November 14, 2021
by Steve Stofka
Put a bunch of people in a crowded theater, then yell “Inflation!” and no one runs for the exits. Instead they all turn to each other and start arguing. The recent rise in prices has prompted much discussion on the dynamics and causes of inflation. In the first six months of this year, the Fed cautioned us to compare 2021 prices to those of 2019 to get a more accurate picture of inflation. That longer term perspective began at 2.0% in January and slowly rose to 3.0% in June (BLS Series CUUR0000SA0). However, it keeps inching up and topped 3.7% in October. The one-year inflation rates have topped 6%. There are several causes including supply bottlenecks and higher demand but how long will it last? Is it temporary or more permanent? What should the Fed do? Is this the return of 1970s inflation?
This will be a two-parter so that I don’t strain anyone’s attention. First some background. Inflation is an increase in the overall price level. Why do prices go up? Because buyers buy stuff. How do people get the money to buy stuff? By working. In the 1950s, a British economist William Phillips studied a seventy year period of data and established an inverse relationship between unemployment and inflation. If more people are not working, they don’t have the money to buy stuff and prices don’t go up much. During the 1960s, unemployment declined more than 3% to 3.4% and inflation rose from 1% to 5%. This interplay confirmed Phillips’ hypothesis and policymakers believed that they could make a tradeoff between unemployment and inflation, balancing the two to produce an optimal economy. In the 1970s, high inflation and high unemployment dashed those hopes. Later, the Phillips hypothesis was revised, matching the relationship of the change in the inflation rate to unemployment.
Still other revisions included the role of the public’s expectations of inflation. I’ll take a real life example from the late 1970s. The price of a stereo with turntable and speakers is expected to go up in price by 20% next year. A store is offering credit with a 20% interest rate. If a consumer buys it now rather than saving up until next year, the amount of interest equals the change in price. A consumer gets to use the stereo for a year for free! Consumers start moving their future buying decisions toward the present and this ratchets up demand and inflation.
Let’s go back to the definition of inflation as an increase in the overall price level. Where does that start? It may be the price of a commodity that we all use every day. During the 1970s, the sharp increase in the price of oil certainly had an effect. However, there was a sharp increase in oil in the summer of 2008 and there was not a prolonged bout of inflation. In fact, it may have contributed to the ongoing job loss that began in 2007 and added fuel to the developing housing crisis. Every time people think they got inflation figured out, it ducks and weaves like a boxer.
Without any change in policy, inflation automatically transfers income around the economy. Real, or inflation-adjusted, wages may remain the same but workers pay higher taxes on the nominal gains in wages. Economists call this seigniorage. The price of goods is higher so sales taxes are higher. Older people with savings earn higher interest income but those who want to borrow pay more in interest. Banks bank more profits on the difference, or spread, in the interest they pay on deposits and what they charge for loans. At higher mortgage rates, people can buy less house with their money because mortgage payments in the early years of a mortgage are mostly interest.
At higher rates of interest businesses cut back expansion plans and unemployment increases. This may help curb price pressures but people begin to adopt coping strategies than can prolong or exacerbate inflation. This creates a tug of war over the direction of prices. Next week I’ll review some of these behaviors and data trends from the past decades.
////////////////
Innocent Investor 