Prices are rising at their fastest rate in decades, and Americans are becoming increasingly concerned about inflation. While some inflation is inevitable in a healthy and developing economy, rapid and prolonged inflation is harmful to American families because it wipes out wage growth and erodes savings. Consumer confidence can be shattered by inflation, which harms U.S. firms trying to recover from the pandemic recession.
There’s a lot of dispute over whether current inflation is just a blip on the radar or a more serious sort of systemic inflation. On the one hand, inflation could be a one-time occurrence brought on by the global economy’s reopening. The United States is ahead of many other countries in terms of recovery, and supply networks are still recovering after more than a year of continuous disruptions. Rising inflation, on the other hand, could be a direct outcome of government stimulus, which has greatly raised household income and demand at a time when labor markets and other economic functions are still weak.
This article indicates that rising prices are most likely a mix of temporary inflation and longer-term inflation driven by government stimulus after reviewing the evidence. While higher prices for American producers will eventually subside as global supply chains adjust, demand-driven inflation could worsen if government stimulus continues to raise consumer income before the job market rebounds. Increases in taxes that stifle business activity could exacerbate inflation.
Background
In the face of an unprecedented pandemic and economic slump in 2020, the federal government took unprecedented fiscal and monetary measures. Since the outbreak of the pandemic, Congress has authorized $6 trillion in new spending through the American Rescue Plan, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, and other measures. To pump capital and liquidity into the market, the Federal Reserve purchased nearly $4 trillion in fresh assets at the same time. As a result, the government debt has increased significantly and is now nearly equivalent to the size of the economy, accounting for nearly 100% of GDP.
The Federal Reserve’s monetary response was rapid and adequately accommodating, especially when combined with Congress’ early pandemic relief, which helped stabilize household income during the recession’s worst days. Following a series of spending packages, these policies overcorrected for the slump by increasing income and savings above what they would have been in the absence of the pandemic.
Despite this, Congress continues to pursue major new government spending initiatives, including a $3.5 trillion budget resolution, the single largest spending package in history, more than a year after the recession officially ended.
Legislators should be cognizant of the costs if they continue to drive government expenditure to unprecedented heights. These expenses go beyond the simple cost of new purchases. For example, government investment has well-documented opportunity costs, and in many circumstances, it replaces more productive private investment, causing the private sector to decrease.
Furthermore, huge government expenditure packages are frequently accompanied by tax hikes, which slow economic growth by reducing employment and investment. According to one study, even if the $3.5 trillion budget resolution boosts productivity in line with historical norms, the effect of the corresponding proposed tax increases will cancel out any benefits of the government investment, resulting in a reduction in economic growth only five years after it is enacted.
Increased government spending also brings extra threats to American families, which lawmakers should be aware of. Today’s most significant threat is growing inflation. While monetary tightening is the usual mechanism for preventing inflation, if abnormal expenditure patterns continue, further monetary tightening may be ineffective.
Inflation is Rising
Inflation is rising at the quickest rates since the early 1990s, according to two prominent pricing measures. The Core Consumer Price Index, which analyzes prices of routinely purchased products excluding volatile categories in the food and energy sectors, rose 4% year over year in August. Similarly, the most recent Core Personal Consumption Expenditures Price Index gained 3.6 percent, tracking real expenditure by households on items other than food and energy.
Despite the fact that inflation has slowed in recent months, it remains well above the Federal Reserve’s 2% target. Furthermore, consumer anxiety about the Delta variant has reduced consumer demand for transportation and travel, contributing to the recent cooling. Increasing fear is neither a commendable nor a long-term strategy for lowering inflation.
If rising inflation continues, it will have a negative impact on American families by reducing their purchasing power. Consumer price increases virtually reversed all nominal salary gains in the first quarter of 2021, causing real wages to decrease. Consumer morale has also declined dramatically in recent months, with studies indicating that Americans are becoming increasingly anxious about inflation.
What Causes Inflation?
To determine whether the current rise in inflation is merely a passing trend or the direct outcome of government action, it is necessary to first distinguish between two types of inflation.
The first is cost-push inflation, which occurs when production costs increase. Cost-push inflation occurs when businesses are hit with unexpectedly high expenses for raw materials, intermediate goods, or labor and pass those costs on to consumers. This form of inflation can be sustained if the cause is a long-term policy shift, such as additional taxes on foreign-made inputs, but it can also be a transitory response to an external shock, such as supply chains reacting to the global economy reopening.
