Example for demand driven but supply caused inflation

 

As an example for the demand-driven but supply-caused perspective, take airline tickets. When pandemic hit there was a total annihilation of demand and supply, as nobody was allowed to fly. Afterwards, supply partially recovered as operation of airlines was allowed, but demand was suppressed, as nobody really wanted to fly given the associated conditions. This state persisted until re-opening was in full swing. This brought rebound in demand and with it also dramatic increase in prices. This can be seen in following figures: left panel shows the development in quantity, while right shows the prices.

Is this increase in prices demand-driven or supply-driven? Clearly, this corresponds to a demand-driven increase in prices, given that in 2022 increase in prices coincided with increase in quantities. But does it make sense to assign increase in airline ticket prices to increase in demand? Sure, it did come as a result of the rebound in demand. But at the same time, the quantities remain well below their pre-pandemic levels, so they are not above normal, which means that it cannot be straightforwardly concluded that extreme prices are result of extreme demand.[1]

Rather, the story is probably as follows: re-opening led to normalization of demand, maybe slightly above normal demand. This was met with supply that was significantly lower than pre-pandemic normal, which can be seen in how the quantities flat-lined once their reached 85%. As a result, prices reached well above normal levels. While labeling inflation as supply or demand driven is straightforward, labelling it as supply or demand caused is somewhat harder. That said if one category has to be chosen then I would certainly opt for supply. Why? Because it is the supply which is further away from pre-pandemic normal.

The main point, then, is that with more refined terminology we can have both demand-driven and supply-caused inflation labels. We can say that the recent rise in flight ticket prices is driven by rebound in demand, but that the abnormally high flight ticket prices are caused by shortfall in supply.

I think this story of airline ticket prices applies more generally. What we have been observing since beginning of 2021 onwards has been normalizing demand hitting below normal supply, which led to above normal prices. Together with airline tickets it applies to many travel-related categories, albeit with some of them I would argue it is more about (temporarily) above-normal demand. It also applies to cars, where it is harder to argue that demand is higher than before pandemic. And in some sense it also applied to euro zone energy, where demand was abnormally low during pandemic, and then in rebounded to meat depleted supply; of course, later on a decrease in supply became dominant driver.

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[1] Of course, lower than pre-pandemic quantities does not on its own imply that demand was lower than normal, because we also have to contend with the supply side of the story. Simply, output can be lower even with demand above pre-pandemic, if decrease in supply was large enough.

Is euro zone inflation demand driven but supply caused?

The big discussion now in macroeconomics is whether supply or demand is driving current surge in inflation. This being an empirical question, the answer is typically provided using an econometric models. I will have later a post on these empirical analysis, but first I would like to put a compromise proposal out there based on elaboration on the terminology we use: While inflation is to a large degree demand driven, it is at the same time mostly caused by supply.[1]

What do I mean by the destination between “driven” and “caused”? By demand driven inflation I mean that it is the increase in demand that was the force that is recently pushing prices higher. By supply caused I mean that the underlying cause of higher prices lies in supply.

How could this be true at the same time? Imagine that onset of the pandemic has brought a large drop in demand and supply at the same time, leaving quantity much lower but prices mostly unchanged.[2] And then imagine that demand gradually returns to its “normal” position, because the pandemic fades away, while supply fails to fully return to its normal position, because it is (temporarily) unable. You end up with higher prices and lower output than is normal.

What is driving/causing the higher prices, demand or supply? From perspective of recent development, which is movement from E’ to E’’, higher prices are driven by increase in demand, as that it the force behind higher prices. This is also confirmed by the fact that both output and prices increased at the same time. However, from broader perspective, moving from E to E’’, it is the supply which is the cause of higher prices: demand just returned to normal, while supply is still far from normal. Hence, the distinction between “demand driven” and “supply caused”.

I might be naïve but I think this distinction could to a large degree reconcile the two sides of the discussion. Why? I think each side focuses on different facts when making their case. The “demand driven” camp points out that output has recently increased and so did prices, suggesting increase in demand. The “supply caused” camp points out that output is still below pre-pandemic level while prices are higher, suggesting decrease in supply. Effectively, the two sides are focusing on different time scopes (or if you prefer, use different benchmarks). Using more elaborate terminology could help clarify this differences in focus and possibly eliminate part of the disagreement.

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[1] I will ignore the aspects of inflation which are clearly supply driven, like energy and food components. There little disagreement over those.

