An a recent WSJ oped (which I will post here when 30 days have passed), I criticized the “supply shock” theory of our current inflation. Alan Blinder responds in WSJ letters
First, Mr. Cochrane claims, the supply-shock theory is about relative prices (that’s true), and that a rise in some relative price (e.g., energy) “can’t make the price of everything go up.” This is an old argument that monetarists started making a half-century ago, when the energy and food shocks struck. It has been debunked early and often. All that needs to happen is that when energy-related prices rise, many other prices, being sticky downward, don’t fall. That is what happened in the 1970s, 1980s and 2020s.
Second, Mr. Cochrane claims, the supply-shock theory “predicts that the price level, not the inflation rate, will return to where it came from—that any inflation should be followed by a period of deflation.” No. Not unless the prices of the goods afflicted by supply shocks return to the status quo ante and persistent inflation doesn’t creep into other prices. Neither has happened in this episode.
When economists disagree about fairly basic propositions, there must be an unstated assumption about which they disagree. If we figure out what it is, we can think more productively about who is right.
I think the answer here is simple: To Blinder there is no “nominal anchor.” In my analysis, there is. This is a question about which one can honorably disagree. (WSJ opeds have a hard word limit, so I did not have room for nuance on this issue.)
Suppose there are two goods, TVs and hamburgers. Chip production problems make TVs temporarily scarce. We agree, the relative price of TVs must rise. TVs could go up, hamburgers could go down, or half of both. When the chip shortage eases, the relative price goes back to normal. TVs could come down, or hamburgers go up.
In Blinder’s view, TV prices go up now, and hamburger prices catch up when the chip shortage eases. (“Inflation creeps in to other prices.”) The reason, true enough, is that prices are stickier downward than upward.
As Blinder writes, a half century ago monetarists started making an “old argument” against this analysis. Informally, they pointed out that people have to have enough money to buy TVs and hamburgers at higher prices. If they don’t, the price level cannot permanently rise. Maybe TVs go up temporarily, but if people don’t have enough money to pay the higher prices, those downwardly sticky prices eventually drift down.
A bit more formally, monetarists start with MV=PY, money times velocity equals overall price level (TVs and hamburgers) times overall quantity. Without more M, PY cannot go up. In the short run with sticky downward prices, we’ll have less Y. But lower demand for hamburgers eventually causes sellers to lower their prices, and when the chip shortage eases lower demand also brings back the price of TVs. Without more M there is, eventually, no more P.
So to monetarists, a “supply shock” would indeed first raise the price of TVs, and thus the measured price level. But lower demand for TVs and hamburgers means the price level eventually comes back to where it was, as I had stated.
MV=PY is a “nominal anchor.” It is a force that determines the overall price level. Relative prices changes cannot change this overall price level, once we get past the price stickiness that sends some demand into output.
My analysis also has a nominal anchor, fiscal theory, that nails down the overall price level, while allowing some stickiness in the short run. The difference between fiscal theory and monetarism or some other theory does not matter for today’s discussion. (Exercise for the reader: do new-keynesian models have a nominal anchor, and if so what is it?)
Now, how does Blinder avoid this logic? Simple. In his view there is no nominal anchor.
There are two kinds of economic analysis that removes the nominal anchor. First, the nominal anchor simply may be absent. Standard 1970s ISLM analysis, the subject of an eloquent elegy (eulogy?) in Blinder’s recent book, does not have a nominal anchor. The price level today is whatever the price level was yesterday plus whatever supply and demand shocks move it around today. The MV=PY constraint on the overall price level is simply absent. Given Blinder’s writing in favor of ISLM and against everything that has happened since, I think this is the basic disagreement in our analysis.
So you have it: If you think there is a nominal anchor, then you’re with me: Supply shocks without more demand (more M, more debt), cannot permanently raise the price level. If you think there is no nominal anchor, and prices are whatever they were yesterday plus shocks, then Blinder’s analysis that supply shocks can set off inflation that does not reverse, and permanently raise the price level, is possible.
A second possibility: There is a nominal anchor, but it is passive. In a monetarist analysis, a supply shock comes, that raises the price of TVs because hamburgers are sticky downwards. The Fed, not wishing to see a recession, “accommodates” this supply shock by printing more M, so the price level goes up. And in monetarist analysis an interest rate target automatically provides that sort of accommodation, which is why they don’t like interest rate targets.
This is a standard analysis of the 1970s supply shocks. They didn’t cause inflation directly, but they did induce the Fed to accommodate, to print up more money, which allowed broad-based inflation. Indeed, that might be a good fiscal theory story for recent inflation, merging supply shocks and fiscal theory. Why did the government send $5 trillion to people? Exactly so they could pay the higher prices, and no price had to fall. It worked like gangbusters. Facing the energy shortages after the Ukraine war, Europe subsidized demand with fiscal transfers to much the same effect.
I don’t think Blinder is making this argument, though. If that’s the argument, the “supply shock” really still isn’t the important driver of inflation. The inflation would not happen without the Fed (or fiscal policy) giving people the money to pay the higher prices. It’s a supply-induced demand shock. The emergence of inflation is still 100% tied to loose monetary and fiscal policy. It’s just making a plea that this inflationary policy was a good idea, avoiding painful price declines in some goods and wages.
A minor rhetorical complaint: “This is an old argument that monetarists started making a half-century ago,” Old arguments aren’t necessarily bad. Adam Smith made the argument that free trade is good 250 years ago! And if “old” is an insult, I might point out that ISLM hasn’t been publishable since about 1980, while “new” Keynesian models, which work in a completely different way, have been the rage.
I emailed Alan, who answered in part,
The Fed’s reaction function is the nominal anchor, but for the inflation rate more than the price level.
This is an interesting and important comment, and I think it is representative of the standard view. It’s halfway between the two views I articulated. There is no natural nominal anchor – no M in MV=PY or no B in B/P = expected present value of surpluses (fiscal theory alternative) – that constrains the price level. The price level is wherever the Fed drives it by interest rate policy (the “standard view” of “interest rates and inflation part 1” But for a supply shock to cause inflation in this view, there must be monetary accommodation. The Fed could run a price level target. It would raise interest rates to keep the price level from rising, or to bring it back after a shock. The Fed could run an inflation target. It would raise interest rates to keep the price level from rising. So inflation does not really emerge as a pure “supply shock.” It is supply shock + demand accommodation, via the interest rate policy.
Back when OPEC I struck in 1973-74, many monetarists denied that it could possibly cause inflation without a rise in M.
The argument has indeed been around for a while. Did M rise? I’ll leave monetarists to the history on that one.
To be clear in this sequence, I used MV=PY as an easy illustrative example. I think there is a nominal anchor, but it is fiscal theory not monetarism. And I acknowledge that Blinder’s “standard view” is most prevalent in policy commentary.
A correspondent reminds me of basic IS/LM AS/AD. Do not confuse a “supply shock” — a relative price movement — with an “aggregate supply shock” — a shock that makes the overall price level, and wages, rise for a given level of output. The latter is a Phillips curve phenomenon. They may be related in the depths of Keynesian thinking, but they are not the same, and it is a bit of a mistake to jump from one to another.