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.
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