The second type of inflation is demand-pull inflation, which is generated by rising consumer demand. If it is the outcome of a healthy economy in which more people are employed, income rises, and demand rises with it, demand-pull inflation can be a sign of growth. However, it can be damaging if it is caused by new government policies that supply consumers with so much money (subsidies and transfer payments, or easy access to credit via low borrowing costs) that demand outpaces output.
Both sorts of inflationary pressures are likely to blame for the current price rises faced by American consumers, and these pressures are combining to worsen costs even more. Consumer demand for goods is increasing, placing pressure on businesses to boost production despite supply chain problems and labor shortages. When this happens, American families confront greater costs and shortages at the same time, decreasing their quality of life.
Cost-Push Inflation and Supply Chain Disruptions
As the United States and the rest of the world continue to battle with COVID-related production challenges, producers are seeing huge cost hikes. Figure 1 demonstrates that the Producer Price Index increased by more than 25% during the pandemic recovery, which is 350% higher than price rises following the Great Recession.
Source: Producer Price Index by Commodity: All Commodities, US Bureau of Labor Statistics, acquired from the Federal Reserve Bank of St. Louis.
The Producer Price Index (PPI) is a measure of wholesale inflation that measures the prices that U.S. producers receive for the selling of their goods and services. The present rise in producer pricing reflects a number of ongoing concerns, including a decline in production during the COVID era and businesses’ difficulty recruiting willing workers, which is aggravated by increased consumer demand.
To begin with, import prices are increasing. While demand for foreign-made goods in the United States suffered during the pandemic, imports have since recovered. In reality, imports from Asia are increasing, up 33% in the first half of 2021 compared to pre-pandemic levels. At the same time, other countries are lagging behind the US in terms of economic recovery, and supply chains continue to be disrupted. Because 60 percent of U.S. imports are inputs to production employed by American enterprises, this imbalance between U.S. demand and worldwide supply has put upward pressure on import costs, which in turn translates to higher producer pricing.
The uneven rebound in global production is causing shortages of raw materials such as steel and lumber, as well as critical components such as computer chips, which is driving up prices. These changes are a result of the unexpected worldwide recession in 2020, which forced many industries to close, reduce production, or retool their manufacturing facilities to satisfy a new consumer demand. When demand for autos fell during the pandemic, for example, many semiconductor makers turned to produce chips for consumer electronics, which remained in high demand while Americans were compelled to stay at home. However, this decision, when combined with the commonly used “When demand for automobiles recovered quicker than expected, semiconductor makers’ “just-in-time” inventory strategy left them unprepared for auto chip production.
In addition, the United States is experiencing labor shortages, which is compounding the rise in producer prices. According to a recent Joint Economic Committee report, there are more jobs available in 30 states than there are people looking for work. Even though manufacturers aggressively attempt to expand their workforces, employment in the manufacturing industry has yet to recover from epidemic lows. Labor shortages are also hurting businesses in the services sector, according to recent surveys of non-manufacturers “Their capacity to hire workers is being hampered by stimulus checks and unemployment extensions.” Indeed, new unemployment insurance claims are still more than 50% higher than pre-pandemic levels, indicating Americans’ unwillingness to return to work and a skills mismatch between unemployed Americans seeking work and the skills employers require.
Finally, rising transportation costs are pushing up producer and consumer prices in the United States. In August, freight transport costs in the United States were about 35% higher than a year before, indicating significant new cost pressures that show no indications of abating. One explanation for the cost increase is current labor shortages; goods producers simply cannot find enough truck drivers, train workers, or other transportation personnel to meet their needs. Another cause is the rising cost of automobilesas supply chain interruptions restrict new vehicle availability, customers are flocking to old vehicles, driving up used car and truck prices.
The tremendous increase in consumer demand for goods, which has in turn boosted demand for freight transit and shipping prices, is perhaps the most significant source of growing transportation costs. As companies struggle to acquire enough containers for transport, the cost of shipping containers is skyrocketingup 350 percent year over year in August. Furthermore, the increasing number of cargo ships delivering goods to the United States is clogging up American ports and generating major shipping delays. According to reports, at least 350 container ships are stranded outside of ports throughout the world, and cargo ships off the west coast of the United States are being forced to dock for seven to ten days before offloading space becomes available. There is just not enough port infrastructure to handle the current demand for foreign-made goods from American companies and consumers.
