What’s Going on With Inflation?
Posted: Brandon Arns
January’s CPI (Consumer Price Index) numbers came in last week and inflation was hotter than expected. Prices were up 0.6% in January, which means a year over year (yoy) increase of 7.5%. As you may have seen, this is the highest since 1982.
As we’ve said previously, inflation is one of the scariest words in finance. It invokes troubling memories of the 1970’s where inflation was high every year for several years, and a mortgage cost you 15% a year in interest. Many recall horrifying images of a failing currency, such as in the Weimar Republic after WWI or Valenzuela today.
But not all inflation is the same. Let’s think of some small examples. If a corn field burns down, the price of corn goes up. This is supply side inflation, and it will return to “normal” once new corn is grown. If the government hands out checks to everyone, and we all go spend it, this should cause demand side inflation. Most likely if those checks stop coming, spending should go back to normal, and that inflation should subside. And finally, if the rest of the world no longer values our currency, we get the doomsday inflation scenario where we all rush for gold.
So we have to put today’s inflation into context to understand where it’s coming from, and how long those forces will stay. There seems to be two main sides to the debate on what’s causing inflation.
One side argues that inflation is the result of a pandemic that shut down the economy which then reopened abruptly. This led to all sorts of issues in our supply chains such as shut down factories, cargo transportation shortages, etc. You can read more about the specifics of these issues here. On top of that, you have people staying in their homes with government checks suddenly spending more of their money on material goods, rather than on services/experiences. When you combine these supply bottle necks with increased demand for goods, you get inflation.
The other argument primarily centers around the actions of the government, as well as the Federal Reserve (The Fed). The Fed has been “printing” money for over a decade now, but this was accelerated in March of 2020 as the pandemic began taking hold. In addition to the Fed’s money printing, the US government (and, in fact, governments around the world) all began taking serious stimulative actions to help cushion the financial blow of the pandemic. As a result of all this extra money flooding the system, our dollars should be worth less. Those on this side of the argument SHOULD be more concerned about inflation, as it is a monetary issue rather than simple supply/demand dynamics.
There are varying amounts of truth to both sides but those are the general narratives. The interesting thing about this debate, is that your stance on it informs how you think inflation should be dealt with.
For example, if you think inflation is simply the result of temporary supply/demand imbalances, your solutions will revolve around creating efficiencies in the supply chain. Maybe this means hiring more truckers and workers at the ports, building additional factories, planting more crops, etc. Of course, this is a global issue, so you’d need coordination with other governments as well. Regardless of those actions, you think at some point it’ll more or less work itself out.
On the other hand, if you believe inflation was caused by loose monetary policy, your solution is…tight monetary policy. The biggest talk of the markets right now is how much, and how many times the Fed will raise interest rates this year. Increasing interest rates raises the cost of money, making it less attractive to borrow (mortgage rates way up for example) and therefore should have the effect of decreasing overall spending, which finally lowers inflation. The fear here is that you lower demand too quickly, which can then lead to a recession. So it’s a fine line. Raise rates enough to curb inflation but not so much that you kill the economic recovery.
I’m oversimplifying a bit, but this debate is what’s driving markets right now. A high inflation number leads investors to believe that the Fed will be MORE aggressive with raising interest rates. This should hurt demand, and ultimately stock prices. It’s not just inflation, but any indicator that leads investors to believe the economy is hot will lead to a stock sell off. We had a much better than expected jobs number a couple weeks ago, and the market went down! Why? If the economy looks strong, the perception is that it makes it easier for the Fed to be aggressive about raising rates, as the economy can take it. So as silly as it sounds, in some cases “good news is bad news”.
Personally, I’m more on the “inflation is the result of simple supply/demand dynamics from the pandemic” side of the debate. Some of my reasons for believing so are the fact that so much of the rise in inflation has been in sectors that were most sensitive to COVID-related disruptions. If this was truly a monetary phenomenon, I’d expect a more uniform rise in prices. Also, the Fed has been printing trillions of dollars for over a decade with no inflation, and the US dollar has been strong against other currencies.
This can all change of course. One interesting cause of inflation can simply be the BELIEF that we have inflation. If you believe your dollars will be worth less in the future, you’re incentivized to buy things today, which raises prices. So, in an interesting way, inflation can be self-fulfilling. I don’t believe this is the case today, but certainly as inflation drags on, I worry it could.
A final point on the CPI numbers. The year over year (yoy) increase is typically what gets discussed since it’s the easiest to understand. Things are 7.5% more expensive than last year for example. But it’s important to remember what that % increase is based off of. For example, inflation growth in 2020 was very low (around 0-1.4% yoy depending on the month). So all 2021 yoy numbers are especially high since they grew off a low base. The same is true for GDP growth which grew double digit % for most of 2021. I’m very interested to see what the CPI numbers look like in 2022, since they will be growing off 2021’s higher base.