Americans take a refresher course in inflation with every fill-up or trip to Walmart, but entire generations have come of age with no real memory or experience of prolonged periods of rapidly rising prices. And having not had to deal with the phenomenon, thinking about what causes it and how to lick it may not have been high on their priority list until last year either. Today we will delve into the causes of excessive inflation and the extraordinary confluence of events that have brought us to this point.
The classic definition of inflation is a sustained increase in the general level of prices over a period of time. A more familiar and intuitive definition is the loss of purchasing power because a dollar doesn’t go as far as it used to. It is notoriously difficult to predict accurately, as the pandemic surge shows, but it is essential to attack it vigorously once diagnosed.
Inflation can result from too much money in the system relative to economic activity. The Federal Reserve is responsible for calibrating the money supply to support the demand for dollars, measured by the speed or number of times a dollar moves through the economy during the year. When the economy is growing rapidly, dollars change hands more frequently, causing the Fed to add more dollars to the system (increase the money supply). Too many dollars relative to the velocity or demand for dollars can lead to inflation.
It should be noted that control of the money supply was the Fed’s main tool in the 1970s and 1980s, but has largely been replaced by the interest rate targeting that we hear so much about today. With the explosion of electronic and virtual transactions, managing and even defining “money supply” has become difficult, but the concept of too much easy money as a cause of inflation remains valid.
Another potential source of price instability is called “demand-pull” inflation, because the economy is growing rapidly and growing demand for goods and services exceeds production capacity, driving up prices. Demand-driven inflation can often be seen in house prices during periods of booming real estate sales. As the number of buyers grows faster than the pool of sellers, house prices rise, sometimes rapidly. Real estate is an indicator for the broader economy, as it makes up an important part of price indexes like the CPI. The housing market and automotive manufacturing are particularly relevant as they generate secondary economic activity in construction, sales, insurance, parts manufacturing and lending activity.
The third major episodic cause of rising prices is “cost-driven” inflation, a shock to the supply side of the supply-demand equation in which demand remains relatively stable but the supply of goods or services is restricted or hindered. Cost inflation often occurs in response to a natural disaster that damages production facilities or an induced shortage due to geopolitical forces. For readers of a certain age, the Arab oil embargo of 1973 is the classic example in which the oil-producing countries of the Middle East formed a cartel called OPEC and conspired to limit the supply of oil. crude from the West, tripling oil prices and forcing drivers to line up. at service stations.
We can easily cite historical examples of inflationary pressures resulting from each of these conditions. What is remarkable about the current price instability is that it has its origins in these three conditions resulting from external factors as well as political reactions to the crisis.
In response to the pandemic emergency, the Fed quickly inflated the money supply by a third in a bid to revive the plummeting economy as velocity plummeted. The surprisingly rapid rebound from the covid shutdown resulted in too many dollars for too few goods, one of the classic causes of inflation triggers. Hindsight of course brings clarity, but the reaction at the time was informed by the potential for a prolonged depression in economic activity resulting from a health emergency that only occurs once in a century.
By mid-2020, the likelihood of a severe and prolonged recession was the benchmark case as the world waited for an effective vaccine and shutdowns and social distancing were the only measures available to stem the rising death toll. As it happens, many workers have been able to keep their jobs remotely, just as Congress and two presidents have pumped more than $5 trillion in direct stimulus spending into the economic bloodstream. Overwhelmed with cash and stuck at home, households have increased spending on everything from homes to cars to iPads. Hello demand inflation: A sudden and unexpected spike in consumer demand has fueled the flames of inflation.
Meanwhile, off California: 109 huge container ships awaiting unloading last January witnessed the unprecedented collapse of supply chains that had rightly slowed down awaiting a prolonged slowdown. This supply restriction was a case study in cost inflation that is only now beginning to ease. Witness a triple whammy of inflationary influences that will serve as a case study for future generations of graduate students.
The good news is that we know how to whip inflation from the lessons of the 1980s. The bad news is that medicine tastes bitter and will require cooling labor and housing markets, but over time the patient will will restore.
Christopher A. Hopkins is a Chartered Financial Analyst and co-founder of Apogee Wealth Advisors.
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