This Spring’s big betting questions are, Which team will win the NBA crown? What Broadway musical will capture the Tony Award? And why is inflation still so low? Wall Street and the Federal Reserve are more puzzled by the last question than the first two. Here’s the answer: the economy is enjoying a supply-side shock. It is a good thing, and it is not going away soon.
(A shorter version of this post appeared in today’s Wall Street Journal.)
What is a positive supply-side shock? Consider a simple story. Let’s say that you live in a remote village that gets its fuel from a single oil well. Then a neighbor, call him Jed Clampett, fires a shotgun while hunting varmints and, as a result, up from the ground comes bubbling crude. Suddenly, the village has twice as much oil, and the price will go down. Now, what happens if this same type of phenomenon (not the varmint-hunting) erupts in other sectors?
Every college economics student learns about the “production function,” a simple formula showing that output is a function of land, labor, capital, and technology. The more inputs, the more stuff people can create. The Internet and globalization are effectively increasing the magnitude of these factors.
Wait a minute, how can we have more land? Am I talking about reclamation, the Chinese building weaponized new islands in the sea, or 14th century Holland diking up swamps, which inspired the adage, “God created the world, but the Dutch created the Netherlands”? No, I am talking about companies like Airbnb that take idle rooms and dump them onto the market. This effectively increases the supply of land available and curbs the price of vacations. Airbnb, which boasts over 6 million listings worldwide, has increased the number of available vacation rooms by over 25 percent in U.S. cities.
With that massive influx, the hotel industry’s favorite measures, Average Daily Rates and Revenue per Available Room have lagged GDP growth. The shock is not over. Just this week, Marriott announced it was going head-to-head with Airnnb by launching a home rental business.
How can physical capital magically grow? It’s not magic, but upstarts like Dozr and Yard Club have boosted the supply of equipment by creating a kind of Uber for earthmovers and dump trucks. We used to see yellow Caterpillar trucks sitting idle at construction sites awaiting the start of some scheduled task. Now those trucks are available to work elsewhere during off-hours. Steamrollers don’t complain to the union foreman if they work more than 14 hours. We have more capital because existing capital is used more intensively.
The Internet, through fintech and software firms like Square, PayPal, Salesforce, and Zuora, fosters a freer flow of funds and a faster connection among buyers and sellers. Former Fed Chair Ben Bernanke has pointed to a gush of global savings that slosh across borders.
Consumers play a role when equipped with handy tools from online platforms. Amazon’s nifty feature, “Customers who viewed this item also viewed,” teaches buyers to consider substitutes when they are shopping for an item. Without leaving the garage and without expending a dime on search fees, a shopper looking for, say, a Honeywell portable air conditioner that costs $500 may discover a Black & Decker that will do the job at $470. By increasing the visible supply of alternatives, Amazon’s feature tamps down prices paid. Research by former Obama CEA chair Austan Goolsbee and Peter Klenow found that online inflation is one percent lower than the CPI’s calculation.
These forces do not explain the entire story, because inflation is, as Milton Friedman taught, a monetary event. The strong dollar, up 20 percent since 2014, makes foreign goods appear cheaper to Americans and creates a hurdle for domestic firms that try to raise prices. Further, the destruction of wealth during the Great Recession has spurred households to rebuild their balance sheets, pushing up the saving rate to about 6.5 percent, almost twice the pre-crisis level and reducing the velocity of money circulating in the economy.
I would calculate that together the supply-side shocks dampen inflation by about 1.5 percent. That 1.5 percent makes an enormous difference because sleepy inflation allows the Fed to keep interest rates low, which supports equity prices, and, when combined with President Trump’s new expensing rules, prods firms to invest in even better equipment and technology, which lifts productivity. That is why we are finally seeing wage gains.
The supply-side shock is not a deliberate government plan like President Reagan’s individual tax cuts in 1981. It is more like Jed Clampett’s well-timed buckshot. But it is potent. And as long as policymakers do not try to strangle competition, our standard of living should be bubbling up.