Today, the government reported the Consumer Price Index (CPI), the popularly reported number for inflation, at 8.3%. What does this mean? What we as average people know is that we are paying more for the stuff we buy, especially gasoline and food. This paper will share some of the root causes for inflation. I do not have the solution. What I do know is that much of the commentary I read on inflation is appalling. This includes commentary from so-called “experts.” My hope is to educate the reader on inflation.
We have to start at the beginning. What is inflation? The
dictionary defines inflation as, “a general increase in prices and fall in the
purchasing power of money.” While technically correct, the definition does not
get to any cause. A better definition, one I read many years ago, holds that
“inflation is too many dollars chasing too few goods.” It gets to the causes of
inflation: 1. Too many dollars; 2. Too few goods. Too many dollars is the key
component. The great economist, Milton Friedman, once said that “inflation is
always a monetary phenomenon.” When I refer to too many dollars, I am speaking
of the money supply. “Too many dollars” refers to excess money supply floating
around in the economy.
There are 3 basic definitions of money used by economists,
called M1, M2 and M3. M1 is the narrowest and most liquid definition of money,
M3 is the broadest and least liquid. The Federal Reserve no longer reports M3.
The components of the money supply are as follows:
M1:
Currency plus checkable deposits. Travelers checks fall here but are seldom
used.
M2: M1
+ short-term time deposits (such as CD’s), and money market deposits.
M3: M2
+ long-term time deposits
When economists speak of the “money supply” they usually
refer to M2. When I speak of the money supply throughout this article, I will
be referring to M2.
As you might have guessed, when I think about inflation, I
focus like a laser on the money supply. Normally, the money supply growth
should be in line with economic growth. If the economy grows 3% per year, and
the Fed targets a 2% inflation rate, the money supply should grow by 5% per
year. Now, if the money supply grows by 7-8% per year while the economy grows
by 3%, this imbalance likely will not affect the overall economy, but the
imbalance will need to be corrected in a reasonable amount of time. If done
successfully, the Fed will engineer what is known as a “soft landing,” where
they can slow down the economy a bit without sending it into a recession.
When more money is added to the system, each dollar becomes
worth less than before. Policy makers will
sometimes lower interest rates as an incentive to put more money in the system.
Interest rates are the price of money. As rates drop, more money gets put into
the system and each dollar’s value drops. With more money in the system, and with
the value of money dropping, it takes more dollars to buy the same basket of goods
as before. Hence, inflation is created.
What we have going on today is a great imbalance between
economic growth and money supply growth (too many dollars). It started in 2020
with the great stimulus actions put in place by the federal government in
response to the COVID-19 pandemic that swept the globe. During 2020, the money
supply grew by 24.8% while GDP contracted by 3.4%. The gap was further
increased in 2021 as the money supply grew 12.3% and GDP grew by 5.7%. While
the overall inflation was just 1.4% in 2020, it is no wonder that the CPI
jumped to 7.0% in 2021, and now stands at a 40-year high through the first 1/3
of 2022.
It is not just the money supply that creates inflation. Like
the inflation of the 1970’s, there are supply shocks that spike prices (too few
goods). In the 70’s, it was energy. Today it is semiconductors that go into a
broad swath of products that we use. We see this described today as “supply
chain” issues, but these are shocks to the system. In this case, I do not
believe that the supply-chain issues will work themselves out quickly. It will
take time to bring on board additional capacity to relieve supply shocks. Many
of the semiconductor companies that are experiencing supply chain issues have
cautioned that they expect these issues to last another 12-24 months.
It is not just the semiconductors. Prices will creep up all
across the economy due to the increased availability of money. The next waves
of inflation that hit the broad economy will likely be rents (shelter) and wage
inflation.
How do we break this inflation? The model for this was
served up by Federal Reserve Chairman Paul Volcker in the 1979-1982 timeframe.
Unfortunately, this will involve a lot of economic pain. Economists are
starting to call for a recession beginning in the late 2023, early 2024
timeframe. I fall into the camp of those who believe that we will see such a
recession. Given the large disparity between money supply growth and economic
growth the past couple of years, the recession could be severe. Volcker broke
the back of inflation by raising interest rates. In 1980, inflation ran at 12%
for the year. By 1982, inflation was at 4%, which is where is largely remained
throughout the decade. However, in between 1980 and 1982 was the worst
recession that we had experienced since the Great Depression (the 2007-2009
Great Recession eclipsed it). I consider Mr. Volcker the greatest Fed Chairman
of all time because of his relentless action to break inflation. Current Fed
Chairman Jerome Powell has indicated that he will likely follow the path that
Mr. Volcker charted, though not near to the same degree. As I see it, Mr.
Powell has no other choice.
A few final thoughts on this inflation. It will likely be
the number one issue in the mid-term elections this fall. Unfortunately, what
the politicians have to say about it will likely amount to a bunch of
half-truths at best and outright lies at worst. Sad as this is to say, they
will say a lot about this issue from a position of either ignorance, or just
sheer stupidity or both. With that in mind, here are three observations to keep
in mind to filter out the noise:
1.
It is not all Joe Biden’s fault. Yes, he has
done some things to fuel this inflation, but the significant portion of the
blame falls elsewhere. Sorry Republicans and Conservatives.
2.
Corporate greed has nothing to do with
inflation. Sorry Democrats and Progressives.
3.
Oil is a special case. Oil is a global
commodity. When a 13-nation cartel (OPEC) controls 75-80% of the world’s
supply, and all international transactions are consummated in US Dollars (which
have declined due to the large growth in the money supply), you have a very
special situation. OPEC and the strength/weakness of the US Dollar largely
determine oil prices. War between Russia
and Ukraine does not help either. The declining dollar plus geo-political
instability in Eastern Europe have come together to send oil prices soaring.
This inflation will be with us for awhile. The actions needed to relieve the inflation will take time, likely several years. We will get through this. I do believe in people’s abilities to work their way through these kinds of troubles.
