Inflation is making the news, but nobody seems to have a firm handle on what is causing it and how it will play out. Many have said supply disruptions due to Covid are the reason. It is certainly a concern. In the summer of 2020, I watched the price of a 2×4 stud rise from C$4.25 to C$12.50 because mills had been shut down. I looked a while ago and saw them at $4.28. As I type this, they are back up to $8.89 as lumber prices have soared again. If you listen to conservatives in America, it’s all Joe Biden’s fault for his support programs and infrastructure bills. Valid points, but while these do add inflationary pressure, they are not nearly enough to drive us into the 5% range let alone the 10% range which we are now beginning to see.
Inflation is the general increase in consumer prices at an unhealthy level. Our capitalist economies are founded on the principle of growth: we need to grow. You see this message everywhere. Our GDP is expected to grow by a healthy 2% next year. We need to bring in more immigrants so our city can grow. Whether this is right or wrong is a topic I won’t discuss further here. It is what it is.
Picture the economy as a train locomotive. It chugs relentlessly along the tracks transporting goods and making our lives great. But sometimes forces push this growth train a little too fast and if not curtailed, it runs out of control. A runaway train is inflation: prices rise then workers say we need more pay. When the workers have more, they spend more, prices rise, and the workers demand even more pay. And the cycle continues, chug, chug, chug, unabated until someone slams on the breaks.
The main tool our western governments use to slow down the inflationary train is interest rates. Wait a minute, both consumers and producers say, the cost of doing business just got higher. The cost of owning my home just got higher. The cost of borrowing to buy that new car just got higher. You want that much for using my credit card? Well, I’m cutting it up. High-interest rates throttle back demand, and prices eventually stabilize. At least that’s the theory. It worked in the 1980s, but my goodness it hurt. People were faced with 18% mortgage rates and 20% or higher credit card rates. People lost homes and went bankrupt. Businesses disappeared. But it stopped inflation in its tracks. Governments around the world are contemplating raising interest rates to dampen the current growth.
Our current inflation is not due to a runaway train. We are at the tail end of a pandemic and economies around the world are nowhere near their pre-pandemic levels. There has not been a robust let alone over-robust economic cycle to fuel inflation, yet stock markets have risen quite high, commodities have soared, and consumer prices and wages are steadily rising. We are also seeing wage increases.
One of the acknowledged forces driving inflation is supply. In supply and demand theory when you reduce supply, prices rise. If you watch car shows you’ll see comments like, oh, they produced a hundred thousand of those things, they aren’t very rare, I’ll pay you five-hundred bucks for it. Yet for the next car, you might hear, oh, they only made fifty of those, and I can’t afford to buy it from you. When supply of a product or service is low, people are willing to spend more to acquire it. This is because of competition. Picture a hundred people trying to buy the last loaf of bread and perhaps the last loaf any of them will see for a month. The person willing to spend the most for the loaf would get it. A bidding war. Then picture a single person wanting to buy a loaf from a store with shelves full of spoiling bread. Here, take two. When you lower supply, you make your goods rare and the price for it rises.
Raising interest rates will have no effect on this inflationary force. As I have shown, raising interest rates curtails demand, but it has no effect on short supply. If anything, it makes goods more expensive to make and lowers supply further. If we have closed lumber mills, do we really want to make it harder for companies to open them back up by increasing their cost of borrowing? And we do see this hesitancy in central banks around the world. Talk is we will see modest rates but no striking rises.
Supply has been reduced for several reasons. The main one is Covid. Besides lumber mills and operations, we have seen poultry and beef processing plants shut down for periods in Canada. These shutdowns reduce supply. We’ve seen international workers unable to travel. A friend of mine works in the mining industry, and what is normally a busy life of international travel has become a sedentary life of reading books and sipping bourbon. Meanwhile whatever he digs from the ground isn’t getting dug. Raw material production and manufacturing are coming back, but supply around the world is still low. Keep in mind, the USA is now largely open for business, but it’s the only country in the world that is. Most nations are still living with restrictions that reduce supplies. Again, raising interest rates will not get people back to work to reduce these inflationary forces.
There is an oil shortage in the world and while some of it may be due to Covid and even diminishing reserves, most attribute it to diminished exploration. And most attribute this reduced exploration to environmental concerns. The rabid environmentalists view oil as evil, and much money has been redirected away from oil. Group pensions for example not investing in oil companies to appease their members. Anyway, you can read a lot about this and I won’t get into the details. The only point I want to make is that oil supply shortages are here, will likely remain, and this is an incredible inflationary force. Everyone, even the rabid environmentalists, uses products made from oil.
The final force at play, and perhaps the most significant and least understood, is the money supply. The basic premise is the more money there is in the economic system, the more there is to spend, and this equates to increased demand for goods and services. It pushes the demand curve upward on the supply and demand graph and the equilibrium price follows. Inflation. If I put an extra $1,000 in your pocket, you are going to buy more of whatever it is you buy. You might go for a few extra meals, you might go on a vacation, you might buy whatever. And you might stow it away for a rainy day. Give it to someone else to invest and then hopefully pay you for that down the road. Mutual funds are the primary investment tool today as interest-bearing securities pay nothing anymore. But all that does is shift money around. It temporarily takes it from your pocket and moves it to someone else’s. That investment firm you gave it to bought shares in companies. More increased demand for those shares makes their prices rise, so the value of your mutual funds rise. Then buddy down the road cashes in his gains and buys a new car. The lines are not always clear but rising money supply results in increased demand which raises prices.
The problem for inflationary control is this money supply will be spent regardless of interest rate hikes. It’s out there in the system and fundamentally equates to permanent demand. It needs to be spent and it will be spent, interest rates be damned.
In March 2020 the U.S. Federal Reserve bought some $12 trillion worth of bonds. That basically means they pumped that much money into the economy. They created an extra $12 trillion out of nothing as shown in the M1 money supply graph. That’s $12 trillion that needs to be spent. Now M1 is not the best measure, and this amount is somewhat hyperbolic. A more meaningful measure is the M2 money supply. It only rose about $3 trillion at that time. Still, that’s a lot of coin to be spent. And they haven’t stopped. The latest numbers show M1 up about $4 trillion more, and M2 up about $1.5 trillion. That’s a $4.5 trillion movement of the demand curve upward. Prices have to follow.
Not only has the U.S. federal reserve thrown gas on the inflationary fire, but so have policymakers around the world. Every country has expanded and extended unemployment programs, given out business support loans and grants, implemented infrastructure programs, business incentive programs, and other unplanned incentives to kickstart their economies. Yes, they were needed to stave off mass unemployment, starvation, home loss, and general rioting, but they added to the inflationary train push. Many of us have been sitting around, paying down our debts, and waiting to get back to spending mode. And when we all do, it will be with a vengeance. Kinetic inflationary pressure is put into play. We’re just getting started down this very steep inflationary slope.
This current inflation is not due to a runaway train but a fundamental shifting of the supply and demand curves. The supply curve can and will eventually be corrected back to equilibrium levels, but it will take time. Many nations that supply raw materials have very low vaccine rates. Oil shortages are now pretty much entrenched until greenhouse energy takes over or more oil is found and exploited. At today’s prices, the monetary incentive is there for it if the environmental appeasement isn’t. Most importantly, the excess money created will remain created. This is a demand-pull that cannot be easily shifted back without taking money out of the economy. And nobody wants depression. In my opinion, it’s a perfect inflationary storm, so hold on tight.