Why are prices going up?

Introduction

In one of my recent videos I discussed the hot housing market. That video is closely related to today’s topic on inflation. We are seeing an increase in inflation. We just had the fastest increase in the annual CPI rate since 2008. The monthly gain in core inflation was the largest since 1981. People have been asking me what are the possible reasons for this increase in inflation.

The reasons range from supply shocks and supply chain issues to the recent stimulus packages passed in 2020 and 2021. Some fear that it might be cause the economy to “overheat”. So what does all of this mean for you? Should you be worried about the recent inflation numbers? Let’s discuss what is happening, why it is happening, what to expect in the future, and how it will impact your bottom line.

If you are interested in learning about inflation itself and how it is calculated, check out my other series of videos where I discuss how inflation is measured.

Spending after the Pandemic

A year ago, spending took an unexpected and drastic drop. With quarantines and lockdowns, people were stuck at home, unable to go out, and not spending at their usual levels. Now with covid cases decreasing, vaccinations increasing, and restrictions easing people are suddenly going back to their pre-pandemic spending levels. This sudden shock is pushing prices up. This change in spending is going to complicate things. Year-over-year comparisons are going to be distorted for a few months because of the pandemic’s impact.

Supply Chain Shocks

The pandemic slowed down production of goods and services over the past year. Firms have struggled to revive these supply chains. There is a shortage of items/inputs in the the market. This is driving up prices. We are seeing a shortage in car manufacturing, the lack of semiconductors and chip shortages, have pushed car prices up, especially in the used car market.

Some economists believe that the elevated price increases, because of the increased demand and the supply side lag, are only temporary. They are calling this recent 4.2% increase in prices as transitory inflation. For that reason, Federal Reserve policymakers are dismissing the current round of numbers as transitory with the expectations of inflation settling down later this year around the 2% range targets by the central bank.

Others are more worried about inflation because they believe that inflation will last longer than the Federal Reserve predicts because it is being driven by the recent by the recent stimulus packages and expansionary monetary policy. The money that the government and central bank  is pumping into the economy can cause a positive output gap, where spending in the economy is growing too fast due to the extra liquidity in the market. This has the potential of causing runaway inflation if not controlled in time. 

It is not clear if inflation is here to stay or if it is temporary. Most economists, including Fed Chair Jeremoe Powell, believe that it will pass. After the latest Fed meeting he said,

Federal Reserve Chairman Jerome Powell

Our expectations is these high inflation readings now will abate.

The Federal Reserve has raised its expectations for 2021 inflation to be 3.4%, but expect it to return down to their target inflation rate of 2%.

So what does this mean to you? The price increases you are seeing today are responses to the falling prices of last year. We saw this in the energy markets, oil fell sharply last year as market demand fell and now it is back up. Here is a graph of the Brent European Oil Prices. Current market prices are lower than they were in 2018 but much higher than they were in Q2 of 2020.

In the short run we will see increasing costs, relative to a year ago. Some increase may stay to make it in long term contracts. We are seeing average wages finally start to pick up, which is a really good thing! Wage growth has been low in the US since the 1980s. 

Another thing to talk about is that inflation helps redistribute wealth. When there is unanticipated inflation, there is a redistribution between lenders and borrowers. Lenders are hurt by unanticipated inflation because the money they get paid back has less purchasing power than the money they loaned out. Borrowers benefit because the money they pay back is worth less than when they borrowed. So borrowers might benefit from this inflation.

Over the next several months as we return to “normal” and supply chains are connected again, as work hours pick up, as we start to move away from fears of covid breakouts, we will start to see supply increase, and then we will know if inflation is transitory or if it will be here for a while.