The second factor for increasing inflationary pressures is demand-pull inflation.
Demand-Pull Inflation and Government Stimulus
While the rest of the globe struggles with supply chain challenges, COVID stimulus initiatives and other federal programs have improved household income in the United States beyond what it would have been if the pandemic had never happened. “Under the exceptional circumstances of the COVID-19 pandemic, personal income was supported by fiscal policy even as consumers spent less, employees lost jobs, and businesses lost revenues,” according to the 2021 Joint Economic Report. The effect was unprecedented: as the economy contracted, discretionary personal income increased.
Figure 2 shows how disposable personal income increased at three separate timesin March 2020, January 2021, and March 2021each corresponding to a new round of COVID-19 stimulus bills and economic effect payments to households. Consumers were frightened of the economic uncertainties generated by the epidemic, and felt unsafe investing their money on activities that required in-person connections, according to the chart. That a result, consumer spending declined at the same time as household income increased, and Americans began saving more than they had in the past, nearly tripling aggregate savings in the second quarter of 2020.
Figure 2: Real Personal Consumption Expenditures vs. Real Personal Disposable Income, 2006-2021
Real Disposable Personal Income and Real Personal Consumption Expenditures, both from the Federal Reserve Bank of St. Louis.
In the face of rising earnings, the story of higher saving and lower consumer spending appears to contradict the traditional view of demand-pull inflation, which is characterized as too much money chasing too few commodities (and services). In fact, personal consumption expenditures in the second quarter of 2021 were substantially equal to the Congressional Budget Office’s pre-COVID predictions. To better understand present inflationary pressures, it is useful to divide consumer expenditure into goods and services spending.
Sources: United States Bureau of Economic Analysis, Real Personal Consumption Expenditures: Goods, and United States Bureau of Economic Analysis, Real Personal Consumption Expenditures: Services, both from the Federal Reserve Bank of St. Louis.
The dramatic disparity in recent spending patterns on goods and services is shown in Figure 3. Because the United States is primarily a service-oriented economy, with over 85 percent of workers working in service-providing businesses and about 70 percent of consumer expenditures spent on services such as housing and health care, spending on services has stayed greater than spending on products. Despite the fact that the recession is over, service spending is still below pre-pandemic levels, which is likely due to continued concerns about COVID-19 and the in-person interactions that many services necessitate.
After barely four months, goods expenditure has fully rebounded and has subsequently risen 15% above February 2020 spending levels. Demand-pull inflation has resulted from the rapid increase in goods consumption, with goods prices surpassing services costs.
Increased demand-pull risk could be exacerbated by rising inflation expectations. Consumer inflation expectations have risen sharply in recent months, from 3% in January to above 5% in August. Expectations of future price increases may mistakenly encourage people to buy more items now, creating extra demand-pull inflation. Similarly, as consumers’ inflation expectations rise, firms may raise their pricing to fulfill those expectations.
These demand pressures are compounded by the cost-push pressures of U.S. labor shortages and persistent supply chain challenges, all of which are compounding to produce the inflation that Americans are seeing today.
Housing Prices: A Case Study
Inflation is putting a strain on Americans’ finances, as evidenced by rising home prices. After the COVID recession, housing inflation accelerated: According to the most recent S&P/Case-Shiller national home price index, home prices grew 19.7% annually in July, the fastest rate in the indicator’s 27-year history. According to Zillow, both home and rental prices witnessed their highest rises on record.
In contrast, the Consumer Price Index implies that housing inflation is finally slowing. It gives a more up-to-date picture of housing and rent prices, which grew 0.2 percent from July to August, half as much as the previous month. However, a closer examination of the data suggests that declining hotel prices are driving the slowdown in shelter inflation, a symptom of greater COVID-19 fear and Americans’ growing aversion to travel. Housing inflation would continue to rise if there were no concerns about COVID-19.
The underlying inflationary pressures driving up house prices, like most of the present inflation, can be explained by a mix of demand-pull inflation, which is generated by rising demand for housing, and cost-push inflation, which is driven by material shortages.
COVID-19 accelerated demand-pull housing inflation by accelerating two pre-existing trendsrising remote employment and relocationcausing many Americans to flee urban areas for more affordable suburban locales. The combination of Americans moving to new places where they can afford housing, government-induced rising income and savings, and the Federal Reserve’s near-zero interest rates boosted home demand dramatically.
