Excess Demand for Goods Caused Supply Constraints

Was the recent rise in inflation caused by supply constraints or excess demand? The answer is vitally important for monetary policy. The Federal Reserve can’t do much about supply-chain issues, but it can influence the pace of demand. There is no question that supply chain issues are hampering firms’ ability to supply enough goods and services, which is driving up prices. But much of the supply issues in goods markets have occurred BECAUSE there is too much demand. The combination of expansionary monetary and fiscal policy during and after the lockdowns fueled demand beyond levels that firms could comfortably satisfy. So although there is ample evidence of supply constraints pushing up inflation, the actual root cause was too much demand – which is something the Fed can address.

A look at retail sales gives a clear picture of the excessive amount of spending that has occurred in 2021 and 2022 (Figure 1). Prior to the pandemic, consumer demand for goods was running at a pace that was close to its long-term trend. We can view this trend line as the steady state growth rate – the pace that spending can grow without generating supply-chain issues and ultimately inflation. In other words, the trend line in the chart represents the maximum amount of retail sales that will not generate demand-led inflation pressures.

If we extend the trend line from before the pandemic to the present, we get a sense of what steady state spending on goods would look like today. You can see that actual spending has far exceeded this steady state pace. Retail sales averaged $100 billion per month higher than trend for the past year. That is a lot of excess demand, and firms have had a hard time keeping up. The drive to match demand resulted in bottlenecks and supply-chain breakdowns, which in turn caused rising demand for inputs (including energy) and rising inflation.

We can see the dynamics of how this excess demand ignited inflation by looking at real and nominal consumer goods spending together (Figure 2). After the bounce back from the pandemic lockdowns, consumers responded to the stimulus with a further surge of spending that created excess demand conditions. This was evident in both real and nominal spending. However, as firms struggled to satisfy the demand, prices began to rise faster, which limited consumers’ spending power and real (inflation-adjusted) spending. The widening gap between real and nominal spending represents the shift to rising inflation.

There really is only one solution for the current inflation problem. Demand has to downshift back to trend. The Fed can engineer slower demand, and has taken bold steps by raising rates by 150 basis points in two meetings. But it must be willing to maintain tighter policy as demand weakens or risk an intractable inflation problem.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.