Supply, Demand, and Stagflation
Why the Economy Suffered in the 1960s-80s, and the Risks for Today
What’s going on with inflation? Is it driven mostly by demand, or supply shocks? Is the Fed going to get the situation under control; or are we headed for a persistent period of stagflation?
It’s helpful to contrast our situation to the newly relevant inflationary period from 1966-1982. In the standard account: the Fed let inflation get out of control, and Volcker needed to hike aggressively (a Taylor coefficient >1, or raising rates more than 1-1 with inflation) and risk recession to re-anchor inflation expectations. The revisionist version by my colleagues Itamar Drechsler, Alexi Savov, and Philipp Schnabl (DSS) instead puts the blame on Reg Q — a piece of financial repression which prevented deposit rates from rising, and so meant that rising inflation led quickly to out of control consumer spending.
This period also featured another element relevant to modern debates — the stag part of stagflation: the possibility of supply side shocks that coincide with higher inflation. How can we understand that aspect of history, and understand the supply and demand side determinants of inflation today?
What was Behind the 70s Stagflation?
In the period from 1966-1982, inflation and GDP growth were very negatively correlated. To generate that, you need some sort of negative supply shock to account for prices rising while output falls. Some of this was the oil shocks in 1973 and 1979, but this relationship shows up even before the oil shocks as well. So what can explain the negative supply shocks then in that period?
DSS have a new paper which argues that the Reg Q ceiling can explain those too. Remember, Reg Q was a limit on the deposit rates which banks could offer. Before Money Market Mutual funds and other shadow banking institutions, this became a binding constraint on the interest rates people received. So as inflation got high, and the Federal funds rate rose, deposit rates could not keep up. And we see deposits fleeing the system whenever these rates get really binding:
The consequence of deposit flight is that bank credit dried up, generating a negative supply shock, and tough financial conditions. According to the Chicago Fed index — this period actually saw worse financial conditions than the height of the global financial crisis. Now, financial shocks turn out to have indeterminate impacts on prices. In the financial crisis itself, firms faced financial constraints but also weak demand, which led to only moderate price pressures. But in the 1970s, financial constraints combined with strong demand amplified inflation. So instead we see firms cut production, unfilled orders rise, and prices rise.
There’s a lot more in the paper, including cross-sectional tests which compare areas where banks were more or less exposed to Reg Q, and industries which were more or less credit sensitive to flesh out the story, but you can get the main picture from the time-series plots.
So what does this mean today? We see pretty severe supply chain shocks from two channels: (1) the pandemic itself, which has led in particular to a re-routing of consumption across durable goods and services; and (2) monetary policy shocks leading to tightening financial conditions.
We don’t have Reg Q anymore, so the specific channel of financial repression cutting bank credit is unlikely to happen. But we still see the effects monetary policy tightening on rising spreads and tighter financial conditions. Unfilled durable goods orders are also rising a bit; which points to possible stagflation concerns through supply shocks. At the same time, demand has been up a lot as well, and the composition has shifted across goods categories.
To tease apart the effects of supply and demand here, one thing we can do is look at the correlation of inflation and output. The more that the supply-side is determining output, we would expect a negative correlation (as in that 1970s period); whereas a positive association of inflation and output would point to demand side factors instead.
I think what you generally see is that demand seems relatively more important in the US; and supply shocks are a bigger deal in Europe. In the United States, you have substantial amounts of income saved over the pandemic (“excess savings”) as well as stimulus funds which provided a substantial boost to consumption above trend. That’s combined with supply shocks across many pandemic associated industries — oil refining capacity, for instance, which seems down. Europe by contrast appears to have a more pure stagflationary situation as they are experiencing a lot of inflation even while consumption and output hasn’t gone back to trend. A lot of that seems to be related to a relatively bigger energy shock with the Russian invasion. Another diagnostic is the greater rise in nominal wages in the US compared to Europe; which also points to more demand-led factors in the US.
The situation in real estate is worth focusing on here in more detail. Mortgage rates have been rising quickly of course — mortgages are priced relative to a 10-year Treasury rate, and those have gone up too. But we also see the spread between mortgages and the risk free rate go up a lot too; it’s now about ~240 basis points. In normal times this is between 150-200 basis points; the financial crisis saw about a ~285 spread at the peak, and March 2020 had a ~265 spread. So we basically have crisis level spreads on mortgage products, which are going to directly hit housing markets.
The problem here is the convexity of mortgage bonds — the fact that homeowners are going to get “locked in” and not move in high rate environments, which lengthens duration. For Fannie/Freddie products which are the bulk of the market, the government covers defaults and understanding prepayment risk is the main hurdle.
