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OPINION

OPINION: Inflation Is Here, And It’s Only Getting Worse. Here's How It Affects The Lake

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Inflation - Dollar Bills Disappearing

The dominant issue in the business media since early May has been the very rapid increase in the rate of inflation. That is when the April data was reported indicating a surge to more than 4% (annualized). This represents a nearly doubling of the long-term trend of around 2%.

As an economist, I thought “Wow!” Although I was expecting an increase, the magnitude surprised me and most other economists. Moreover, in early June, the May inflation data was reported indicating a further increase to a whopping 5%. The June data released in early July was even worse showing an inflation rate still higher at 5.2% annualized. “Double, or make that Triple, Wow!!!” These statistics are stunning from an economic perspective. Last September, in a series of articles regarding Lake economic issues, I stated the following specifically related to the stimulus payments resulting from the pandemic:

“It is true the huge and unprecedented economic stimulus funds pumped into the US Economy by the Federal Government softened the short-term blow significantly, but there is no free lunch and such funds do not represent actual economic output. Nobel Laureate Economist Milton Friedman once stated, “Inflation is always and everywhere a monetary phenomenon.” Therefore, expect some serious inflationary tendencies as all those dollars chase a fixed, or perhaps shrinking, stock of goods. This means we will soon be paying much higher prices for just about everything.

Like most economists, my firm forecasted a surge in inflation in 2021 resulting from the huge and unprecedented stimulus bills that made their way through the US Congress and were ultimately signed by the President. The impact was almost immediate as we began to experience steep price increases in various products such as building materials, energy and, in the Lake area especially, real estate. Therefore, the April, May and June inflation reports were widely expected and feared by most economists. But the magnitude of the increase in the span of just three months exceeded the vast majority of projections by economic forecasters.

In the simplest explanation, inflation is defined as the decline of purchasing power of a given currency over time. Rising prices cause a decline in purchasing power. For the average consumer, this means that fewer goods and services are affordable due to their higher than usual prices. Over time, the effect can be significant.

So why is inflation feared?

Inflation wreaks havoc on long term economic growth. In its extreme form, it is known as “hyperinflation” and has been the cause of economic collapse around the world. Countries such as Venezuela, Hungary, Zimbabwe, Yugoslavia have all experienced periods of hyperinflation. Hyperinflation has not just been the nemesis of third world countries, as even Germany experienced the phenomena early last century. Usually, inflation is associated with periods of economic growth; however, another form of inflation has been associated with periods of economic contraction. In the 1970s, the US experienced a prolonged period of economic contraction and inflation simultaneously. This phenomenon became known as “stagflation” and represented a dreary and prolonged period for the US economy.

For illustration purposes, imagine a small micro-economy with just one thousand consumers and businesses (think isolated island somewhere). These one thousand businesses and consumers as a group produce a “basket of goods and services” known as total output. They use a “currency” to facilitate buying and selling to each other. If there was a fixed amount of currency in circulation, the price level would remain stable. But what would happen if the local island “central bank” increased the money supply significantly, say by 20%, by simply mailing out checks to all one thousand consumers and businesses.

Our thousand businesses and consumers are still producing (approximately) the same amount of output but now there is a much greater amount of liquidity in the system (more money in their pockets) to purchase the same output. Therefore, prices will rise as consumers “bid up” the price of goods. Most consumers and businesses are rational; when they see the effect occurring, they will increase their own prices in attempt to offset the previous rise. As the process repeats itself, inflation is said to “spiral” out of control. This is very bad for any economy and, in extreme cases, can cause economic collapse.

Inflation At The Lake

How is this phenomenon affecting the Lake?

Of course, consumers here are faced with the same general price level rise as elsewhere. However, the most visible effect at the Lake is in the real estate market. All those dollars chasing what has become an extremely limited supply of Lake real estate for sale has caused a rapid increase in prices. In some cases, real estate prices have doubled in the span of barely two years. Another effect has been the simple lack of product available. For example, dock builders are as much as two years behind in projects. So if you want your dock modified or a new one built, you likely will be waiting awhile as there is no current supply of that product/service at any price. Many other service businesses simply cannot handle the volume of work available. The labor market is also out of equilibrium causing some businesses to close or reduce hours simply because they cannot find enough employees. Unfortunately, “shortages” are often an unpleasant side effect of excessive monetary stimulus and often accompany periods of high inflation.

Inflation affects all consumers, but it is especially significant for individuals on a “fixed income” such as many retirees. Even individuals in the workforce are impacted. Wage rate increases over the last several years have averaged approximately 3.5%. Therefore, at a 2% inflation rate, workers are gaining ground and becoming “wealthier” in real terms. Conversely, at a 4.2% or a 5% rate, workers are losing ground. Historically, wage rate increases have remained relatively stable so workers have fared the best during periods of low inflation.

