What is inflation? Here’s why prices are going up, and who’s to blame

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Inflation is, paradoxically, both incredibly easy to understand and absurdly complicated.

Let’s start with the simpler version: Inflation occurs when prices rise significantly.

This “largely” is important: at any time, the price of goods fluctuates according to changing tastes. Someone does a viral TikTok on Brussels sprouts and all of a sudden everyone must have them; boom, germ prices go up. Meanwhile, sellers of cauliflower, last season’s trendy vegetable, are practically giving away their produce. Such fluctuations are constant.

Inflation, however, occurs when the average price of virtually anything consumers buy goes up. Food, houses, cars, clothes, toys, etc. To pay for these necessities, wages must also increase.

This is not a bad thing. In the United States, for the past 40 years (and especially this century), we have lived in a low and slow ideal inflation level that comes with a well-oiled consumer economy, with prices going up to at about 2% per year, if that. Of course, the prices of some things, like housing and health care, are much higher than before, but other things, like computers and televisions, have become much cheaper, so that the average of all things combined is relatively stable.

Still with me?

Alright, let’s move on to today, and why inflation is all over the news.

When “inflation” is a dirty word

Inflation becomes problematic when this low, slow simmer is brought to a boil. That’s when you hear economists talk about the economy “overheating”. For a variety of reasons, stemming in large part from the pandemic, the global economy is currently in severe turmoil. Economists use two primary indicators to track inflation in the United States, and both are at their highest levels in nearly four decades. The consumer price index for November rose 6.8%, while the personal consumption expenditure price index, which the Federal Reserve prefers, rose 5.7%.

And here’s where Econ 101 merges a bit with Psych 101. There’s a behavioral economics aspect to inflation, where it can become a self-fulfilling prophecy. When prices rise for a sufficiently long period of time, consumers begin to anticipate price increases. You will buy more goods today if you think they will cost significantly more tomorrow. This has the effect of increasing demand, which drives up prices even more. Etc. Etc.

This is where it can get particularly tricky for the Fed, whose main job is to control the money supply and control inflation.

How did we get here?

Blame it on the pandemic.

In the spring of 2020, as the Covid-19 spread, it was like cutting the cable to the global economy. Factories around the world are closing their doors; people have stopped eating in restaurants; airlines have grounded flights. Millions of people have been made redundant as businesses disappeared virtually overnight. The unemployment rate in the United States climbed to almost 15%, from around 3.5% in February 2020.

It is the strongest economic contraction on record.

At the same time, the Fed put in place emergency stimulus measures to prevent financial markets from collapsing. The central bank lowered interest rates to near zero and started pumping tens of billions of dollars into the markets every month by buying back corporate debt. In doing so, the bank likely avoided a total financial collapse. But maintaining those easy money policies over the past 20 months has also fueled inflation, you guessed it.

In early summer 2020, demand for consumer goods started to pick up. Quickly. Congress and President Joe Biden passed a landmark $ 1.9 trillion stimulus bill in March that suddenly drained Americans cash and unemployment aid. People have started shopping again. Demand went from zero to 100, but supply couldn’t bounce back that easily.

Turns out, when you unplug the global economy, you can’t just plug it back in and expect it to start buzzing at the same rate as before.

Take cars, for example. Automakers saw the onset of the Covid crisis and did what any smart business would shut down temporarily to mitigate the losses. But soon after the factories were closed by the pandemic, it also increased demand for cars, as people worried about exposure on public transport and avoided flying. Automakers (and car buyers) have suffered a whiplash.

Cars require an immense number of parts, coming from an immense number of different factories all over the world, to be built by highly skilled workers in other parts of the world. Bringing all of these covert operations back online takes time, and doing it while keeping workers from getting sick takes even longer.

Economists often describe inflation as too much money for too little good. This is exactly what happened with the cars. And houses. And Peloton bikes. And a number of other items that have become hot items.

How is the supply chain involved in all of this?

“Supply chain bottlenecks” is another problem you see everywhere, isn’t it?

Let us return to the example of the car.

We know that high demand + limited supply = prices go up.

But strong demand + limited supply + production delays = prices go up even more.

All modern cars rely on a variety of computer chips to operate. But these chips are also used in cellphones, home appliances, televisions, laptops, and dozens of other items that unfortunately were all in high demand at the same time.

This is just one example of the disconnect in the global supply chain. Because new cars have been slow to arrive, the demand for used cars has exploded, pushing up headline inflation. In some cases, car owners have been able to sell their used cars for more than they paid a year or two earlier.

What happens next?

Prices and wages are expected to continue rising until 2022, officials and economists say. But for how long and how much depends on countless variables across the world.

Policymakers and business leaders are working to unblock supply chain bottlenecks to move goods at their pre-pandemic pace. It is much easier said than done. And it’s unclear what kind of shocks a resurgent variant of Covid, a huge shipping container stuck in a key waterway, a natural disaster could delay progress.

The Fed, for its part, has publicly admitted that inflation has been much more of a headache than it expected. The bank unwinds its bond buying program, a process known as tapering, in the first half of 2022, and plans to hike interest rates three times during the year.

And when money becomes more expensive to borrow, it can dampen price increases and bring the economy back to that sweet, sweet simmer.

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