inflation, and when it’s a problem

I reader asked me to write about what I think the current inflation situation is. Here goes:

warming up

In an inflationary environment, prices are generally rising. In a deflationary one, prices are generally falling. It’s not just about prices, though, it’s also that different economic environments change people’s behavior and beliefs.

In a developed economy like the US, the principal price is wages.

We live in an inflationary world, which is ok if the rises are slow and predictable. The Great Depression of the 1930s demonstrated that deflation, a world of falling prices, is far, far worse.

If you’ve gotten the biggest mortgage you can afford so you can buy a house, and then wages start to drop at 10% a year, pretty soon you don’t make enough to make the payments any more. Both you and the bank are in trouble. If the place you work has borrowed, too, it may be forced into bankruptcy, leaving you homeless and out of work.

South America is littered with cautionary tales of what can happens when inflation runs out of control. When people lose their belief in the value of their currency, they stop saving and begin to buy anything that they think will preserve purchasing power–from gold and silver to used cars and power tools. The US had its own bout with this in the late 1970s. It took interest rates at close to 20% and a decade of austerity to break the hoarding reflex in consumers’ minds.

Inflation near zero also has its problems. Japan is the poster child here, with negligible inflation but virtually no economic growth for the last three decades.

The consensus of academic economists is that the best situation is having some inflation, but not too much.

money policy during the financial crisis

By 2000, inflation in the US was relatively steady at around 3%. Academic economists argued that the optimal rate should be 2%, and that we should reduce inflation to that level. They said that if that assumption proved to have negative economic consequences, then we could always push it back up to 3%.

Then the 2008-09 financial crisis happened, causing a year of deflation in the US in 2009. Money policy alone was barely able to nudge the country out of the furrow plowed by Japan in the 1990s–and even then only maybe a couple of rows over. Congress was its usual inept self and almost no help at all. Republicans argued a second Great Depression would be better than bailing out the banking system. Only a stock market freefall after their vote against any relief produced aid that was perhaps a quarter of what was needed.

I think this near-disaster is what has motivated the domestic economic community to approve of a policy that has been consistently erring on the too-loose side recently, in an attempt to create a comfortable distance between us and debilitating deflation.

today’s inflation

I think the major story is a temporary surge in demand. For example:

I started kayaking during the pandemic. Last spring I decided to buy a touring kayak so I could paddle longer distances. That’s when I discovered there was a kayak shortage.

Touring kayaks are a cottage industry, where unit demand grows by 1% or 2% a year. Suddenly, demand is up by, say, 30%. If I’m a manufacturer, what do I do?

I can increase capacity, meaning buying new molding machines and hiring/training new workers. I make a lot more money this year. But as the world returns to normal, demand drops back to the old level. Most likely, demand sinks below the old level (maybe way below) for at least a year. That’s both because some customers who would have bought in 2022 did so in 2021 and are no longer in the market for a kayak and because some of the 30% of newbies realize they don’t like kayaking, or no longer have time for it. So they put their barely used boats up for sale, depressing both demand and prices.

Now I’m stuck with the new machines and a bunch of workers I have to lay off because new orders in 2022 have melted away. Why take the risk of destroying a family business that’s worked just fine for, say, the past twenty years?

What makers have, in fact, done is, I think, the most economically sensible thing–they’ve raised production a little and upped prices by 10%. Long experience has taught them that surges in demand like this can come and go very quickly.

In a technical sense, the price rise is inflation. But there’s no reason to believe–and every reason not to believe–that this is the first in years-long series of price hikes that will convince people to hoard kayaks as a kind of savings, as a substitute for having a bank account or money in the stock or bond markets. What’s happening now is not the kind of inflation that occurred in the late 1970s in the US.

I think this sort of thing–one-off price rises–is what’s going on in the world economy now. The long-standing problem of very inefficient ports on the West Coast probably make the situation a bit worse in the US than elsewhere. Typical bungling by the “Big Three” US automakers likely also contributes. My guess is that we’re at or near (maybe even past) the peak of yoy price increases and will soon return to normal. This is also what the 10-year Treasury at 1.4% seems to be saying.

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