Deflation

As bad as inflation is, “deflation” or a decline in prices can be even worse. For an economy to grow, maintain high levels of employment and produce rising living standards, the money supply must be controlled. As output is increased the money supply must be gradually increased to “accommodate” the economic growth. How the government controls the money supply is beyond the scope it this article, but suffice it to say, the government has numerous effective tools at their disposal (more on that later). Optimally, the rate of growth of the money supply should be carefully correlated with the actual growth in economic output. Increase the money supply too rapidly and inflation results; increase the money supply too slowly and deflation results. In either case, economic growth can be stifled or even decline. Economists now generally agree that the Great Depression of the 1930s was the result of deflation from poorly orchestrated monetary control by the central bank. As my grandfather aptly described the Great Depression, “You could by a candy bar for a nickel, but nobody had a nickel.”  The central bank of the time failed to accommodate the economy by not introducing liquidity into the economy. Hence, it is important for the money supply to be gradually increased to provide consumers and businesses the required “liquidity” to purchase goods and services.

Price stability and high levels of employment are such important economic goals, the United States Congress created the Federal Reserve System in 1913. The Federal Reserve (or Fed) has a dual mandate: Maintain price stability and maximize sustainable employment. The two mandates are interrelated and often conflicting. By controlling the money supply, the Federal Reserve indirectly controls the rate of inflation. Carefully feeding the economy the necessary liquidity provides money for businesses to invest and grow which leads to high levels of employment and ultimately economic growth.

In practice, the Federal Reserve “targets” a low rate of inflation, typically around two percent. If inflation is bad, why does the Fed target some low rate, shouldn’t the inflation target be 0 (zero)?  Earlier in my career, surprisingly, I had never asked this question. Nary an econ professor addressed it in grad school. Fortunately, at a banking conference I heard the question asked of then Philadelphia Federal Reserve President Charles I. Plosser (2006 – 2015). I will paraphrase his answer: Plosser stated that there are two schools of thought. He was a disciple of the first explanation that inflation measuring tools are imprecise and deflation is such a serious risk that by targeting a low positive rate of inflation the threat of any chance of accidentally falling into negative (deflation) territory is greatly diminished. Makes sense. The second school of thought (supported by then Federal Reserve Chairman Alan Greenspan) is that the rate of inflation must be low enough that it will not generally influence economic decisions made by consumers and businesses. In countries that have experienced high rates of inflation, consumers and businesses often made irrational economic decisions such as purchasing and hoarding goods that were not needed in fear of the prices rising sharply in the short term. Also makes sense; I believe both Charlie Plosser’s and Alan Greenspan’s explanations to have merit.

So what does rising inflation mean to the average consumer? Reduced purchasing power over time. If wages do not rise at a rate commensurate with the overall price level, we become poorer in real terms. With a low rate of inflation such as two percent, the price level doubles about every 36 years. At the 4.2% rate such as was experienced in April, the price level doubles more than twice as fast in approximately every 17 years. At the inflation rates reported in May and June, the price level would double in less than 14 years. So it is not a linear function, i.e., a small percentage increase has a huge impact over time. Think about that. At the current rate of inflation, goods and services will cost twice as much on average in less than a decade and a half. Ouch!

One final thought:

Inflation tends to accelerate – and not in a linear fashion. Stated differently, April’s 4.2% reported rate was almost certain to be followed by even higher reported rates in subsequent months – such as was experienced in May and June. And July and subsequent months are likely to be even worse. Therefore, it is important for the Federal Reserve to move aggressively now to reverse the trend. Failure to do so promptly will almost certainly lead to a recession or worse.

How should the Fed tame inflation?  By sharply reducing the rate of growth in the money supply (i.e., making money more expensive by raising interest rates). Over time, this will allow output to fall back into equilibrium with the current money supply in circulation. Unfortunately, in some cases, a recession is necessary to accomplish this. Back in the early 1980s, Federal Reserve Chairman Paul Volker is largely credited with “breaking the back” of the very high inflation rate of the time. Within a year of his appointment in 1979, Volcker used the tools of the Fed to aggressively fight inflation. He was successful. Inflation peaked in March of 1980 at nearly 15% (flirting with hyperinflation). After a brief recession, inflation was back to a normal range of below 3% in less than three years and the economy began a sustained period of robust growth. Most economists now agree that had inflation not been allowed to get so far out of hand in the 1970s a recession could have been avoided. Listen up Mr. Powell!

It is true that the massive amount of liquidity dumped into the economy by Congress to offset the pandemic buffered the economic impact for many in the short term. However, it is equally true that the resultant inevitable inflation and market dislocations will cause a much longer term and more severe negative economic impact overall. 

There is no free lunch...

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