Inflation 101: Understanding the ‘why’ behind today’s inflation

The Bureau of Labor Statistics just reported a whopping 9.1% year-over-year increase in the inflation rate. This is the highest in forty years and many economists suggest that inflation will get worse before it starts to get better. To put a 9.1% inflation rate in perspective, one million dollars today has only $909,000 worth of purchasing power compared to just one year ago.

Americans are facing higher prices for food, fuel, and housing and are grasping for answers about what is causing inflation. How long it will last, and what they should personally be doing to combat its effects.

There are no easy answers or painless solutions when it comes to the inflation problem. Before we jump into how long it will last and what can be done to resolve it, we need to define how inflation is caused.

What is Inflation?

Stated in its simplest terms, “inflation happens when too many dollars are chasing after too few goods and services”. So, inflation is really a supply and demand problem. When there is an equilibrium between the supply of goods and services and demand (money available to spend), inflation is in check. When the demand outpaces the supply of goods and services, inflation accelerates. Once this concept is understood, we can dissect what is limiting the supply of goods and services and what is driving demand.

The Supply Issues Impacting Inflation

A couple of events have contributed to the limited supply of goods and services:

First, the COVID pandemic in early 2020 led to lockdowns and numerous restrictive measures by governments around the globe to stop the spread of the virus. These government-imposed lockdowns disrupted the global supply chain as factories were shut down and maritime ports were closed. Currently, COVID continues to affect worldwide supplies as China, the world’s largest manufacturer, is still troubled by shutdowns as they try to get on top of the COVID pandemic still plaguing their nation.

Second, the United States went from being energy independent just a couple of years ago to once again being forced to purchase oil in the world markets.  U.S. production has decreased while our consumption has increased. The inevitable result of this supply/demand imbalance is inflated oil prices. Higher oil prices serve as a catalyst to higher prices in all other parts of the economy as higher energy prices increase the cost to produce and ship goods.

The Demand Issues Impacting Inflation

Consumers are spending big. When the pandemic started, the personal saving rate in the United States was sitting at an all-time high. With large amounts of savings on hand, the federal government sending out relief checks to individuals and businesses, and employees sitting at home with shopping at their fingertips, the U.S. consumer spent a lot of money. And the spending spree isn’t over, with unemployment numbers sitting at all-time lows, employees are either finding better paying jobs or are requiring higher wages from existing employers. These higher wages continue to encourage high demand for the limited goods and services available.

Additionally, with the pandemic mostly behind us, there is a pent-up demand from people looking to travel and vacation once again. If you have traveled recently, you would have noticed the inflated prices of airline tickets, rental cars, hotel rooms, restaurants, and more.

So, how long will high inflation rates be with us?

There are thousands of economists attempting to answer this question, all with different opinions. So, how long this recent inflation acceleration might last is anybody’s guess. However, there is a consensus on how the inflation supply/demand equilibrium will be brought into balance. The inflation rate will decrease as consumer spending slows down, or in other words, when the demand for goods and services is reduced. Two of the main ways demand is reduced is either by raising interest rates, by the economy suffering a recession, or both.

Raising Interest Rates

The Federal Reserve has the responsibility to monitor the economy and implement policy to maintain the equilibrium between supply and demand, in other words, keep inflation in check. The Federal Reserve is raising interest rates to slow consumer demand and subsequent price growth. This policy response means that the economy will surely head for a slowdown. We have already seen how higher interest rates and higher borrowing costs have begun to cool off the housing market. The question — and big uncertainty — is just how much federal action will be needed to bring inflation under control.

Having A Recession

A recession is when the economy shrinks. This is a more painful and less desirable way to slow consumer demand, but it can work towards taming inflation. During a recession, the overall economy struggles, corporations make fewer sales and become less profitable. Workers are laid off and unemployment surges.

The hope is that the Federal Reserve can raise interest rates just enough to slow consumer demand without throwing the country into a recession. This optimistic scenario, often called a soft landing, is difficult to orchestrate and despite the best efforts by the Federal Reserve board, can still end up throwing the economy into a recession.

In our current environment, the so-called soft landing is especially challenging. As the Federal Reserve tries to reign in demand with higher interest rates, they have zero control on the supply side of the equilibrium. If supply chain shortages persist, the Federal Reserve will be required to raise interest rates more drastically. This will slow the demand enough to bring higher prices under control. It’s an economic tightrope, we will see if the Federal Reserve can walk it.

What will not help inflation?

Currently, there is talk on Capitol Hill of sending out additional stimulus checks to help the U.S. consumers pay for high gas prices and other goods. This is indeed a noble thought, but terribly misguided. The demand side of the equilibrium is already out of balance. In other words, there is already too much money chasing too few goods and services. Going into more debt, to throw more money at a problem caused by too much money pursuing too few goods and services is not the answer. We cannot spend our way out of inflation and any attempt to do so, will only result in higher inflation.

Conclusion

We have addressed the causes of inflation and talked about how inflation rates will be reduced. In our next blog we want to get personal. We will be going over the personal dos and don’ts of managing higher interest rates and making good decisions concerning your investments during recessionary times.

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