As prices rise and each dollar buys fewer overall goods and services, it’s clear inflation is increasing. You see it at the grocery store and gas pump. The cost of beef was up 9.6 percent in 2020, while chicken was up 5.6 percent. Gas prices have risen since late 2020, driven by higher oil prices.
Already in 2021, lumber prices are up over 80 percent — trees have stayed cheap, but sawmills are unable to keep up with surging demand chasing a limited amount of sawmill production capacity. Of course, if your income doesn’t keep pace with all this, you have less purchasing power.
The cause of the inflation centers on reopening, stimulus, and base effects. First, when the economy shut down, oil prices crashed. As we reopened, oil prices have recovered, now around $60 per barrel. Because energy prices are a significant driver of overall prices in an economy, and energy consumption makes up a good portion of our budgets, the oil price recovery pushes overall inflation higher.
Stimulus plays a role. Under both Donald Trump and Joe Biden, we’ve spent trillions more than the government taxes. Before the pandemic, we were running nearly trillion-dollar deficits — spending $984 billion more than we took in in 2019. Trump’s tax cuts reduced corporate revenue as a share of GDP to extremely low levels, but government revenue improved slightly between 2018 and 2019 with a growing economy.
Yet federal spending increased nearly $300 billion between 2018 and 2019. In 2020, because of the coronavirus stimulus, spending exploded, resulting in a deficit of $3.1 trillion, the largest deficit as a share of GDP since World War II. 2021’s deficit will rival 2020’s. Government overspending can mean more money chasing after a relatively set amount of goods and services.
Others point to Federal Reserve money creation causing inflation. This gets complicated, but much of the money the Fed “prints” ends up sitting in excess reserve accounts at the Fed. The money has real-world effects and pushes financial assets higher because the printed money is buying up government debt or other securities, but it doesn’t directly hit the economy — at least not immediately.
The line in the sand between today and inflation overshooting is if the Fed explicitly begins to finance, not just subsidize, rising deficits with no end in sight. We’re not there yet, but some would take us there.
The ‘Inflation Pundits’
The unprecedented stimulus coupled with rising prices has all sorts of pundits, many of whom are trying to sell their investment funds, warning that investors aren’t prepared for higher inflation. National Review’s Kevin Williamson also warns all the stimuli could end in misery. Yet there’s a possibility that the bump in inflation is transitory, at least in the near term — meaning prices rise, such as in the energy space, but fundamentals of inflation such as workers’ wages or imported goods remain subdued.
This is where base effects come into play. In 2021, inflation is accelerating on a month-over-month basis. Yet most people talk about inflation in terms of year-over-year percent changes. Because the last inflation report for March 2021 compares against the onset of the pandemic in March 2020 — when prices fell because of lockdowns — inflation will look high on a year-over-year basis until at least June. Headlines noting high annual increases in inflation are just comparing against the COVID-19 lows of 2020.
Into the back half of 2021, the current inflation acceleration could lose steam because the year-over-year comparisons normalize, and we aren’t comparing against the peak of the pandemic. On top of this, Washington — still overspending — may be spending less money in 2022.
Biden’s so-called infrastructure plan contains about $300 billion in spending over taxes over ten years, but the taxes take effect immediately while infrastructure spending usually takes off more slowly. Investment pundits forget that spikes in inflation can quickly dissipate — like in 2008, where oil went to $140 a barrel that summer, only to crash below $50 by year-end.
What This Means For You
Americans have, over decades, seen the prices of the things needed for the American dream go up — from cars to houses, to education — without wages keeping pace, especially the wages of blue-collar Americans. One factor is that the government’s efforts to boost inflation tend to have redistributive impacts, and not always from the rich to the poor. Washington’s policies have been short-changing blue-collar and working-class Americans.
One example is that the working and middle-class historically depended on savings for their “nest egg.” They didn’t put all their money in the volatile stock market because they received an acceptable return from safe corporate or government debt, or from longer-term bank deposits. But the government trying to boost inflation via low rates has harmed savers, incentivized excess debt, and boosted financial assets the rich disproportionately own.
Redistribution also happens when government overspends and the people who receive the money first have more purchasing power than the general public. The middle class usually pays for the largess. This is called “the Cantillon effect,” named after Richard Cantillon, an Irishman who made a fortune on the boom and subsequent collapse caused by a money-printing scheme in 18th-century France.
The latest stimulus bill was $1.9 trillion. Let’s assume that $1,400 went to each living American (not the case because of income limits), about 330 million people. So, less than a quarter of the bill, $460 billion, went toward direct checks. Where’s the other three-fourths? — think Cantillon effects.
Also worth mentioning in all of this is “Modern Monetary Theory,” or MMT, which is growing in popularity in the Democratic Party. Without going into too much detail, MMT says the government can spend whatever it wants and can simply raise taxes if inflation overshoots. There are many problems with MMT, but the greatest is it enriches those connected to government at the expense of everyone else.
The Outlook
Inflation may decelerate in the latter part of 2021 and into 2022. Yet inflation might be structurally higher in the coming decade. Some of this is due to demographics, like a soon-declining working-age population and low birth rates (though policymakers have more control over these trends than many in the GOP think). Other factors might be shifts in global trade alliances, somewhat less use of the dollar globally, and increased trade regionalization.
Yet MMT could mean inflation spirals out of control. The solution to avoiding this and exiting our country’s debt problems is more complicated than many establishmentarians think. Government overspending that goes directly to the people, which can come with incentives to use the money to pay down household debt — a modern jubilee — is much better than government overspending for Washington’s special interests or foreign wars. Direct spending to people could also couple with measures to curb long-term entitlement programs, and other largesse.
Yet government checks only to grease the wheels of Washington special-interest spending rob America. Likewise, government overspending that goes to immediate consumption of goods, given where things are produced today, just fuels the trade deficit and creates jobs overseas.
The lesson of America’s recovery after World War II is that government spending was cut sharply, from about 50 percent of GDP to the low-teens — but also that the war effort meant few consumer goods were available and households built up large savings, which helped spur demand for American goods once the war ended.
If only spending could reduce consumer debt, increase interest rates, but also be part of a package that cut future expenditures. Yet many in both parties fear cutting out the Washington middleman. Maybe an enterprising politician will figure out a way to do both the smart and popular thing.
