US inflation: it’s mainly global

To hear many pundits tell it, sky-high inflation in the US – 9.1% in June – is the outcome of the misguided policies of the administration and the Federal Reserve. But it is exceedingly unlikely that today’s surging prices owe entirely to the profligacy of the $1.9 trillion Covid-relief plan president Joe Biden signed last year, or to the Fed’s failure to act quickly enough to tighten monetary policy. The fact of the matter is that inflation is a global phenomenon, and all kinds of countries with all kinds of policies are now confronting the steepest rise in prices they’ve seen in 40 years. And the lion’s share of this inflationary surge has been, at least so far, beyond the control of governments or central banks.

The chart below tells you, if not everything you need to know, then at least quite a bit of it. It relates recent rates of inflation in advanced economies, shown on the vertical axis, to their average inflation in pre-pandemic times, shown on the horizontal axis. It shows so-called “core” inflation rates because unlike “headline” inflation rates, these exclude the direct effects of skyrocketing food and energy prices, which owe more to the global economic recovery, Russia’s invasion of Ukraine, and oil supply decisions than to national fiscal and monetary policies. To further abstract from the global disruptions of the Russian invasion, it focuses on inflation as of March of this year.

1. Higher pre-pandemic inflation leads to higher pandemic inflation

The chart shows us, first, that most advanced economies are experiencing inflation well in excess of their (usually) 2% targets. Clearly, the factors pushing up inflation in the US – supply chain dislocations, rebounding demand as the pandemic eases, and the pass-through of rising food and energy prices into the prices of other goods and services – are at work throughout the global economy.

Second, countries that had comparatively high inflation before the pandemic have comparatively high inflation today as well. This can be seen in the blue trend line linking Switzerland, the perennially low-inflation country in the bottom-left corner of the chart, with Iceland, the persistently more inflationary country up in the top-right corner.

Moreover, the slope of that trend line is quite steep, at 1.76. This means that higher rates of pre-pandemic inflation are not only associated with higher current inflation, but also with larger increases in current inflation over pre-pandemic inflation. The reasons for this are not mysterious: in economies with lower inflation, wages and prices are less likely to be sensitive to expectations of future inflation, and those expectations, in turn, are less likely to respond to supply shortages and soaring energy and good prices.

This helps to explain why the US tops the global leader board for core inflation. Unlike in Japan and the euro area, whose central banks spent years striving unsuccessfully to reach their inflation targets, US inflation averaged a more normal pace – near the Fed’s 2% target – in the years before the pandemic hit. This set up inflation in the US to respond more fully to the shocks hitting the global economy once the pandemic started to ease. Indeed, as is evident from the chart, most of US core inflation appears to be explained by its pre-pandemic inflation alone.

What about the part of US core inflation not explained by its pre-pandemic trend? In research with my colleagues John Kearns and Michael Strain, we found that among a broad array of indicators, only a few measures help to further explain differences in core inflation rates among advanced economies, and those are all indications of demand pressure: the change in job vacancies, the growth in real private consumption, a measure of “excess saving” during the pandemic period, and the growth of M2 (cash, reserves and short-term deposits).

Our preferred model predicts (in-sample) US 12-month core inflation of 6.6%, close to its actual March value of 6.4%. Of that prediction, 3.4 percentage points represents the contribution of pre-pandemic inflation and 2.6 percentage points stems from the stupendous rise in US job openings over the past couple of years.

Thus, our research supports the views of other economists that much of the rise in US inflation owes to strongly rising demand, and some of this may indeed be attributable to stimulative fiscal and monetary policies. But even more of that rise reflects a factor largely ignored in recent commentary: the role of moderately high (compared with other advanced economies) US pre-pandemic inflation in also supporting current high inflation rates.

This finding does not excuse US policy-makers from their responsibility to contain and reduce current high inflation rates. But it does emphasise that much of the surge in inflation in the US and elsewhere was not solely the result of policy choices: it likely resulted from the interaction of pre-existing inflationary dynamics with the shocks to aggregate supply, demand, and commodity prices that have occurred over the past couple of years.