Inflation Station

My attempt at an inflation explanation.

Inflation is painful; unless, it’s the inflation of subscribers to this newsletter. Since the economy hasn’t been doing anyone any favors, I have decided to run a discount of 9.1%. You can now get the free version of this newsletter for 9.1% less than last week.*

*Deal is offered on a first-come, first-served basis and will only run while supplies last.

Inflation

Inflation has been the top of mind for everybody over the last year. That was no different this week when the latest CPI data came out with the headline number of 9.1%. In a nutshell, goods that everyday consumers buy are 9.1% more expensive this year than they were last year… not ideal.

Most people intuitively know that inflation means prices go up, but there are few people that understand what exactly inflation is, why prices go up, or or why it happens in the first place. My goal in this newsletter is to make sure that you, The Burnett Breakdown Bunch (yes, I just made that up, and yes it is permanent), are part of the few that can captivate a party audience with a riveting soliloquy on the topic.

From the outset, I want to be clear that I am not an economist and am probably unqualified to speak on inflation. I am also going to try and keep this as simple as possible which means not being as precise as an economist. It is with that bode of confidence that we begin.

I want to start with the basics of economics and talk about how the price of goods and services is determined. This is basic in that it’s probably the only thing most of us remember from our high school economics class: supply and demand. High supply + low demand = low price. Low supply + high demand = high price. I am increasingly convinced that if you understand this one economic principle, then you can understand pretty much all of economics.

The “supply side” of the broad-based economy is the goods and services produced and the “demand side” is the amount of money that consumers are willing/able to spend. If the law of supply and demand is true (and it is, so just accept it), then the higher prices we are experiencing right now are the product of a change in the relationship between these two sides. In the words of Milton Friedman, “Inflation is caused by too much money chasing after too few goods.”

Higher prices can only happen for 3 reasons:

1. The amount of goods and services decreased while demand remained the same.

2. The demand for goods and services increased while supply remained the same.

3. The amount of goods and services decreased AND demand increased.

COVID

With this in mind, let’s talk about what happened when COVID shut down the world. Governments across the world shut down businesses and discouraged people from leaving their homes for anything other than essentials. Businesses that were not absolutely flush with cash were put in dire straits. Many businesses were not able to continue operating and unfortunately had to shut down.

At the same time, businesses that had enough cash to survive were not eager to spend their cash that was being saved in a sort of rainy day fund. This meant many businesses stopped planned investments and/or growth plans that would require spending any cash. Even if a business wanted to continue investing, it likely could not because the companies or workers needed to fulfill the plans were unable or unwilling to work.

This same scenario played out all across the world and remained this way to varying degrees based on the situation in each country. Some countries opened up earlier and were able to get their economies up and running again. Other countries were slower to open. Since the economies of the world are so interconnected, the global supply chains were a mess and full of uncertainty.

All of this decreased the amount of goods and services that were available to purchase.

Meanwhile, the federal government passed the $2.2 trillion CARES ACT which “included $1,200 stimulus checks, enhanced unemployment benefits, created the Paycheck Protection Program small business forgiveness loan program, aid for state and local governments, and aid for corporations.” A year later, President Biden signed into law another COVID-relief bill that was $1.9 trillion and extended many of the provisions in the CARES Act.

In other words, the federal government increased demand by injecting a huge amount of cash into the economy. Decreased supply with increased demand will lead to higher prices every time.

While this all sounds obvious, the reality is much more complicated. Unexpected world events, such as the Russian invasion of Ukraine, have also contributed to economic shocks. Not to mention, economists differ on whether the supply side or demand side of the economy is more to blame. They disagree over how necessary the COVID-relief bills were or were not and the subsequent effects.

Solutions

So, what can be done about inflation? In simple terms, supply needs to increase and/or demand needs to decrease.

If business are able to produce goods or services at the same or faster rate that demand is growing, then prices will fall accordingly. Part of this will happen naturally as supply chains continue to adjust and smooth out; however, there is some stuff that the government can do to incentivize production as well. For example, burdensome and costly regulations can be cut back which would allow businesses to produce more efficiently and at a lower cost. Similarly, tariffs can be reduced or dropped completely so that companies can import at a lower cost.

Which brings me to the Federal Reserve and the demand side of the equation. The Fed is doing two things that are both attempting to decrease demand.

First, the Fed is raising the federal funds rate. By law, banks must maintain a certain percent of their cash in an account at the Federal Reserve. When a bank falls short of that amount, they will borrow money from another bank that has excessive reserves in their account. The rate that banks can charge one another for this type of lending is the federal funds rate set by the Fed.

The higher the interest rate, the more expensive it is for banks to borrow from each other. This makes them less likely to loan out money to customers and when they do, it will be at a higher interest rate. This makes borrowing money more expensive across the board and slows down the amount of spending/demand throughout the economy.

Second, the Fed is making long-term interest rates go higher by a process called quantitative tightening. This process is more complicated and will take more time to explain, so if you want to know more, you can read about it here, but just trust me that it is also meant to decrease demand in the economy.

The issue with decreasing demand is that it could very well send the economy into a recession as consumers spend less money, leading to businesses making less money, leading to businesses laying people off, leading to higher unemployment and even less money to spend, leading to businesses making even less money, etc.

There is a lot more to be said about inflation, and I have done it an injustice with some of my simplification; however, I hope this at least provides some clarity on the most basic issue. I also felt obligated to talk about it at some point since it’s been all over the news, so if this helped please feel free to send it to someone who may be interested.

God Bless,

Hunter Burnett