The discussion on major news outlets and social media in the United States in the past week has been the feud between Jeff Bezos and President Joe Biden. And it is all about inflation. How did it get so bad and who to be blamed for it? But what is inflation and why is it bad? To simplify, Inflation is the rate of increase in the price of goods and services over a given period of time.
The government evaluates the standard of living by conducting a survey of the common goods and services consumed by its citizens and tracking how these prices increase over time. The goods and services range from eggs, Cheese, and rent to services such as a haircut. The cost of this basket of goods and services at any given time expressed relative to a base year is known as the Consumer Price Index or CPI. The percentage change in the CPI over a certain period is known as the Consumer Price Inflation. This is the most commonly used measure of inflation. For example, if the base CPI is 92 and the current CPI is 100, inflation is 8 percent over that period. The current Rate of inflation in the United States for the period ending April 2022 is 8.5%.
Causes
Inflation is a concern for consumers, politicians, and policymakers. Inflation reduces the purchasing power of consumers and renders them poorer if their nominal incomes do not keep pace with the increase in prices. If people are buying fewer goods and services with the same amount of money over time, their standard of living decreases.
Fiscal Stimulus.
During the covid-19 crises of 2020-2021, cities instituted lockdown and most businesses were closed. This means people were out of jobs and a lot of companies could not make payroll. To prevent an impending economic calamity, the government took a series of measures to stimulate the economy, such as providing grants to businesses to keep employees on their payroll.
The American rescue plan was signed into law
to soften the effect of the pandemic came
with a cost of 1.9 trillion dollars.
When a government increases the money
supply without a corresponding increase
in the output of goods and services –the
the velocity of money held constant—there is
bound to be inflation.
This is what we are seeing play out.
Supply Chain gridlock and China Lockdown.
As countries began climbing out of the Covid lockdown in 2021, overseas factories were slow to back online, much less operate at full capacity. Demand by consumers in the U.S. was strong and people, fueled by stimulus checks, placed online orders. Strong consumer orders led to an unprecedented number of container ships calling at the ports in the United. At one point [ in December of 2021], there were more than 150 ships waiting to dock at the Los Angeles and Long Beach complex. This gridlock led to shortages and subsequent price hikes.
The situation has only gotten worse with the 2022 Covid-19 lockdown in China which started in the middle of March and continues to date. The U.S. economy is a consumer-driven economy. The United States has been running a trade deficit with its major trading partner China. When a country depends so much on imports and there is a disruption in the supply or the supply of essential commodities and components, the subsequent shortage will lead to an increase in price.
Possible Solutions
Dealing with inflation is an easy proposition. There are market forces in control, making it difficult for any government to provide targeted prescriptions. In most cases, it was government policies that led to the rising prices in the first place. So, what can the Feds do to tackle inflation without making the situation even worse and plunging the country into recessions?
Structural changes.
As discussed earlier, part of the reason for rising prices in the United States is the shortage of essential commodities and the delays in getting goods from factories to stores resulting from the supply chain gridlock and China lockdown. The United States needs an overhaul of its economy. The government needs to provide incentives for manufacturing at home. This means states and local government needs to implement policies and incentivize manufacturing. Companies complain about rigid rules and years of environmental review processes that prevent factory construction. Elon Musk’s decision to build the new Tesla Giga factory in Austin, TX, was partly because of the complex and rigid process of approval for a factory in California. The country needs to make manufacturing a priority---and this should be at all levels—Federal, State, and local governments.
Interest Rate Increase
The United States has witnessed about three decades of low inflation. But that is slowly changing. The price of most consumer goods is going up—from gasoline to used cars and eggs. The overall CPI at the end of April 22 was an estimated 8.5%. The United States Federal Reserves [as part of its dual mandate] is tasked with keeping inflation low—at about 2%. The Feds has signaled it will raise interest rates several times this year—about five times. So how does raising interest rates tame inflation? The hope is that—by raising interest rates--the cost of borrowing by banks will increase. The banks pass on this high cost to businesses and consumers. This high cost of capital means businesses will have to pay more to borrow capital and may decide to put off borrowing which in turn slows down economic activity. A company may decide to put off hiring new employees or expand its factory operations if the interest it pays on the loan goes up. This is the cost to the economy. And this is what slows inflation. Prices for goods and services go up with increasing demand. But when demand slows down, the reverse happens, generally speaking.
Conclusion
Relying on the Feds to tame inflation may be a daunting task. The current inflation is a result of structural features in the United States economy and misguided fiscal and monetary policies. A long-term solution will depend on a holistic approach by the government to limit dependence on imports of essential goods, expand manufacturing at home, and limit interventionist fiscal policies that tackle short-term pain at the expense of much-needed structural economic fixes.