Inflation is finally here, and it’s real. In 2021, inflation grew at a year-over-year rate of 7%–the highest growth rate since the early 1980s. At first, its impact was felt in certain sectors and products, especially those that were affected by supply chain issues. It then progressed to the grocery shelves. Now consumers are seeing price increases on products all across the spectrum.
After ignoring the prospect of higher inflation for most of the year, the stock market is starting to buckle under the weight of rising inflation and the prospect of higher interest rates.
So how did we get here?
What’s Driving this Inflation
Most people alive today have never experienced a severe bout of rising inflation, so it’s worth revisiting how inflation comes about. Generally, inflation has two components—rising prices and the persistence of those rising prices. In an inflationary environment, rising prices are not temporary as they might be in certain sectors at certain times of the year. For instance, airline prices rise during high traffic seasons or gas prices during the summer months when people take their vacations. This time, we’re talking about generalized price increases that are persistent over time.
A Function of Supply and Demand
At its simplest, inflation is a function of supply and demand. When there’s insufficient supply to meet demand (too many dollars chasing too few goods), prices rise. One of the factors that have caused the current supply-demand imbalance has been the impact of COVID on our economy. The lockdowns and subsequent shrinking of our labor force constrained supply, so fewer products were being produced.
That was fine for a while because people were hunkering down for nearly two years, saving their money instead of spending it. Then, as COVID restrictions began to lift, people went back to the stores, creating a surge in demand. Thus far, supply has not been able to keep up, causing an imbalance. Lingering supply chain issues coupled with surging demand are exacerbating inflation because they’re both spiking in the wrong direction.
Unbridled Money Printing
We also know the Fed has been rigorously printing money to create more liquidity in the economy and stimulate growth during the pandemic. While the growth of production of goods and services has slowed, the massive money supply growth has begun to overtake it, resulting in the bidding up of prices. When too many dollars are chasing too few goods, you get inflation.
Rising Wages
In addition, wages are increasing. Employers are having to pay more to get people to come to work. Employers have to increase prices to cover their higher costs. Then you have the hiring gap, with four to five million people not seeking any of the 11 million jobs still available. They’re not contributing to production, which also contributes to supply chain issues and rising prices.
Cheap Money and Drunken Spending
Finally, we have the convergence of monetary policy guided by the Fed and fiscal policy driven by government actions. The Fed has done its best to keep interest rates low over the last several years, near zero. Consumers and the federal government have gotten drunk off cheap money, creating unnatural demand. Meanwhile, Congress and the administration have been doling out trillions of dollars over the last few years in the name of “COVID relief” and “infrastructure.” When you add those trillions to the trillions being printed by the Fed, and the rise in post-pandemic consumer demand, you get a trifecta of spiking demand in the face of lower supply. It’s unprecedented.
Where Do We Go from Here?
One of the Fed’s primary responsibilities is to control inflation. They create monetary policies designed to keep the inflation rate near 2%. They do that by controlling the money supply (the amount of money in circulation) and the cost of money (interest rates). The inflation rate has come in well under that target for much of the last couple of years.
Some experts say the Fed has come a little late to this part because the inflation rate blew past that target in early 2021. For months, the Fed posited that the increase was transitory and would subside later in the year once supply chain issues were resolved. We now know that was wrong.
The Fed announced they plan to stop the money-printing in March 2022. After that, the only arrow they have left in their quiver is to raise interest rates. Higher rates will increase the cost of money, which should slow demand. Theoretically, this is how they correct the imbalance of supply and demand, though that also relies on the supply chain issues getting fixed. We can expect this battle to go on for at least a year, maybe even two years.
For now, most of the effects of rising inflation on consumers are being offset by rising wages. As long as the hiring gap continues and the competition for workers stays heated, employers will continue to bid up wages. While rising prices are inconvenient, rising wages create a kind of equilibrium that eases the pain. That should continue as long as the economy remains strong.
What Could Go Wrong?
However, if higher inflation persists too long, it’s likely that wages won’t keep up, causing demand to go down and increasing the risk of a recession and deflation. If you thought inflation was scary, it’s nothing compared to deflation. Deflation can have a devastating effect on the economy. Once it starts, it’s difficult to stop because it is self-perpetuating.
Normally, when demand decreases, it can lead to a correction in the supply-demand imbalance, which is good. But, if demand falls too far too quickly, it can cause a downward spike in supply, which can drive prices even lower. When consumers believe they can wait on their purchases because prices will be lower in the future, it can accelerate the decline of supply. When supply declines, businesses cut back on inventory and production, leading to lost jobs and wage deflation. Then consumer spending falls further, exacerbating declining demand and price reductions, which will force businesses to close and drive the economy further into a recession.
While that scenario is not likely in the foreseeable future, it helps to understand that inflation is not the worst thing that could happen. Allowing mild inflation to persist reduces the risk of deflation. If the Fed makes the right moves, it should be able to get this inflation under control and back to a mild 2 to 3%.
