The trouble is, his story only presents a best-case scenario.
At the heart of it is the idea of a vertical supply curve -- which Powell has cited during congressional testimony as a possible reason why inflation may fall as quickly as it has soared, without much disruption to economic activity.
In “Econ 101,” students learn that rising demand tends to push up prices, which then encourages producers to supply more goods and services.
In the current economy, however, it could be that in the labor market, unemployment is so low and workers have become so scarce that higher wages aren’t drawing more of them into the pool of available labor for hire. And in product markets, businesses have become so constrained by a lack of available inputs that higher prices no longer induce additional production.
If this is an accurate representation of the state of the economy, then it may be possible for the Fed to bring inflation down from its current four-decade highs without damaging employment and consumption. All it would need to do is push up interest rates until demand for labor, goods and services drops back.
Once demand and supply are in balance, inflation would then travel back down the vertical supply curve without affecting the number of workers employed or the amount of goods and services produced.
Easy Up, Easy Down
“If you have a model like that, one implication is ‘easy up’ with inflation at the vertical part, but also ‘easy down,’” said Gauti Eggertsson, an economics professor at Brown University in Providence, Rhode Island. “If they hit it right -- exactly right -- then in principle, one wouldn’t need to see that big of a recession. But that’s obviously very model-dependent.”
The Fed has in recent months dramatically accelerated the pace of increases in its benchmark interest rate and moved up its projections for that rate’s peak as inflation has shot higher. They raised rates by 75 basis points last month -- the largest move since 1994 -- and have signaled they will probably do so again when they meet next week. Government data published July 13 showed US consumer prices rose 9.1% in the 12 months through June, the most since 1981.
At the same time, Powell has increasingly faced questions about whether aggressive Fed tightening will plunge the economy into recession. The S&P 500 index of US stocks is roughly 18% below where it began the year and more and more Wall Street economists are saying they expect a downturn in the coming quarters.
The vertical supply curve story is the Fed chief’s latest attempt to answer those questions in a way that won’t add to the fears swirling in financial markets and on Capitol Hill.
“What we saw in the early part of 2021, when inflation went up, was very strong demand surged against what were unanticipated supply-side constraints, and the result was prices went up a lot,” Powell told senators last month in semi-annual testimony. “We have had what is, in effect, a vertical supply curve, where there isn’t any more supply, or a very-steep supply curve. So, you get really sharp increases in prices. You could get sharp declines for the same reason.”
That’s probably a good description of what’s going on in certain parts of the economy, like auto manufacturing and air travel, according to Omair Sharif, president of Inflation Insights, an independent research firm.
Poster Child
Auto manufacturing has arguably been the poster-child of pandemic inflation: Prices of used cars and trucks were 53% higher last month than in February 2020, according to Labor Department data. Sales of new vehicles, meanwhile, were 23% lower, according to WardsAuto.
Airlines have already canceled thousands of flights for the summer travel season even as demand ramps up. Delta Air Lines said July 13 in its quarterly earnings report that it would limit capacity throughout the remainder or the year, even in the face of continued strong demand.
“In the case of autos, it’s the chips problem, and in the case of airlines, it’s a staffing problem,” Sharif said. “I suspect that they would -- at least, certainly in the case of automakers, and also I think in the case of airlines -- say there’s money to be made by flying more planes and building more cars.”
But the analogy becomes more tentative when applied to the economy as a whole, the way Fed officials do when they point to elevated numbers of job openings relative to unemployed persons actively searching for work, and talk about the possibility of reducing demand for labor without actually reducing employment.
“In labor, it’s much harder to tell that story,” said Peter Williams, an economist at Evercore ISI in Washington. “The best likely set of explanations is that you have a relative decrease in supply and surge in demand for certain sectors, if not the economy in aggregate.”
Regardless, Powell and his colleagues have signaled they are prepared to accept higher unemployment to bring down inflation if necessary -- that is, if the labor supply curve isn’t actually perfectly vertical. Projections published after their most recent policy meeting last month showed they expected the unemployment rate to increase by a half-percentage point from the current level of 3.6% in the years ahead as they raise interest rates to reduce aggregate demand.
The Fed chief was careful to nod to that possibility when explaining the idea to senators a week later.
“In principle, if demand can move back down, then inflation could move to back along that path just as quickly as it went up,” he said. “In principle. No one’s guaranteeing that.”