The fundamental dilemma that we face at the Fed right now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation. But the fundamental productive capacity of our economy as it existed just before COVID—and, thus, the ability to satisfy that demand without inflation—remains largely as it was, and the factors that are disrupting it appear to be transitory. Looked at purely in that light, constraining demand now, to bring it into line with a transiently interrupted supply, would be premature. Given the lags with which monetary policy acts, we could easily find that demand is damping just as supply is increasing, leading us to undershoot our inflation target—and, in the worst case, we could depress the incentives for supply to return, leading to an extended period of sluggish activity and unnecessarily low employment. [Emphasis added]
—Fed Governor Randal K. Quarles, 20 October 2021
Earlier this week the ISM manufacturing report revealed a sharp increase in its manufacturing inventories index, making it the highest reading since 1984. Meanwhile, the ISM’s customer inventory sentiment index is signaling their inventories are extremely low and there is very strong demand for these to be rebuilt—something that is normally exceptionally bullish for capex growth in the coming year.
The messages we are receiving from these indices are, however, being heavily distorted by the combination of the ongoing supply chain problems and our reactions to those problems, making it that much harder to tell whether the current demand we are seeing is genuine and will be sustained, or whether the shortages are driving companies and individuals to over-order for fear that they will be left without stock, possibly resulting in a large inventory glut and potentially a recession. As the quote from Fed Governor Quarles above indicates, this is a serious dilemma that policy makers are also facing in their policy decisions, and it is the topic of this Economics Weekly.
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Richard de Chazal, CFA is a London-based macroeconomist covering the U.S. economy and financial markets.