Published on May 5, 2022 in the Rochester Business Journal

If you’re in your 50s, o.k. early 50s, you probably remember a time when a gallon of gas cost less than a dollar, when a gum ball cost a penny and when a giant shopping cart of groceries cost less than $100 – ah, the good old days. Today, gas is over $4 a gallon, a gum ball costs a quarter and your hundred dollars probably buys you half a cart of groceries, if you’re lucky. That’s inflation folks and it can become more pervasive when governments implement poor policies, when input costs rise, and when demand exceeds supply.

Poor government policies can be monetary or fiscal in nature and often become apparent as an unintended consequence of a problem they were intended to solve. For example, during the Great Recession of 2008, and more recently during the COVID pandemic of 2020, the Federal government not only cut interest rates to almost zero, but also engaged in a massive quantitative easing (QE) program which dramatically increased the money supply. As part of this program, the Federal Reserve Bank and the U.S. Treasury effectively created trillions of dollars to purchase Treasury bonds and mortgage-backed securities. With more demand chasing a relatively fixed supply, prices eventually went up and, in as much as price and yields tend to move in opposite directions in the bond market – for safe, high-quality bonds, at least – the resulting high bond prices maintained downward pressure on interest rates.

The rate cuts and massive QE programs mentioned above were designed to keep the price of money cheap, to encourage people to borrow, spend and invest, and to carry us through two particularly difficult periods of time. One of the unintended consequences of QE, however, is that we now have a bunch of extra money sloshing around in pursuit of the same basket of goods and services: the result - higher prices (i.e. inflation).

Aside from misguided monetary policies, misguided fiscal policies can also have unintended consequences. Remember all those stimulus payments issued during the COVID pandemic? The ones designed to ease the burden on the U.S. taxpayer for being sick or otherwise constrained from working? Sadly, between this type of stimulus, unemployment payments, social security payments, other Government-based forms of assistance and the concurrent high cost of day care, many found it more advantageous to stay home, rather than return to work. Fewer workers led to higher wages for those willing to work and, ultimately, rising input costs. Rising input costs, in turn, have resulted in something called cost-push inflation, where producers of goods and services pass higher input costs on to the consumer (in the form of higher prices) to keep profit margins constant. Other examples of cost-push inflation include rising input costs resulting from sanctions imposed on other countries (i.e. Russian oil and gas) as well as trade policies resulting in higher taxes on imports (i.e. Chinese goods), both of which lead to higher prices.

Aside from cost-push inflation, there’s a second concept known as demand-pull inflation. This occurs when demand exceeds supply. When such high demand exists, prices are pulled upward as goods and services are continually sold to the highest bidder (i.e. those bidders willing to pay more for a scarce good or service). The recent COVID pandemic created the perfect storm for both types of inflation. At its onset and as the economy contracted over 30% in just three months during the early part of 2020, inventories were worked down and production capacity was shuttered. As we began to emerge from the pandemic, and in terms of what we’re still experiencing today, disruptions in the supply chain have increased input costs (i.e. cost-push inflation) at the same time pent-up demand is exceeding available supply (i.e. demand-pull inflation). Accordingly, annualized inflation rose to 8.5% in March, its highest level in over 40 years.

Now that everyone, including the Fed, is keenly aware that an inflation problem exists, the discussion has turned to what we do about it. Here, some issues are more easily resolved than others. Withdrawing stimulus by winding down QE and raising interest rates seems to be the easiest way to bring down inflation, and rather quickly at that. The concern here, however, is that the Fed moves too far, too fast and pushes us into another recession. Raising bank reserve requirements is another effective way to head off inflation, as banks would generally be required to hold more capital for every dollar lent. This would lessen the overall supply of credit and, in turn, the amount of money in circulation. Less money in circulation ultimately equates to less consumer spending which, by implication, means less demand and downward pressure on price.

Withdrawing QE, raising interest rates and raising bank reserve requirements may be an effective way to reign in inflationary pressures in some parts of the economy, but other factors like higher wages and higher input costs resulting from geopolitical circumstances may be more difficult to contend with. In the case of the former, wages rarely go down, and in the case of the latter, it’s anyone’s guess as far as whether things get better or worse from here. What does seem clear, at least historically, is that periods of high inflation are generally followed by periods of lower inflation, sometimes even deflation. Long-term, however, inflation has averaged approximately 2.5-3.0% per year.

Inflation rates will ebb and inflation rates will flow, sometimes based on governmental policy, sometimes based on rising input costs, and other times based on the simple imbalance between supply and demand. We may not like it, but this has always been the case and we shouldn’t expect that to change anytime soon.

To see this column in the RBJ, click here.