Federal Reserve Chair Jerome Powell has not hit the inflation panic button. Photo: AFP / Kevin Dietsch/Getty Images

NEW YORK – The data firm Markit-IHT reported Friday “survey-record rise in backlogs of work as firms struggled to meet demand due to supply chain bottlenecks and labor shortages” in October, “in turn driving the steepest rise in prices yet recorded by the survey.”

Markit’s widely followed Purchasing Managers’ Index showed continued economic growth as well as stiffening inflationary headwinds.

Also on Friday, the Atlanta Federal Reserve Bank lowered its “Nowcast” for US gross domestic product (GDP) for the third quarter to just 0.5% per annum, that is, nearly zero growth. The “Nowcast model” translates current data releases into an estimate for overall growth. A similar model devised by the St. Louis Federal Reserve estimates third quarter growth at a robust 6.85%.

The huge differences in forecasts reflect an unprecedented degree of uncertainty about the US economy. Most workers who dropped out of the labor force during the Covid-19 pandemic haven’t returned. Some businesses can pass on higher input prices, but many can’t. Supply shortages are constricting business activity.

As Markit noted, order backlogs and price increases are the worst in the 15-year history of its survey. The one thing that all the forecasters agree about is that inflation is the worst in 40 years and getting worse.

US Federal Reserve Chairman Jerome Powell spent the first nine months of 2021 insisting that inflation wasn’t there, and if it was there, it was “transitory.” On Friday, Powell said in a virtual panel discussion moderated by Bloomberg that “our policy is well-positioned to manage a range of plausible outcomes.” Equity markets fell.

Whether businesses can maintain profit margins in the face of surging input costs, and whether consumers will pay higher prices now out of fear that prices will be even higher later, are completely uncertain.

One of the best US economic surveys comes from the Philadelphia Federal Reserve Bank. Its September survey of non-manufacturing business (88% of the US economy) suggests that service businesses can’t raise prices fast enough to keep up with rising input costs.

As the chart below indicates, prices paid to businesses are rising much faster than prices received.

In the manufacturing sector, though, prices paid and prices received are rising in lockstep, according to the Philadelphia Fed’s survey of manufacturers.

The problem is that the Federal Reserve increased its balance sheet by nearly $5 trillion since early 2020 and set off a tsunami of demand. In the sort of monetary theory that prevailed while the US economy was reasonably sound, a surge in the money supply was supposed to lead to higher inflation.

The difficulty with the Quantity Theory of Money championed by Milton Friedman and others is that the same amount of money can have different impacts on prices at different times. For example, bank lending has collapsed in the US since the pandemic, which means that the trillions of additional reserves that the Fed put into the banking system haven’t translated into bank credit.

As a rough-and-ready check, I adjusted the broad (M2) money supply (checking plus savings deposits) for changes in velocity. Money supply has jumped but velocity has fallen.

In the chart below, I show the annual growth rate of velocity-adjusted money supply (M2 multiplied by velocity) against the annual change in the Consumer Price Index (CPI).

There doesn’t seem to be much of a coincident relationship. Nonetheless, lagged values of velocity-adjusted money supply have some predictive value for the Consumer Price Index. Using nine months of lagged values of this money measure, I obtain a reasonably good (62% fit) explanation of inflation during the past 60 years or so.

This isn’t precision forecasting, to be sure, but it rubs in a point that should be obvious: Governments cannot create vast amounts of demand in a matter of months and expect the supply to magically present itself to meet the demand. In particular, they shouldn’t expect it when the massive amount of demand creation gave millions of workers an incentive to stay home.