Inflation: A Primer for 2022

David J. Haas CFP®
January 12, 2022

Inflation is all over the news. You might be noticing it as your rent is going up, meat prices have risen, and you have to pay far more than list price for your car. If you are lucky, maybe your employer has given you a raise, or you took advantage of the tight labor market and got a new job with much higher wages. All of these things are signs of inflation. Consumer prices in the US went up 7% last month when compared with the previous year. This is the highest rate of inflation since 1982.

What Causes Inflation

Inflation has to do with supply and demand. Let’s take the example of cars. Normally manufacturers do a pretty good job of supplying the US with cars. They can produce all the cars they want to meet demand. If demand increases for a particular model, its price might go up (or maybe you have to pay sticker price), but you could decide to substitute a cheaper car if you didn’t want to pay the higher price. The demand for cars might vary with the economy, but basically supply and demand match.

Take a look at today’s situation. Car manufacturers had to close plants because of COVID in 2020. At the same time, they forecast a drop in demand, so they decided to slow down their orders for parts, including computer chips that modern cars need. It turns out that the 2020 recession was a very short one and many people who normally used public transit, now decided they needed a car. At the same time massive government stimulus and lower borrowing rates meant that car demand didn’t drop, it actually increased. Suddenly there is a big mismatch between supply and demand, raising car prices. Normally, car manufacturers would have just ramped up their production and within a couple of months have met the increased demand. But their parts were unexpectedly unavailable for all sorts of reasons including parts manufacturers shutting down or making parts for other products and shipping delays which meant parts could not get to the car factories. Labor for logistics is in very short supply so the shipping delays have persisted. Yet car demand has stayed at a high level. This is why car prices have increased so much and is similar what’s happened across the economy for other goods.

Inflation is a mismatch between supply and demand. If demand is higher than supply, then prices will increase.

Is Inflation Bad?

A relatively low level of inflation is actually a good thing in the economy. Prices rise a little and wages rise a little. A low level of inflation is the sign of a healthy economy. If prices drop (deflation), then you usually have poor demand and excess supply. Manufacturers and service providers will cut back and that will lead to unemployment and recession. But high  inflation (or excess inflation) is also bad. It leads to a lower overall standard of living because prices usually rise faster than wages and people on fixed incomes become significantly poorer. Inflation also causes the dollar to go down when compared to other currencies (since what a dollar can buy is less) and this causes import prices to go up, feeding the inflation loop.

Is Inflation Here to Stay?

Inflation tends to feed on itself. If prices of goods and services rise, then workers expect to be paid more. Employers will want to raise wages to attract workers. In our economy today, there is a shortage of workers, so employers basically have to either raise wages or try to make their existing workforce more efficient. Most have tried to do both. But this raises employers’ costs, so what do they do? They have to raise their prices even further. This loop means excess inflation is sticky.

When inflation first reared its head last year everyone said it was because of supply chain issues and that as soon as the supply chain normalized, everything would be fine. What we are finding out now is that the supply chain was stressed prior to the pandemic. COVID has made the situation worse and its lingering effect has caused continuous disruption. It turns out the supply chain is not easily healed. Some of the problem is COVID disruption at overseas manufacturers, but there is a shortage of truckers and warehouse workers in the US as well. Capacity in our ports and on our rails is limited. With the global economy, even US-based manufacturers rely on imported parts, chemicals, and raw materials. All this will take a while to fix. The supply of goods in the US is likely to be constrained for most of 2022.

At the same time, demand for goods and some services is still very high. People have money to spend and they want to spend it.

Inflation and the Federal Reserve Bank

The Federal Reserve Bank (Fed for short) is the US central bank. The Fed has a very important job. It controls the money supply in the US. Without going into too much detail, the Fed increases the money supply to stimulate the economy and decreases the money supply to cool the economy down. The Fed actually has two mandates: control inflation, and maintain full employment. If unemployment goes up, the Fed can increase the money supply, which stimulates the economy and more people get employed. If inflation is too high, then the Fed can cool the economy down, which should lower inflation. How? By lowering demand. The Fed indirectly controls demand for goods and services.

The Fed has a number of tools to control the money supply, but primarily the Fed uses interest rates. The Fed directly controls short-term interest rates because they set an overnight rate for funds banks can borrow from the Fed. The Fed also influences long-term rates by purchasing or selling bonds in the open market. If the Fed buys bonds, its pumping money into the economy. If the Fed sells bonds, it is reducing money in the economy.

Inflation in 2022

The Fed lowered rates and has been buying bonds since the 2020 pandemic recession. This has stimulated demand and lowered the unemployment rate. At this point, the Fed governors have announced they think we are close to full employment and the bigger risk is inflation. The Fed has now pivoted to fighting inflation. They have already announced they are going to stop buying more bonds by March. At the same time, they are expected to raise short-term interest rates three or four times this year, probably starting in March.

What will this do? It is meant to lower demand, which is the only thing the Fed is capable of doing to lower inflation.

Meanwhile, the supply chain issues will slowly improve. They might not totally resolve by the end of 2022, but as the year progresses and the COVID surge gets better I expect the supply of goods will increase.

The question is whether the Fed can lower demand without causing a recession. What the Fed really wants to do is engineer a soft landing where demand is reduced enough for inflation to go back to their 2% per year target but the economy continues to grow. Unfortunately, the Fed often overshoots the target. Reducing the money supply has a nasty habit of bursting asset bubbles which can pull money out of the economy much faster than the Fed wants. Are their any asset bubbles in the economy right now? We typically don’t know until after the fact, but possible bubbles include crypto-currency, venture capital, private equity, and tech stocks.

It will be an interesting year.

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