Understanding Inflation
It’s not enough to lament all the money printing.
Inflation: it is what everyone’s talking about. Myself included. But as I find myself discussing it at dinner parties, it is clear we are all feeling it, but we don’t all understand it. Have a conversation with someone about it, and you get a dressing down of the pandemic policy and a tsk-tsk with regard to all the money printing.
While that isn’t wrong, I set out to better understand the terms, causes, and concepts behind the word you can’t escape in 2022.
Why Inflation Is So Insidious
Inflation is, at its simplest, the rate at which prices increase. And why do prices increase? When the money supply grows faster than the economy, a currency’s purchasing power diminishes and prices rise. It is basic supply and demand principles. Supply increases demand, demand increases price.
You first feel it on a micro level. Yesterday, I bought a head of purple cabbage for $8.12. To be fair, I have no idea what cabbage previously cost. But that’s the point: it sneaks up on you.
The average person notices it first on a consumer level. Products are more expensive. That cabbage is more expensive at retail, but at wholesale, which causes restaurants to raise prices.
Then, as if in unison, commodities such as lumber, metals, and energy rise in price. While that may only affect those in construction, energy is felt by all. Everyone has to heat their home and fuel or electricity to get places.
The most natural response to increased cost is an increased wage, which can be the beginning of a dangerous chain reaction.
Rising wages increase disposable income, thus raising the demand for goods and causing prices to rise. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a perpetual loop. This is called Wage-Price Spiral.
But there are those that don’t have the option of increased pay. Their only option is to reduce expenses. Sure, you can eat out less and buy less cabbage. But there are things you can’t cut back on: like putting fuel in your car or heating your home.
The most insidious thing of all: when those on the poverty line *can’t* afford to heat their home and simply shut the heat off.
How The Pandemic Led Us Here
In March 2020, due to the coronavirus epidemic, stock markets saw one of the fastest drawdowns in history. The sentiment was extreme fear. At the time, I was about to close on a property. I’ll never forget my mortgage broker calling me to say:
“I’ve never said this before, but lenders aren’t returning my calls. I don’t know if I can get you a mortgage.”
The Great Depression saw a market tumble of 89% over three years and took over a quarter century to recover. In those early pandemic days, many wondered if we had a similarly bleak future ahead.
A couple of weeks later, I signed my mortgage agreement. Markets had recovered. Yet central banks had started printing money to stimulate the economy.
Markets were back to their peak by April 2020. Yet the Federal Reserve and other central banks were printing money at an unprecedented rate. $13 Trillion for The United States, to be exact.
For much of 2020 and 2021, society was ground to a halt to stop the spread of a deadly disease. Why then pump obscene amounts of money into a comatose economy? The two directives are in opposition to each other.
While it was clear that central banks across the globe did this to starve off a recession, the immediate and clear result is inflation.
The Role of Central Banks
Unless a financial crisis is afoot, most people don’t hear much about central banks. Because they only hear about them in turbulent times, it is understandable that many feel central banks simply manipulate money.
Which is accurate. Central banks control, regulate, and stabilize a nation’s currency and banking structures. In a healthy market, the central bank hums along, the white noise of the economy.
But in unusual times, central banks often have to intervene after an economy has gotten sick. While many condemn central banks for causing the sickness (and they have a point), the aggressive rate hikes that we are seeing now will hopefully take some air out of the inflationary trends.
It can be a tricky situation for central banks. Company A has recently negotiated higher salaries for its employees. The company has either dipped into healthy cash reserves to pay for its workforce, or it took on debt. If it borrowed, it would have gone to a bank for maybe a nominal 3% interest rate.
But if rates have risen and the company cannot afford an 8% interest rate, what does that company do? It can’t afford to pay its staff higher wages, so the staff leaves for higher pay. Or it over leverages itself to pay for higher wages, but that’s just one aspect of that company’s bottom line, which is rising every quarter.
Soon enough, that company collapses. Companies in similar positions follow suit, and soon enough, you have a significant contraction in the economy. This is the insidious spiral of inflation.
If the central banks don’t do their best to curb it, a recession often follows. We know this because it’s happened before.
Inflation of the 1970s
If there is anything that history has taught us with regards to economics, it is that if bad policy is enacted and then followed by bad luck, runaway inflation and recession will follow.
In the 1970s, inflation peaked around 25%. It was a time when the powers that be decided to accept rapid inflation for a high employment rate. But unfortunately that decision was compounded by bad luck. The 1973 oil crisis spiked gas over a dollar per gallon for the first time in U.S. history.
Sound familiar? Rapid inflation? Yes. High employment? Yes. Bad luck? Yes, spelled as P-U-T-I-N. Fuel has sky rocketed and affordability is in real question for millions across the world.
We are right in line with the early 1970s. If we’re not careful, double digit inflation could be on our horizon.
In the 70s, the central banks of Germany and Switzerland hiked interest rates aggressively and early. The result? They had the shortest and shallowest recessions of all major economies.
That’s what needs to happen now. On July 13th, Canada hiked the interest rate 100 basis points. The U.S. recently followed suit with a 75 basis point raise. The United Kingdom is taking a more conservative approach but still increasing rates.
A Contrarian Takeaway
In an interview with Sky News, former Bank of England Governor Mervyn King lays the fault of our current situation not on the individuals at central banks and governments but on the profession of economics as a whole.
Economists did not predict inflation would be so persistent. Nor did they predict supply chain issues would be so persistent. They didn’t believe Covid would last so long.
And herein lies the rub: the future cannot be predicted. Economists often use computer models forecasting the financial state of the world using inflation targets, numbers that they themselves set. They believe economic futures will come to be because of their will alone, often ignoring the macroeconomic forces at work.
Here’s hoping the measures being taken will work. Here’s hoping policymakers have learned from the past. It’s going to be uncomfortable in the short term, but hopefully, the deep economic strife of the 1970s isn’t doomed to repeat in the 2020s.
