Americans get a refresher course in inflation with each fill-up or trip to Walmart, but whole generations have come of age with no real recollection of or experience with sustained periods of rapidly rising prices. And having not had to contend with the phenomenon, thinking about what causes it and how to lick it may also not have been high on their priority list until the past year. Today we will take a deeper dive into the causes of excess inflation 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 as a dollar doesn’t go as far as it used to. It is notoriously difficult to accurately predict, as the pandemic surge demonstrates, 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 charged with calibrating the money supply to support the demand for dollars, measured by the velocity or number of times a dollar circulates through the economy during the year. When the economy is expanding rapidly, dollars change hands more frequently, requiring the Fed to add more dollars to the system (increase the money supply). Too many dollars relative to velocity or demand for dollars can lead to inflation.
It should be noted that money supply control was the primary Fed tool in the 1970s and 1980s but has largely been replaced with interest rate targeting that we hear so much about today. With the explosion in electronic and virtual transactions, the management and even definition of the “money supply” has become challenging, 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, as the economy expands rapidly and surging demand for goods and services outstrips production capacity, bidding up prices. Demand pull inflation can often be observed in home prices during periods of booming real estate sales. As the number of buyers expands faster than the pool of sellers, home prices rise, sometimes rapidly. Real estate is a bellwether for the broader economy, as constitutes a significant proportion of price indices like the CPI. The housing market and auto manufacturing are especially relevant since they generate so much 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 is restricted or impeded. Cost push inflation often occurs in response to a natural disaster that damages production facilities or an induced scarcity due to geopolitical forces. For readers of a certain age, the 1973 Arab Oil embargo is the classic example during which Middle Eastern oil-producing nations formed a cartel called OPEC and conspired to limit supplies of crude oil to the West, tripling oil prices and forcing drivers to queue up at gas stations.
We can easily point to historical examples of inflationary bouts arising from each of these conditions. What is notable about the current price instability is that it traces its origin to all three of these conditions arising out of external factors as well as policy reactions to the crisis.
Responding to the pandemic emergency, the Fed rapidly swelled the money supply by a third in an effort to revive the crashing economy as the velocity plummeted. The unexpectedly rapid rebound from the covid shutdown has resulted in too many dollars chasing too few goods, one of the classic causes inflation triggers. Hindsight of course provides clarity, but the reaction at the time was informed by the potential for a prolonged depression in economic activity arising from a once-in-a-century health emergency.
In mid-2020, the likelihood of a severe and extended recession was the base case as the world awaited an effective vaccine and shutdowns and social distancing were the only available measures to stem the growing death toll. In the event, many workers were able to maintain employment remotely, just as Congress and two Presidents injected over $5 trillion in direct stimulus spending into the economic bloodstream. Flush with cash and stuck at home, households ramped up spending on everything from houses to cars to iPads. Hello demand pull inflation: a sudden and unexpected spike in consumer demand added fuel to the flames of inflation.
Meanwhile, off the coast of California: 109 massive container ships waiting last January to be unloaded tested to the unprecedented collapse of supply chains which had quite justifiably throttled back in expectation of a lengthy downturn. This constriction of supply was 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 whip inflation thanks to the lessons of the 1980s. The bad news is that the medicine tastes bitter and will necessitate cooling off the red-hot job and housing markets, but in time the patient will recover.
Christopher A. Hopkins is a chartered financial analyst and co-founder of Apogee Wealth Advisors.