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Anatomy of Inflation (and why it’s not the end of the world)

Anatomy of Inflation (and why it’s not the end of the world)

May 06, 2022
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Economic Situation is Complicated and Difficult – but temporary

This is truly the most complex economic and market situation I have likely witnessed in my professional career.   By that I don’t mean the “worst” or the “scariest” – I think the financial crisis of 2007/08 takes the cake for that.  I mean just the most complicated. 

Everyone is focused on inflation – which anyone under the age of 50 has never really experienced in their lifetimes.  Even this one component of the economic landscape is incredibly complicated.  Watch the news on TV and they try to make it all simple.  Conservative commentators say its all Biden’s fault.  Liberal commentators say its all the fault of the pandemic and the war.  Both sides may point to easy money policies left in place for too long by the Federal Reserve.  The truth is that it is some of all the above (and don’t forget President Biden only continued Trumps policy of printing gobs of money to distribute to ever breathing human!) 

At once this complexity can be scary, but it also offers some hope – because all of the above can be fixed, or will resolve with time. 

At its very core, inflation is always caused by one thing.  People want to buy more of something than the economy can produce.  Sounds simple, but the reasons for this imbalance can be complex indeed.

An imbalance in supply and demand can spring from either end of the equation.  First would be not enough supply.  This happens frequently.  A drought reduces a wheat crop in the Midwest, reducing supply of grain, prices go up.  The higher price is like an automatic rationing mechanism, causing people to reduce purchases of wheat products, or encouraging producers to shift to other grains.  It’s not farmers or producers being “greedy” – in fact it is essential for prices to rise when there is a shortage of product.  If price doesn’t increase, there will be shortages as demand continues to outstrip supply.  This was what happened when price controls on gasoline ran into a supply shortage caused by the Arab oil embargo in the 1970’s.  At the same time that higher prices cause consumers to buy less, those same high prices encourage producers to make more.  High wheat prices might cause farmers to put more acreage into production.  High oil prices should cause oil companies to drill more wells.  Eventually supply and demand come back into balance.  This is fundamental economics as first described by Adam Smith’s “invisible hand” in the 1700’s. 

The other possible cause for inflation is demand outstripping supply.  This is what is happening when the economy “overheats”.  Even absent any supply disruption, consumer demand can outstrip the ability of producers to create supply, creating the same effect – prices increase until supply and demand are brought back into balance. Why can demand outstrip supply?  Low interest rates make it easy to borrow money to spend.  Assets like stocks (or crypto) boom in value, creating sudden wealth.  Government prints money and gives it to people.  Labor shortages fuel wage increases.  In the current situation, all of the above.  

What makes today’s inflation so complex is that we are being hit with both supply and demand fueled inflation from multiple sources.  COVID is still resulting in factory shutdowns in China, causing ongoing shortages of finished goods and parts that suppliers need to produce goods.  Russia’s war in Ukraine is impacting global food supplies, as well as oil and gas price shocks.  The good news – these shocks are by their nature temporary – but no one knows just how long they will persist.  

Another ongoing supply issue is the retiring of the baby boom generation.  So many workers leaving the workforce (with retirement accounts flush with inflated stock prices and more time to spend their wealth) means that there is a nationwide shortage of workers to make the goods and provide the services that consumers demand.  There is little easy fix to this.  Either our young people need to make more babies, or we need to encourage more immigration of younger people to fill the open positions.  Meanwhile, wages will rise (which is good) but the higher wages will only result in more inflation.  Workers essentially stand still, while retirees (especially those on fixed pensions) suffer. 

Running into these supply constraints is buoyant demand from consumers who are flush with cash.  (I know…you may not be feeling it right now…)  Consumer debt is low, housing equity is high, stock portfolios (until recently) were at all time highs, and trillions of dollars in “funny money” (aka crypto) have just been manufactured out of thin air.  In short, there is a lot of money out there itching to be spent.  Much of this ties back to a combination of low interest rates and easy money policy of the federal reserve in combination with profligate deficit spending by the government due to the pandemic.  Low interest rates have fueled asset price appreciation from stocks to houses, and fueled runaway speculation on essentially worthless assets such as crypto currency, NFTs or speculative business ventures with no path to profitability.  Making matters worse (and I understand this was all done to some extent in the “fog of war”) was the unprecedented issuance of money to every living and breathing American during the pandemic – including those of us who remained employed and didn’t need the money! 

So thus the very complicated inflation backdrop.  Where to from here?  Well, there are several cures for the demand side – none of which are pleasant to the public. Higher interest rates will eventually quash demand.  But that means mortgage rates go up, house prices may fall, interest rates on car loans and credit cards move higher, stock prices may fall, and business will find it more expensive to expand and operate.  It is very possible that the combined impacts of all these effects will cause the economy to tip into a recession, which although painful, will likely cure the demand side of the inflation problem.  (good news:  the economy is so strong right now that any recession is likely to be mild).  Even inflation itself can reduce demand since people having to spend more on essentials like food and gas means a reduction in demand for other goods and services.   

The other theoretical cure for inflation would be on the fiscal side – government reduces deficit spending effectively siphoning excess money out of the economy.  Don’t expect that to happen…

The supply side is harder to solve, in particular the Russian oil and gas issue.  The world cannot easily replace 3 million barrels of production even if it wanted to.  And it doesn't really want to anyway!  OPEC could increase production - but doesn't wish to for a myriad of reasons.  The US could increase production - but government policy influenced by climate change is a hindrance, and producers have been burned by past "boom and bust" cycles and are so reluctant to invest. The food dilemna is even harder to solve.  Ukraine and Russia are HUGE producers of grains, oils, etc.  You can't just grow more crops out of thin air!   Eventually I suppose the war will end.  How long will it take before Russian oil and gas fully reenters the market?  Who knows?  How long will the Chinese lockdowns last?  Again, no one knows.  But just as I said at the outset of the pandemic – this will end eventually.  It is not a forever thing.  We just need to muddle through these difficult times.  

Next post will be what all this means for stock and bond markets, your retirement plan, and your portfolios.