Americans get a refresher course on inflation with every fill-up or trip to Walmart, but entire generations have come of age with no real memory or experience of sustained periods of rapidly rising inflation. prices. And since there is no need to fight the phenomenon, figuring out what causes it and how to lick it may not have been high on their priority list until last year. Now let’s delve deeper into the causes of hyperinflation and the extraordinary confluence of events that brought us to this point.
The textbook definition of inflation is a sustained increase in the general level of prices over a period of time. A more colloquial and intuitive definition is the loss of purchasing power because a dollar doesn’t go as far as it used to. It is very difficult to accurately predict, as the pandemic outbreak shows, but it is important to attack it vigorously once diagnosed.
Inflation can result from an excess of money in the system relative to economic activity. The Federal Reserve is charged with calibrating the money supply to support the demand for dollars, which is measured by the speed or number of times a dollar circulates in the economy during the year. When the economy is expanding rapidly, dollars are constantly changing hands, requiring 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It is worth noting that money supply control was the main tool of the Fed in the 1970s and 1980s but has largely been replaced by interest rate targeting that we hear so much about today. With the explosion of electronic and virtual transactions, the management and even the definition of “money supply” has become challenging, but the concept of more volatile money as a cause of inflation remains valid.
Another potential source of price instability is called “demand pull” inflation, because the economy expands rapidly and the increase in demand for goods and services exceeds production capacity, bidding up prices. Demand pull inflation is often observed in home prices during periods of booming real estate sales. As the number of buyers outpaces the pool of sellers, home prices rise, sometimes rapidly. Real estate is a bellwether for the wider economy, as it makes up a significant proportion of price indices such as the CPI. The housing market and auto manufacturing are particularly relevant because they generate a lot of secondary economic activity in construction, sales, insurance, parts manufacturing, and lending activity.
The third major episodic cause of rising prices is “cost push” 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 prevented or obstructed. Cost push inflation often occurs in response to a natural disaster that damages production facilities or due to geopolitical forces. For readers of a certain age, the 1973 Arab Oil embargo is the classic example where oil-producing countries in the Middle East formed a cartel called OPEC and conspired to limit crude oil supplies to the West. , tripling the price of oil and forcing drivers to queue. at gas stations.
Let’s quickly point to historical examples of inflationary bouts that arose from each of these conditions. What is known about the current price instability is that it traces its origin to all three conditions arising from external factors as well as reactions to crisis policy.
Responding to the pandemic emergency, the Fed rapidly increased the money supply by a third in an effort to revive the crashing economy as the rate fell. The unexpectedly rapid rebound from the covid shutdown has resulted in more dollars chasing fewer goods, one of the classic triggers for inflation. Hindsight of course provides an explanation, but the reaction at the time was informed by the potential for a long-term depression in economic activity arising from a once-in-a-century health emergency.
By mid-2020, the possibility of a severe and prolonged recession is the base case as the world waits for an effective vaccine and closures and social distancing are the only available measures. to prevent the growing death toll. In the event, many workers were able to continue working remotely, as Congress and two Presidents injected more than $5 trillion in direct stimulus spending into the economy’s bloodstream. Flush with cash and stuck at home, households have splurged on everything from houses to cars to iPads. Hello demand pull inflation: a sudden and unexpected surge in consumer demand adds fuel to the flames of inflation.
Meanwhile, on the coast of California: 109 large container ships waiting in January to be unloaded testify to the unprecedented collapse of supply chains that reasonably returned to the expectation of a long decline. This supply squeeze is a case study in cost push inflation that is only now beginning to abate. Witness a triple whammy of inflationary influences that will serve as a case study for future generations of grad students.
The good news is that we know how to beat inflation thanks to the lessons of the 1980s. The bad news is that the medicine is bitter and needs to cool down in the hot work and home markets, but in time the patient will recover.
Christopher A. Hopkins is a chartered financial analyst and co-founder of Apogee Wealth Advisors.