The Causes of Inflation Explained 2022

Causes of Inflation

Do you wonder why groceries are now more expensive than before? A Bloomberg op-ed even suggested reducing  your grocery bill by cutting back on meat and feasting on lentils instead. If only dealing with inflation were that simple! Inflation is the rate at which the price of goods and services increases over a certain period of time. Your money doesn’t buy nearly as much as it once did. Consumer prices jumped 7.5% in January compared to a year earlier – the highest pace in 40 years. There are several reasons inflation is out of control.

Besides the war in Ukraine that has increased prices on commodities like gas. One factor has to do with supply chain issues. The global supply chain is incredibly connected. Many companies depend on other countries – especially China – for parts. So when factories there shut down with the outbreak of Covid-19, every stage of the manufacturing 
process felt the impact. With fewer parts and products being made – prices began to rise.

To illustrate just how connected the world’s manufacturing industries are – take the example of a pencil. It had to go through a lot of factories and countries before it got to your desk. There’s the rubber for the eraser. The metal that holds the eraser in place. The wood. The lead. The paint.

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This example is based on a well-known essay called I, Pencil by Leonard Read. If it’s that complex just to make a pencil, imagine how much goes into making a car! The automotive industry is struggling to manufacture new vehicles due to shortages in semiconductors – microchips that are used to power many features in vehicles: from steering to backup cameras to triggering airbags.

A single company in Taiwan makes 92% of these sophisticated chips. So with fewer vehicles coming off assembly lines while consumer demand remains strong, their prices are going up. Tesla substantially hiked the prices of its models in North America again by thousands of dollars.

It didn’t say why but Elon Musk recently talked about his company facing the pressures of inflation. Some people have no choice but to buy used cars. Demand is so high they’re selling for 40% more than last year – as much as the price of new vehicles! But the supply chain issues don’t fully explain the inflation we’re seeing. Another factor has to do with government spending. The U.S. government spent $5 trillion to help people and businesses hurt by Covid-19.

Causes of Inflation

The money went to families, mom-and-pop shops that had to close down, restaurants, airlines that had to cancel flights, hospitals, and others. Besides keeping people afloat, the government also wanted to prevent a recession when the economy goes into a nosedive because there’s not enough money being spent. There were concerns people wouldn’t buy anything because they didn’t have a paycheque and faced an uncertain future.

So the government stepped in by providing emergency economic relief – kind of like the parable once described by economist Milton Friedman of dropping bills from helicopters and letting people scoop up the cash  and spend it to stimulate the economy. The Covid-19 checks that millions of Americans received were “an immense fiscal helicopter drop” according to economist John Cochrane of the Hoover Institution in an interview with the  Wall Street Journal. He explained: “People are spending the money, driving prices up” And with that money, some put off returning to work because they were  living off hundreds of dollars a week in unemployment benefits.

Businesses scrambled to lure people back with raises. If a meat processing plant needs to increase worker pay, they’ll raise the price of the product to cover the cost – another reason for the rise in prices we’re seeing. But although people had more money in their pockets, many stores remained closed. And the businesses that were open dealt 
with those nasty supply chain issues. So supply couldn’t catch up with demand.

It’s sort of like a bathtub overflowing — if money pours into the economy faster than it can drain, it will spill over and cause disaster. Economist Cochrane said frankly: “The Fed being surprised by supply shocks is as excusable as the Army losing a battle because its leaders are surprised the enemy might attack.” (Wall Street Journal) He’s referring to the Federal Reserve, America’s central bank which is responsible for managing the money supply.

In the way you and I have checking accounts at the bank – banks have accounts at the Fed – it gives them credit, as in, it supplies them with money by creating dollars out of nothing. When the Fed wants to “print money”, it keeps the interest rate low which it did during the pandemic, at near zero. This is the rate at which banks borrow from each other. If banks are borrowing money virtually for free, this encourages them to lend their money to consumers and businesses at low interest rates for credit cards, mortgages, and bank loans.

The Fed also reduced the amount that banks are required to have in reserve…to zero. This is the amount of money the banks HAVE to store in their vaults overnight so they can meet the needs of their customers for the day. In the past, if a bank had $1 million in deposits, it could lend out $900,000 but had to keep 10% in reserve, or $100,000. Without the requirement for a reserve, banks are free to lend out more, and when they do, this reduces all other interest rates.

If interest rates are low, consumers have less incentive to hold onto their money and are more likely to spend it. The current inflationary cycle  actually came as a surprise to the head of the Federal Reserve, Jerome Powell. He believed that the demand he had created by giving people money – would eventually be met by supply.

But as we’ve shown, supply couldn’t keep up with demand due to the supply chain issues – so there was no “equilibrium” The Federal Reserve is now taking steps to try to reel in inflation. How? Well, in the same way that it can “print” money, it can also “unprint” money by raising interest rates. In March, the interest rate rose from near zero to 0.25-0.50%. As the cost of borrowing gets higher, people and businesses borrow less,  
so they hold off on making investments and purchases, which gradually slows down the economy.

This could also have the effect of helping to ease the supply chain issues because there’d be less demand for goods. However, on the other hand, there’s also the worry that if you raise interest rates too much – if you hit the brake pedal too hard – it’ll stall the economy and you could again face a recession. Some have likened treating inflation to treating cancer with chemo. You have to kill parts of the economy in order to slow it down. But you have to do it very, very carefully to make sure it’s effective.

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