Inflation is a controversial topic these days.
Though your opinion on it probably depends on how old you are and where you live.
A Venezuelan would have a severely different idea of inflation compared to a twenty something guy in Western Europe or the UK where price increases have been pretty low and stable over the last few decades.
To give a brief understanding of inflation it can be useful to know the following:
- It can be caused by supply-side constraints. For instance if companies can’t produce goods faster than consumers can buy them, naturally prices rise.
- It can also be caused by high demand levels, similarly this is when consumer demand outstrips production capacity.
- Other causes include excessive printing of money, which devalues the currency as it takes more of the currency to buy the same products.
- Another is increasing costs of production, which causes price increases along the supply chain eventually reaching the consumers.
- It is usually measured by CPI — the consumer price index, but if taking into account housing related costs it’s better to use the RPI — Retail price index
- CPI and RPI are both calculated using the prices of a weighted basket of commonly purchased goods and services.
- The above list is not exhaustive but I believe it covers the main points for this purpose.
In the past we have seen many cases of this resulting in pretty much devastation for the population of countries. This includes the governments of Venezuela and Argentina excessively printing money to pay off their government debt. Naturally this means that one peso today is not worth one peso next year as there are a lot more pesos next year than today. So my peso today is probably going to be worth 0.10 pesos next year if I’m lucky. This is an extreme case called hyperinflation.
Today, the UK, US and EU governments subscribe to an economic theory known as Modern Monetary Theory (MMT), which is basically the story of Argentina but modern somehow so it’s perfectly fine. Though this is a simplification of the process, the principle is the same: print money to pay off debt (devaluing the currency in the process). And due to The Pandemic, governments have been borrowing a hell of a lot of money. To put a number to that, the US total debt now stands at around 27 trillion dollars.
So what does this mean?
Well we don’t have to speculate about the answer to that. As the answer is obviously inflation. The key argument in this new decade is more nuanced. The real questions are how long does it last? And how bad will it be?
As we know from The Fed, apparently this is just transitory inflation and it will go away after we have gone back to normal for a while. On the other hand we can clearly see that inflation is here right now, and what the Fed says about the future doesn’t actually really matter. This is because of a key principle about inflation: it depends heavily on expectations.
So to consider the average American. Let’s say you wanted to purchase a used car for $1000 in 2020, but due to The Pandemic you deferred the purchase to 2021.
Now 2021 rolls around and you come back to make that purchase. At a 5% inflation rate now the car is selling for $1050.
You haven’t heard the Feds announcement or you just don’t believe them because you can see prices rising with your own eyes.
What now? Well you realise you should’ve made the purchase last year.
Unfortunately you can’t go back in time, so you choose the next best option which is to buy the car now.
So you head back to the dealer and ask to buy the car, he says he’s had offers for $1200 from buyers who have come to the same conclusion as you, albeit a bit more extreme.
Now you may be seeing the problem here, if this perpetuates then prices will continue to rise as people expect prices to rise and hope to buy now in order to save later. As a result the inflationary spiral will continue.
The truth is that this doesn’t just apply for cars. It applies to pretty much all consumer goods, houses as well as wages. As costs increase, workers will naturally demand higher wages, and wages are sticky downwards meaning that even if inflation halts, costs of production still stay high meaning prices still stay high, so inflation won’t stop at all.
So you may also be seeing why the Fed keeps proclaiming that inflation is “temporary” and “transitory”. If the public believes what they see then inflation won’t be temporary. If they believe what the Fed says then it will. Like a self fulfilling prophecy…