Hedging this sort of Delta risk resulting from households’ prepayment option is getting more expensive, and investors are demanding more compensation for purchasing MBS — they recently went “no bid” which shows the lack of investor appetite. Adding to these issues is the fact that the Fed has stopped buying MBS and has begun Quantitative Tightening. The Fed doesn’t hedge its MBS book, while ordinary investors do, so shifting the composition of ownership is going to increase the market risk compensation for bearing prepayment risk.
We’re also seeing substantial declines in housing starts as the impact of these higher rates and tightened financial conditions works its way through the system. Now, part of the point is demand destruction by addressing the wealth effects of high house prices (realized often through cash out refinancing). But while that part is good; the financial repression also destroys investment, which is also broadly necessary for lower prices by increasing supply and keeping rents down in the long-run.
Daniel Dias and João Duarte have a great paper on the differing effects of monetary contraction in housing. Contractionary shocks lower prices; but they actually raise rents: people switch to renting rather than owning, which pushes up rents. Housing investment is also such a large cyclical component of output that people have argued that housing itself really is the business cycle. Now, Dias and Duarte still find that inflation overall goes down with contractionary shocks — it’s just that the shelter component of inflation has different trends, and is a bit more “stagflationary” to the extent that worsening financial conditions actually worsen the ability to address rental inflation in particular.
So do these observations suggest monetary policy should work any differently in stagflationary times? The problem with the standard toolkit — using interest rates, either short or long term to shift demand — is that it has these additional unintended knock-on effects which worsen the supply side. Interest rates are sort of a weak tool to affect consumer demand, and have only indirect effects there through other financial conditions. Financial conditions do ultimately hit consumption; but even some of those channels are a little weak, and they coexist with fairly strong channels which hit investment.
Back in the 1940s, when the US was also dealing with complicated inflationary dynamics coming out of WWII and restarting the domestic economy, the prevailing view of a lot of people including Milton Friedman is that actually fiscal policy should do the brunt of macroeconomic adjustment instead. He co-wrote a whole series called “Taxing to Fight Inflation” for instance. The basic logic here is that if you take the older Keynesian view in which consumer spending is sort of “hydraulic” and a function of income; taxing that income should result in immediate and straightforward shocks to consumption.
Then we had several decades of an intellectual revolution which featured Friedman himself shifting to a more monetary basis for countercyclical policy; the “Woodfordian” revolution which sees interest rate management as isomorphic to other forms of demand management; and the rational expectations revolution which emphasizes far sighted consumers shifting consumption according to marginal rates of substitution through an Euler equation.
I don’t want to get into this, except to note that in the recession side, I think people have generally been convinced back to the old-Keynesian ideas to use fiscal tools in conjunction with monetary ones in recessionary periods. There seems to be general agreement that interest rates alone aren’t enough to manage demand in bad times (due to the ZLB and other issues); and so you need the fiscal authority to partner along and send checks, etc.
The problem is that we haven’t updated demand management in the boom times — so we don’t generally accept unconventional tools to manage excess demand, and are stuck with the interest rate channel which has those various downsides.
Setting aside the political issues; from a purely macroeconomic stabilization perspective you could imagine lots of progressive taxes which would address excess demand without as much damage to the supply-side. You can also imagine lots of interventions designed to shelter investment, as much as possible, during the downturn while letting demand get hit.
Arnab Datt and Skanda Amarnath have an interesting brief on what that might look like at Employ America. These include things like using the Strategic Petroleum Reserve and Exchange Stabilization Fund to stabilize future commodity demand, to encourage energy production. And, on the housing side, addressing material shortages and providing backstop funding through tools like LIHTEC and HUD’s Housing Trust Fund. Despite all of the federal government’s involvement in housing and real estate, we do relatively little to address one of the biggest market failures in the area — that highly cyclical boom-bust pattern in housing investment, which has led to housing investment dragging out for years after the GFC.
I think this is a really underrated problem. It’s easy to engage in theorizing about investment demand and think that the problem is tech firms which don’t need capital. But if you look at the data, you’ll see that tech investment makes up a sizable fraction of the economy, and has actually risen a lot since the pandemic due to remote work. If you want a sector of the economy that has unusually low investment demand — and which might therefore account for secular stagnation and low rates — you want to look instead at housing, where investment has lagged for years after 2008.
You know about the Sunbelt migration in the US. But what does it look like in other countries? In Spain, there has actually been a pretty massive rural exodus over many decades:
And in Russia you see that some of the fastest parts of the country are in their warm-weather sunbelt region around Krasnodar:
The Greg Clark-strain of economic history — investigating long-run persistence of social elites — is really fascinating. Here you see the pre-revolution Chinese elite managed to weather Communism and the Cultural Revolution to be doing still relatively well today.
A great paper by Nicolas Coeurdacier, Marc Teignier, Florian Oswald on the structural transformation. They argue cities have grown substantially less dense over time, and sprawled into the countryside, as agricultural productivity has lowered the value of farmland relative to urban space. Transit improvements grow endogenously as a result to boost speed.