Daniels Finance Professor answers questions on inflation
Nearly two years ago, the world came to a halt amid the spread of COVID-19. Through lockdowns and layoffs, consumers changed.
Demand for goods and services dropped initially, but it has rapidly risen since early 2021. And with unemployment nearly as low as pre-pandemic levels, inflation, which often has an inverse relationship to unemployment, is at a 40-year high.
What is inflation?
Inflation is when you have rising prices. That’s the definition of inflation. Before this last year, inflation was maybe 1% or 2% per year. And that’s not anything that gets people excited about in a negative manner. When it starts to become 7% or, well, 5%, 6%, 7%, and even well above that in certain goods and services, then that starts to attract people’s attention. What’s going on? Why are these prices going up so much?
Is inflation always a bad thing?
Not necessarily bad. It’s just a lot of times inflation comes with a growing economy. As people have more income, they can spend more. They’ll spend more on goods and services, and you’ll see some prices going up. So, that’s not necessarily bad. But when you get up into things like 7%, that hurts. Because prices are going up 7%, but your income is only going up 2% to 3%. Then you’re losing purchasing power.
What is causing what we’re seeing right now?
Normally, you can have inflation when demand for goods and services increases and supply of goods and services is the same. That would cause inflation. You can also have inflation if demand for goods and services stays the same, but the supply of goods and services decreases. What we have now is, we have both. The demand for goods and services has increased at the same time the supply of goods and services has decreased. And so, that’s why we have the big increases we’re seeing today. Because both of those factors are causing inflation.
Are other countries experiencing inflation as well?
I’d say yes. Yeah. A lot of it clearly results from the pandemic. And since that’s global, we’re seeing this globally.
If a lot of this is a byproduct of the pandemic, was this inevitable?
Well, we’ve done some things that have put us in a position on the supply side that certainly now we’re seeing the consequences. For many years now, we’ve shipped production of goods and services out of our country. And so our country is not in a position now where we can increase the production of goods and services. We’re more dependent upon what’s going on in other countries. And then we’re dependent upon getting those goods and services over here.
Can you explain the role of the Federal Reserve in our everyday lives?
There are a couple of things on the government side that have contributed to inflation. One is just the large amounts of government spending that we had during the pandemic. And those were things like all the stimulus checks and all the programs to try to help people out during the pandemic. That put a lot of money into consumer’s hands that is now getting spent. And so, the large increase in government spending has contributed to this. The other role the Fed has played, the Federal Reserve has been doing things to increase the amount of money that’s in the economy. … if they’re doing things to promote lots of money in the economy, then interest rates are going to be low.
Interest rates are at record lows right now. And what that does is, that encourages borrowing to do more spending. And if we do more spending, that’s going to be potentially inflationary as well. What the Fed can do is curtail the amount of money they’re putting into the economy, which is going to increase interest rates.
So for example, it’s going to cost you more now to buy a car. It will cost you more to get a mortgage. It would cost businesses more to go out and borrow if they wanted to expand capacity. They’re hoping that if they do some of that, that’s going to slow down the economy.
The issue with that is … a lot of companies are doing very well during the pandemic. And unless they increase the interest rate to very large increases, companies like Amazon are still going to go out and borrow. If instead of costing 5%, it now costs them 6%, they’re going to say: “It’s still worthwhile for us to borrow money at 6% because we can earn a whole lot more on it. Because right now, we’re doing very well during this pandemic.”
What is the Consumer Price Index (CPI)? How is it calculated?
Consumer Price Index is, essentially said, let’s put together sort of a basket of consumer goods and see what it cost us this year. And then let’s see what it cost us one year from there. And the increase in cost is when the consumer price index says, “On the average, consumer prices went up by 7%.”
Companies like Starbucks and Chipotle have been criticized for giving their CEOs sizable raises and bonuses while increasing prices for consumers. Is that criticism warranted?
Yes. And there’s the gap between what I call regular workers and the CEO-type positions. That gap has been increasing dramatically over the last few years. So, the compensation for CEOs and senior-level executives is going up. And while the rank-and-file workers are seeing some increase, they’re certainly not seeing anything like that.
So the question that gets asked is, why should they be getting paid so much? And it’s kind of a circular argument because some people say, “Well, we’ve got to pay them that much, or they would leave.”
If a CEO gets paid through stock options, how does that affect the employees?
Let’s suppose I’m in that position and someone says, “We were thinking about the increase in the health-care benefits for our employees.” And I say, “Well, this is what is going to increase our expenses and make our net profit go down.” And our earnings per share go down. And the market doesn’t like the fact that our earnings per share aren’t as good or growing as fast.
So our stock price goes down. So that creates impact on my wealth. Even though it would’ve been good for the employees to give them their better benefits. So yeah. I’m not taking any wages, I might make some decisions that are better for me because of the stock return not necessarily the best for the stakeholders.
When do you expect inflation will cool?
The Russian invasion has created more global economic uncertainty, especially in the oil and natural gas markets. Russia is the world’s second-largest producer in those two markets, behind the U.S. We are already seeing a sharp rise in oil and natural gas prices. It will get much worse if Russia is banned from exporting.
Since oil is an input to many more goods than just gasoline, high oil prices will cause the inflation to continue at a high level. In addition, we are not doing much to solve the supply chain problems, which are also a major cause of the inflation. Our consumer price inflation has been 7.5%. I think we can see this rate with us all year, especially if the Russian invasion and sanctions are with us for a long time. Goldman’s forecasts of 4.6% by the end of the year and 2.9% for 2023 are too optimistic. I would predict 7% and 5%, but Russia has made these hard to predict.