The Economics of Inflation

Inflation is not going away soon.

The new CPI number was released for August yesterday and came in at a 8.3% year over year rate.

That makes six consecutive months where the headline number has been over 8%.

The 8.3% number seemed to surprise analysts and economic observers who were anticipating a lower number.

It did not surprise BeeLine. I made this prediction about where the CPI was going in these pages last June.

At some point, we should see some moderation in the index if for no other reason than the base index gets higher with each succeeding month,

At some point the CPI number will come down. That doesn't mean current prices are going to go down.

If gas prices are the same next year that would be a 0% increase in the CPI index. Keep in mind the CPI is only measuring price changes over the last year. The base the CPI is being measured against is getting larger every month for the inflation that started just over a year ago.

Looking at the data I would expect inflation to remain at least 8% through September assuming there is not a total meltdown of the economy that will drastically cut demand pressures. 

The high inflation number apparently dashed hopes that the Federal Reserve would soon be pausing or reversing interest rate increases.

This led to a massive sell-off on Wall Street.

Source: https://www.wsj.com/livecoverage/stock-market-news-today-09-13-2022

A year ago we were told that inflation was transitory.

The same story was told by Joe Biden, Secretary of Treasury (and former Federal Reserve Chair) Janet Yellen and current Fed Chair Jerome Powell.

They obviously didn't know what they were talking about.

We then heard that all of the inflation was due to supply chain issues coming out of Covid.

Or it was Putin's fault.

However, the New York Federal Reserve recently published an analysis that showed most inflation we are seeing has been caused by DEMAND issues rather than supply issues.

Two-thirds of inflation was due to aggregate demand shock issues in the economy.

Simply stated this means too much money chasing a limited supply of goods and services.

Where did all that money come from?

This is a chart showing the growth in the money supply (M2) over the last 10 years.

I added a trend line to the FRED chart below to show how massive the increase supply in the money supply has been in the last two years.

Of course, a lot of this was done to facilitate massive government spending programs in the wake of Covid.

The Fed increased the money supply nearly 40% in less than two years.

This is the primary cause of the inflation we are seeing right now. Too much money was created chasing a limited supply of goods and services.

Students in Economics 101 learn about the effects of supply and demand on prices in the first week of class. However, that lesson appeared to have been forgotten by our economic policy makers over the last two years. 

It is interesting to consider this same concept in looking at prices and inflation in the UK and Russia right now.

Sanctions were placed on Russia by the UK, the European Union and the United States as a tool to increase pressure on Russia and attempting to influence the popular opinion of the Russian people against Putin and the Ukraine war.

Those sanctions have had the effect of reducing the supply of Western goods and services into Russia. Companies like McDonald's, Starbucks, Heineken and Coca-Cola announced they were halting business in Russia.

Many other large retail names also did the same.

Credit: https://www.thesun.co.uk/news/19698308/russia-uk-prices-sanctions-food/amp/

This reduction in supply undoubtedly made these items impossible to get or made them very expensive on the secondary market.

At the same time, the sanctions limited Russia's ability to export Russian products that might normally go to the UK and other Western countries such as vodka, caviar and other food items. This has created a greater supply of these goods to be sold to Russian consumers.

Of course, the Western countries no longer will buy Russian oil although they desperately want Russian natural gas to continue to flow to Europe to keep the lights on.

Russia has had no problems selling its oil and gas to other counties and the worldwide price of both has gone higher since the Ukraine war started insuring there is plenty of money in Putin's coffers. Russia has also been able to demand payment in Russian rubles rather than U.S. dollars (the normal form of payment) for their oil and gas. This has propped up the ruble's value in currency trading.

The end result of this is that prices of those things that people need to live day to day (food and energy) have declined or remained affordable in Russia while prices on these things in the UK and Europe are out of control.

Putin may be also be using some of the cash he is getting from oil and gas sales to subsidize the price of food and energy knowing that people are less likely to rise up when the costs of these items are stable compared to not being able to get their Starbucks coffee every day on the way to work.

This is an example of a comparison of prices between the UK and Russia as recently reported in a UK newspaper, The Sun.

Source: https://www.thesun.co.uk/news/19698308/russia-uk-prices-sanctions-food/amp/

Yet another interesting example of the forces of supply and demand on prices and inflation.

For comparison, here are a few of the price increases of individual items in the U.S. CPI index in yesterday's report over the last year.

It is the highest inflation rate for food at home (groceries) in 43 years--- +13.5%.

Bread +16.2%

Margarine. +38.3%

Eggs  +39.8%

Of particular interest, is the fact that health insurance costs are +24.3%. That is the largest yearly increase in history.

Does anyone remember Obama and Biden claiming that the "Affordable Care Act" was going to reduce health care insurance costs?

That might suggest to you how much inflation is going to be reduced by the "Inflation Reduction Act" that Biden and the Democrats celebrated yesterday on The White House lawn.

Source: https://www.foxnews.com/politics/biden-celebrates-inflation-reduction-act-inflation-rises-august

Energy +23.8% in the U.S.

It is infinitely better than Europe but is still squeezing the budgets of every American.

Of course, what comes next as Winter approaches and energy becomes an even bigger potential issue in Europe and elsewhere?

When economists want to know what comes next with consumer prices they look at producer prices.

The Producer Price Index (PPI) measures price increases that domestic producers are experiencing for their output. If their prices are increasing its means that either they will pass those costs in their prices to consumers or, if they cannot, those costs will have to be absorbed and effect the bottom line of the business. 

What is the most recent PPI number in Europe?

37.9%.  By comparison, the latest PPI number in the U.S. is 9.8% ( the August PPI number will be released this morning ((9/14/22)).

Source: https://www.investing.com/economic-calendar/ppi-935

Compare that number to the 5-year trend in Europe.

Eurozone PPI (YoY)
Source: https://www.investing.com/economic-calendar/ppi-935

The latest CPI in the Eurozone is 9.1%. That is a long way from 37.9%.

Basic economics tells us that the 9.1% is either going to go up further toward 37.9% or we will see more and more European businesses under financial stress that will result in closures, job losses and a recession, if not a depression.

One other economic reality is that supply and demand forces equalize over time.

It is the natural order unless government interferes with that process.

When demand exceeds supply, demand will eventually be diminished or destroyed, or supply will increase to meet demand.

For example, this is an interesting chart from Sweden that compares consumer confidence (potential demand) with total inventories (supply) in that country to show that process is well under way.

Central bankers like to say that when we are in times like this their goal is to bring the economy down into a soft landing.

Considering where we seem to be, those bankers need to have the skills of Pete "Maverick" Mitchell to avoid a hard landing let alone a crash from the ride they have taken us on.