This question has both a simple textbook answer and one that is much more nuanced. Humans always seek to simplify the complex. We establish shortcuts, or heuristics to help us make sense of things and keep from getting bogged down. In some cases, that’s probably the best course – keep it simple, stupid. It keeps us moving forward, and when it comes to inflation, there are a couple of core concepts that help us do just that—the simple supply and demand for goods and services along with the overall supply of money within the financial system. For example, inflation materializes when more money (demand) is chasing fewer goods (supply) or any combination of demand outweighing supply. This makes intuitive sense. If more people are offering you money for goods you have for sale, you’ll probably decide to raise prices. If you have fewer goods for sale, and the same amount of people want to buy them, similarly, you’ll probably be able to raise prices as some of those people might be willing to pay more to assure they can get what they want or need. In addition, if money supply increases within the financial system either due to central banks creating more of it (our Federal Reserve) or banks lending more of it into existence, then demand for goods and services could rise and inflation could ensue. This is a neat little rule of thumb that looks fantastic in a textbook, but unfortunately doesn’t always play out as expected.
Why, you ask? Because the financial world and economies within it are incredibly complex. Many “experts” called for runaway inflation in 2008 and almost every year since as a result of government bailouts and the Fed’s addiction to quantitative easing which steadily increased the supply of money within the financial system. Based on our textbook heuristic, inflation should have arrived, but it didn’t. After all this stimulus and monetary support, why would it take 12 years for inflation to finally show up? Like we said, our economic system is complex, so we’ll never know for sure, but we’d venture to say that a combination of the following factors played a role in delaying its arrival and ultimately opened the gates for it:
- Even though the Federal Reserve was growing its balance sheet (increasing the amount of money in the financial/banking system) through quantitative easing – what a lot of people refer to as “printing money” – that money didn’t effectively make it into the hands of the average person through wage increases, loans, or increased economic activity. Rather, it served as collateral on bank balance sheets that encouraged more financial asset speculation. So, the aforementioned experts were right about inflation, they just didn’t anticipate it would be almost exclusively in financial markets rather than in goods and services.
- Offshoring. Even if we assume some of the monetary stimulus made it into the actual economy via loans or wages, cheaper more profitable trends in offshoring manufacturing effectively served to increase supply. This helped keep prices low by offsetting any marginal increases in demand. The “Walmart effect” if you will.
- Excess capacity. When financial markets are strong and debt and equity financing abundant, corporations have a tendency to build spare capacity to meet anticipated demand. If that demand doesn’t materialize, that excess supply/capacity can have a disinflationary effect. Perversely, this seems the opposite of what we’d intuit from a strong financial market environment.
- Population. The thinking is that when you have a big increase in the working age population, especially when these people are entering the peak spending years of their 30’s and 40’s, you have a situation where there is more demand (at least initially) for the same amount of goods and services. This meets our simplified model for inflation and is likely a contributing factor to the surge in inflation we saw in the late 60’s and 70’s as the Baby Boomer generation hit the workforce and started spending money en masse. This population surge has been absent almost everywhere in the world over the last couple of decades.
- Debt. High debt levels create debt service payments that detract from consumption going forward. Borrowing and spending helps initially, but ultimately reaches a point where it starts to hinder more than help overall economic activity. See Japan 20-30 years ago, Europe 10-20 years ago, and the U.S. over the last 10 years. All of these developed economies saw a dramatic slowdown in growth after reaching suffocating levels of total debt. All else being equal, high debt loads ultimately redirect dollars from productive economic activity toward debt service payments and have a disinflationary effect on prices.
- On balance, fiscal stimulus hasn’t gone directly to the people. Most of the bailout and stimulus money from the government prior to 2020 went to corporations, not consumers. There are many things corporations can do with profits and windfalls that do more to increase prices of financial assets than consumer demand.
So, what changed in 2020? In reaction to Covid, the Fed injected so much money into the financial system that it grew the money supply by ~40% within two years, the Federal government gave stimulus money directly to consumers, and the supply of many goods and services was greatly reduced due to supply chain disruptions. This combination of events seemed to finally offset all those other variables that had a disinflationary effect for so long. The textbook formula was quite obviously playing out – there was a lot more money chasing fewer goods. Prices had no other choice but to rise.
The question now is, how long does this combination of factors continue to hold? Our sense is that consumer demand will soften as the economy slows over the coming quarters, but supply issues could remain a problem for some time. In addition, we still have all those disinflationary forces that should continue to keep true runaway inflation in check until those factors themselves change or go away. What all this means is that in the short to medium term, we should see consumer prices for discretionary items (the things people don’t “need”) ease a bit. Non-discretionary commodity prices on the other hand could remain high for a bit longer due to supply issues and demand being more inelastic (people will prioritize food and energy spending when they have less money to spend). Over the longer term, given the set of variables we’re dealing with now, we should see prices ease even further driven mostly by the obscenely high debt loads being carried in the developed world. However, when it comes to commodity prices, similar to the risks of those prices staying high in the shorter term, supply issues could drive this story over the longer term as well. After years of capital expenditure underinvestment in a number of energy and metal-related commodities, we could be facing shortages for years rather than months. The bottom line is that although inflation may not go too much higher from here, it’s probably not going back to 2% any time soon; especially commodity inflation.
Editor’s Note: This article was originally published in the May 2022 edition of our “Cadence Clips” newsletter.
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