The Problem with Inflation

I am not an economist, but I find the subject fascinating.   What is particularly interesting is that it is far from being a true science, but rather has quantitative, psychological and sociological components.  I have read a great deal on the topic and also done some online coursework to become more familiar with the concepts.

 

The developed world is experiencing substantial inflation for the first time in many years.  The last period of high inflation in the USA was in the late 70’s and early to mid 80’s.  The USA and the EU both have inflation currently, though from what I have read the inflation in the USA is somewhat higher than in the UK and EU.

 

There are many causes for the inflation.  Some of the causes are left over from supply chain problems caused by the pandemic.  Another possible cause is the surplus cash infused into the economy as pandemic relief through the American Rescue Plan.  And of course the recent invasion of Ukraine by Russia, with the ensuing economic consequences and energy embargos, will be a significant contributor to inflation.

 

The problem is that once inflation rises over a modest 1-2%, there are positive feedback effects that are difficult to predict or control.  Positive feedback means that when some quantity increases, the effect of that increase on other things tends to cause the original quantity to increase further.  This is a recursive effect that can spiral out of control in the worst case, and often does in countries where there is limited financial stability.

 

If prices rise, then consumers (especially at the lower end of the pay scale) struggle to make ends meet. This in turn will cause upward pressure on wages to ease that burden.  In a labor market that favors workers (i.e. low unemployment and lots of jobs available) wage increases will certainly occur.  This is the current situation. 

 

If producers are forced to increase wages, then they will raise prices further – positive feedback.  The rise in prices may eventually reduce demand for products, which can then stabilize the wages and prices without a further spiraling effect.  But when this will occur is difficult to predict or control.

 

There are other factors that can increase inflation once an inflationary cycle begins.  One example is that opportunistic producers may raise prices unnecessarily to increase profits, hiding behind the general inflationary trend.  And even if some or all of the inflationary pressure is driven by temporary problems with the supply chain, it is unlikely that prices will return to their original levels.

 

The Federal Reserve will attempt to rein in inflation by raising interest rates.  This will have the effect of reducing the cash flow and availability, which in theory will reduce demand and stabilize prices.  How quickly this stabilization will occur is the key question, and whether it will occur without seriously reducing economic growth and threatening a new wave of job losses.

 

Once anything is out of equilibrium in the economy there is the danger that there will be some major problems – inflation, recession, unemployment, etc.   How well the Fed can manage to hold things together while the world is still recovering from the pandemic and in the midst of a major conflict is a question that has no immediate answer.  We will hope for the best.