What is inflation? Here’s why prices are rising and who’s to blame

Let’s start with the simplest version: inflation occurs when prices generally rise.

This is “broadly” important: at any given time, the price of goods will fluctuate in response to changing tastes. Someone makes a viral TikTok about Brussels sprouts and all of a sudden everyone should have it; boom, sprouts prices are rising. Meanwhile, vendors of cauliflower, last season’s trendy vegetable, are practically giving away their wares. Such fluctuations are permanent.

However, inflation occurs when the average price is almost all consumers are buying up. Food, houses, cars, clothes, toys, etc. To afford all this, wages must also rise.

It’s not always bad. In the United States for the last 40 years or so (and especially this century) we have lived in an ideal low and slow inflation rate, accompanied by a well-functioning consumer economy when prices rose. about 2% per year, if that. Sure, the prices of some things, such as housing and health care, are much higher than they used to be, but other things, such as computers and televisions, have become much cheaper, so that the average of all things combined remains relatively stable.

Still with me?

Okay, let’s get to today and why inflation is all over the news.

When “inflation” is a bad word

Inflation becomes problematic when the slow boil comes to a boil. That’s when you hear economists talking about “overheating” the economy. For a number of reasons, largely related to the pandemic, the global economy is now in a state of intense boiling.

Economists use two main indicators to track inflation in the United States, and although both declined between June and July, they are still close to their highest levels in four decades.

The consumer price index rose by 8.5% in July. The personal consumer spending price index, favored by the Federal Reserve, rose 9.8% in July from the same period a year earlier.

And this is where Econ 101 merges a bit with Psych 101. There is an aspect of behavioral economics to inflation where it can be a self-fulfilling prophecy. When prices rise for a sufficiently long period of time, consumers begin to anticipate price increases. You will buy more goods today if you think that tomorrow they will cost significantly more. This leads to an increase in demand, which leads to an even greater increase in prices. And so on. And so on.

This is where it can get particularly tricky for the Fed, whose primary job is to control the money supply and keep inflation in check.

How did we get here?

It’s all due to the pandemic. And the war between Russia and Ukraine.

In the spring of 2020, when Covid-19 spread, it was like a twitch fork on the global economy. Factories around the world are closed; people stopped eating in restaurants; airlines have suspended flights. Millions of people were laid off as the business disappeared almost overnight. America’s unemployment rate jumped to almost 15% from about 3.5% in February 2020.

It was the sharpest economic downturn on record.

At the same time, the Fed has taken emergency stimulus measures to keep financial markets from falling. The central bank cut interest rates to near zero and began pumping tens of billions of dollars into the markets every month by buying up corporate debt. In doing so, the bank likely averted a complete financial collapse. But the persistence of this easy money policy over the past 20 months has also fueled—you guessed it—inflation.

Consumer price inflation hits new 40-year high in March
By early summer 2020, demand for consumer goods began to pick up again. Fast. Congress and President Joe Biden passed a historic $1.9 trillion stimulus bill in March that forced Americans to suddenly get rid of cash and unemployment assistance. People started shopping again. Demand fell from zero to 100, but supply could not recover so easily.

It turns out that when you turn off the global economy, you can’t just turn it back on and expect it to start buzzing at the same pace as before.

Let’s take cars for example. Automakers saw the start of the Covid crisis and did what any smart business would do – temporarily close to cut losses. But shortly after the pandemic shut down factories, it also boosted demand for cars as people worried about the impact of public transport and avoided flying. Automakers (and car buyers) have had a whiplash.
Automakers' problems are much worse than we thought

Cars require a huge amount of parts from a huge number of different factories around the world, which must be built by highly skilled workers in other parts of the world. It takes time to get all these invisible operations back online, and it takes even longer to prevent workers from getting sick.

Economists often describe inflation as too much money chasing too few goods. This is exactly what happened with cars. And at home. And Peloton bikes. And any number of other items that have become popular items.

How is the supply chain involved in all this?

“Bottlenecks in the supply chain” is another thing you see all over the place, right?

Let’s go back to the car example.

We know that high demand + limited supply = prices are rising.

But high demand + limited supply + production delays = prices rise even more.

The operation of all modern cars depends on a variety of computer chips. But these chips are also used in mobile phones, home appliances, TVs, laptops, and dozens of other items that, unfortunately, were in high demand at the same time.

This is just one example of a disruption in the global supply chain. Since new cars were slow to arrive, the demand for used cars skyrocketed, causing headline inflation to rise. In some cases, car owners have been able to sell their used cars for more than they paid for them a year or two ago.

What happens next?

Prices and wages may start to decline, but are likely to remain high for some time. How long and for how long depends on countless variables around the world.

Russia’s invasion of Ukraine has shattered hopes for a significant price cut in 2022.

The conflict has upended commodity and oil markets, pushing up food and gasoline prices around the world. This exacerbates supply chain headaches, leading to further shortages of critical food and oil.
Meanwhile, a lockdown in China earlier this summer brought the world’s largest seaport to a virtual halt. Corporations also bear some of the blame, as many large companies raise prices to protect their profit margins.

And it is not known what new shocks – a resurgent variant of Covid, a massive shipping container stuck in a waterway, a natural disaster – could stop progress.

The Fed is ready to move faster on interest rates

There is no single government or central bank that can correct the inflation caused by these global shocks.

But central banks are doing everything they can. In the United States, the Fed began raising rates by a quarter of a percentage point in March – the first increase since 2018 – and has since raised rates four times this year. There is no sign that they will stop anytime soon.

When money becomes more expensive to borrow, it can dampen the sting of price increases and bring the economy back to that pleasant, quiet simmer. At least that’s what the Fed hopes. His biggest problem is raising interest rates as fast as the economy can handle—raising them too much, or too quickly, can lead to a drop in demand, which could undermine economic growth or even trigger a recession.

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