[2] Another perspective would be that prices remained unchanged because of downward nominal stickiness, i.e. we were out of equilibrium.

Addendum to "SVB was not a typical bank run"

Turns out that I could have saved my words on Wednesday, and rather than write a blog post, I could have shared a link to interview with Douglas Diamond of the Diamond-Dybvig fame:

https://finance.yahoo.com/news/economist-won-nobel-bank-runs-160025143.html

Huge credit to him for avoid the natural inclination to say "it is all in my models". This was far from DD bank run!

 

SVB was not a typical bank run

 

We know that SVB faced a run on the bank. But there are bank runs and there are bank runs. Was it typical bank run ala Diamond and Dybvig (DD), with illiquidity and sunspot equilibria? Or was it different?

While there were some aspects of the typical bank run – reliance on demand deposits, sudden shift in depositor sentiment – there are important aspects in which it was not a typical bank run. To see that, notice that typical bank run of DD style features one key aspect: inability to liquidate assets without a penalty, and hence mismatch between liquidity of assets and liabilities.

(Sure, it might seem that liquidating assets by the SVB would be costly to the bank. But the reality is that it would not carry a penalty cost, but rather that it would be associated with realizing the losses which have already occurred in the real world.)

The key point is this: In contrast to DD scenario, the asset side of the SVB was extremely liquid, mostly in form of government bonds and government-backed securities. While selling those in bulk would carry some penalty, this would be small – and if the market reaction after the collapse is anything to go buy, plausibly the prices would have even moved in the favorable direction. So the SVB case did not feature the key aspect of DD bank run, the liquidity mis-match.

It was also not similar to the bank failures in 2008. Back then, the problem was still liquidity mismatch: while the assets were securities and not loans, and hence were partially liquid, they were risky assets and selling them in bulk was not an option: due to classical finance problems (information asymmetries, limited arbitrage capacity) the large-scale selling would lead to large penalty. This is also why a regulatory  environment requiring large amount of liquid assets would be irrelevant: SVB did hold large amount of liquid assets.

Therefore, the problem of SVB was more about insolvency rather than illiquidity. True, the insolvency was of unusual type – it was not credit or loan losses, but losses related to interest rate risk, something we typically do not think as major source of solvency risk; and if the bank would not be run on, it would probably turn around and become solvent. But irrespective, it was the current value of its assets, not its inability to quickly liquidate them, which was the problem. And at the same time the current market value of the assets was in now way related to liquidity problems, but simply reflecting different risk-free rates.

So no, this was not a bank run from the 1983 paper, and neither it was a bank run from the more modern fire sale literature.

Update on scenarios after SVB failure

Ok, we now know what the player next in turn did: The regulators and government officials decided to take out the bazooka right away without hesitation. As I said yesterday, "this time around this would come much sooner than it did in 2007-2008 – the action during pandemic showed that with large financial crisis in recent memory, the point when political establishment acts is significantly earlier than otherwise.". This is especially so given that Yellen is sitting at the Treasury.

This changes the likehood of the scenarios quite a bit:

Nothing happens: 20-25% >>> 30-35%

Tremors without casualties: 25-30% >>> 30-35%

Some casualties, but situation remains contained: 25-30% >>> 10-15%

Contagion which is eventually contained: 10-15% >>> 5-10%

Nothing happens: 2-5% >>> 2-5%

Effectively, with forceful action from the government providing backstop to the uninsured depositors the middle of the probability distribution has hollowed out: It is much more likely that this will end as soon as it started. However, this does not mean that adverse outcomes are ruled out. It is just that now they would require other mechanisms to occur, which is less likely. This even applies to the middle outcomes: I dont think we have a good model of depositor's beliefs formation, and it is still likely that at least some of them will act out of caution despite the government guarantee. It is just that now it is rather unlikely this will reach a critical mass. 

Rather than the depositors, the behavior to watch now is of bond holders, sources wholesale funding and stockholders. Bond and stock holders were wiped out in SVB, something that officials did only in rare occasions in 2008 out of fear. It remains plausible that they will pull out in more meaningful fashion. And there is still possibility that there are vulnerabilities we do not know about. Therefore, the probability of truly adverse outcomes has not decreased much.

Addendum: Looking at my probabilities, I realized that the wording of "without casualties" is not aligned with the exact idea in my head. I really mean no meaningful casualties. E.g. few small banks failing still qualifies as "no casualties". By no casualties I mean no banks in the size range of SVB or larger fail.