Inflation

More and more we are hearing experts worry about rising inflation. This worry is new for several reasons but the best one is the data. Since the recession ended in 2009, the inflation rate as measured by the percentage change in the consumer price index has averaged less than 2% per year. 

Some of you remember the extreme inflations of the 1970s but this recent bout of disinflation is extreme even in regards to recent decades. Inflation is clearly on a downward long term trend. And like a boxer on the canvas, we can't call inflation out until the count of 10. Economists for the first time in quite a while -- are wondering if inflation is ready to come back. 

And that's where the stories get interesting. Inflation is one of those household words that we interface with all the time. Fruit prices are up -- housing prices are up -- wages are climbing -- productivity is falling -- the money supply is increasing -- government is spending more -- the list goes on and on. The list of causal suspects is so large that it is overwhelming. What really explains or causes sustained or durable inflation? Is there no simple or more simple way to think about it? Why are some experts ready to see it rise and become worrisome again?

The main source of their concern comes from economic recovery. We have a simple theory that says that prices respond to imbalances between demand and supply. Too much supply and prices go down. Too much demand and prices go up. During a recession the inflation rate often falls because demand is insufficient to buy all the goods and services produced. Whether demand is low because people have meagre resources or is low because government limits what they can buy, the outcome is the same -- demand is low and so is inflation. 

It makes sense that if experts believe that Covid is going to improve and if experts believe that buyers will start buying more -- then they believe that an economic recovery could be in our near future. Firms seeing demand snapping back will be more optimistic and will have more confidence that higher prices will stick. Some experts point out that regulations that made it difficult to buy have caused households to save a lot -- and when the economy improves they will want to convert those savings into cars, clothing, and who knows what else. 

Makes sense to me. But there remains one big question. When I used to teach in a classroom, I would refer to the slope of the supply curve. When the demand curve shifts rightward along a given supply curve, what happens to output and prices depends on the slope of the supply curve. Or in more common language -- a flat supply curve translates higher demand into a lot more output and not much price change. But a very vertical supply curve translates more buying into price increases. 

Why would a supply curve be vertical? 

Vertical means that firms simply cannot or will not increase output when demand increases. Today, firms have plenty of workers and equipment laying around. So a deficiency of inputs is not the problem. The problem is expectations. Why hire a bunch of workers or light up your plant if you are not pretty sure that the increase in demand will keep up? Why go to all the trouble to meet an increase in demand if you don't think you will make profits doing so? It would be much easier to raise prices for a while to see how things pan out. 

Why would firms be worried about future demand and profits? Probably for many reasons. Perhaps they are skeptical about the longer term effects of very unique and  risky recent government policies. Huge government deficits and endless zero interest rates might be cause for concern. Politics of regulation might enter into the equation as well. Raising the minimum wage often affects the whole structure of wages as everyone gets a bump. Higher wages might sound good for spending but it raises costs and reduces profit incentives for suppliers. 

We don't need to repeat every policy the Biden administration is contemplating to reduce the supply of energy and bring on renewables.  And I think it goes without saying that whether it is healthcare or education -- the Biden administration's emphasis on equity is bound to lead to concerns about business costs and profitability. 

Is inflation going to worsen? Probably so. It seems to me that policy is tilting the nation's supply curve in a vertical direction. As policy incentivizes buying yet penalizes selling, the outcome is likely to be less in the way of increased output and employment and more along the lines of higher prices. 

We are living through quite an economic experiment. The ride should be interesting.