Inflation - Myths and RealitiesThere has been a great deal of talk these days about whether the inflation we are seeing is transitory or not. There have been common themes in the press about this subject. One is that we are seeing inflation due to economic recovery from the depths of the COVID lockdowns and the other is supply chain issues.
First of all, inflation is essentially never transitory. There have been very few years in history where the CPI actually fell year over year. The Great Depression is the only period of time in the last hundred years where this was the case. When the media and The US Fed talk about transitory they are talking about a slowdown in the rate of inflation not no inflation.
Could relaxation of COVID restrictions contribute to the inflation levels we are seeing today?
The short answer is that we don't know but probably.
What about supply chain issues?
This is the one that most commentators dwell on and say that once this is sorted out inflation pressures will be reduced.
But is this actually true?
The four biggest components of the CPI are housing, transportation, food and energy. None of these are really affected by supply chain issues. In fact in the US, the annual inflation is now 6.8%. If you take the first three of these out then the rate falls to 4.9%. It is even lower if you take out energy. This would suggest that supply chain issues are really a red herring.
So what about the transistory issue?
Economics 101 tells us that prices are affected by the balance of supply and demand. One key element of demand is Government spending. Most Governments in the world have been running for quite a while historically high deficits and there is little sign that this might change. In fact in the US, the CBO was asked to analyze Biden's Build Back Better plan assuming that the programs continue to run for the full 10 years as opposed to just the first three years which more realistic since these programs cannot be stopped (eg child care) after 1-3 years as set out in the plan. The results? The plan would result in an additional 3 TRILLION in deficit financing by the Government. If AOC has her way, this deficit number would exceed 10 TRILLION!!
So if Biden's plan gets through the Senate then we will see huge stimulus spending for the next 10 years in the US which will continue to fuel inflation for a long time. Economic theory also tells us that such inflation rates will result in demands for higher wages which in turn fuel more inflation.
So what is the clue (to quote Hamlet) that something is rotten in the State of Denmark?
Historically in a healthy economy, 10 year interest rates are usually about 1-2 percentage points ABOVE the inflation rate. Right now the 10 year interest rate is over 5 percentage BELOW the inflation rate. I know of no other period in history where this has been the case and it is clearly a sign that something is out of whack and that an adjustment is needed and at some point the forces resisting this adjustment will run out of tools. History has also shown that the longer the natural forces are held back, the more violent the adjustment will be. Not to scare people, but the last time there was a sustained blocking of the natural forces for an extended period of time was in the 1920s and we all know what happened next.