A decline in housing supply exacerbated demand-pull inflation. For example, between March 2020 and March 2021, the supply of existing homes for sale decreased by 30%, as many homeowners were hesitant to put their properties on the market due to persistent economic uncertainties.
Cost-push inflation, which increased the cost of building new homes, limited the supply of new dwellings at the same time. Labor shortages and supply chain challenges increased the cost of lumber, aluminum, steel, and other components, causing building prices to soar.
The outcome is a historically tight housing market, with rising home prices as a result, which is concerning for American families. Low-income households are disproportionately affected since housing accounts for a larger part of their overall spending, and the housing-share of lower-income budgets has been increasing over time. In 2019, consumers in the bottom 20% of the income distribution spent roughly a fourth of their entire spending on shelter (i.e., dwellings and rents), compared to around 18% for the top 20% of earners.
The good news is that housing supply may be improving, as seen by an increase in new housing starts and monthly housing supply in the United States, which would assist to lessen inflationary pressures induced by rising demand. Despite this, supply chain interruptions, workforce shortages, and other cost-push pressures continue to plague the industry.
Will Additional Government Stimulus Increase Inflation Further?
While it is vital to look back and understand the dynamics that have contributed to recent inflation, it is also critical to look ahead and consider the potential consequences of impending spending bills. Is it possible that the additional, transformative government expenditure currently under consideration in Congress, as well as any subsequent spending legislation that have yet to be filed, could drive up inflation even more? The answer is almost certainly yes.
A $3.5 trillion spending package, commonly known as the Budget Control Act, is now being contested as the largest spending legislation currently being debated “The bill of reconciliation.” To enhance social services, the reconciliation plan combines a combination of deficit spending and tax hikes. It would give free universal pre-kindergarten education, extend the recent extension of child tax credits, subsidize day care facilities, health insurance, and housing, provide free paid family and medical leave, and provide two years of free community college, among other features. A plethora of new tax increases on personal income, corporate income, and investment income are also included.
The legislation’s economic repercussions imply nothing about its goals; boosting affordability for American families is a worthy goal. However, supplying extra cash to households (either directly through checks or indirectly through subsidies) will have the practical effect of increasing consumer demand. Furthermore, the legislation’s tax policies are anticipated to decrease company investment and hiring. More demand-pull inflation will result from the combination of these two forces.
For example, the enhanced child tax credit currently gives between $3,000 and $3,600 in cash transfers per child each year to the great majority of American parents. These cash transfers do little to increase labor force participation and may potentially decrease labor supply, which remains below pre-pandemic levels without the work restrictions that were previously connected to the child tax credit pushing parents to find work. Other subsidies in the reconciliation plan work in a similar way, increasing household incomes and inflating demand while being paid for with tax hikes that will reduce employment and investment.
Despite the fact that the reconciliation bill is expected to enhance inflationary pressures, there are several reasons why inflation may not occur. The first is if consumer demand increases are successful in attracting enough people into the labor force, in which case inflation may not accelerate further. With the revival of COVID-19 and ongoing supply-chain disruptions that are likely to take months or years to resolve, artificially raising earnings is unlikely to result in considerable demand-driven job growth. Furthermore, the bill’s tax provisions are expected to limit hiring and discourage investment.
The second reason inflation may not occur is if spending does not increase in tandem with income, which might be due to increased consumer worry about COVID-19. However, if history is any guide, expenditure on services will decline while spending on products will rise, resulting in supply chain bottlenecks that will continue to raise producer costs and inflation.
Finally, others contend that the reconciliation bill will boost employment and production sufficiently to compensate for the rise in consumer demand. These supply-side proposals would, for example, increase funding for federal job training programs and create a new federal job training program “climate corps for civilians.” However, these initiatives are unlikely to have a major influence on labor force participation and will not be sufficient to offset the negative impacts of tax increases on employment and investment. Prior research has shown that existing federal job training programs are largely ineffective and unresponsive to current and future labor force needs, and estimates suggest that a civilian climate corps would only create 20,000 government jobsa drop in the bucket compared to the 11 million job openings that American businesses are currently struggling to fill.
While the new programs would be temporary in their current form, there is a (very good) probability that Congress would make them permanent in the future. Estimates show that the proposal will result in $5 to $5.5 trillion in government spending over the next ten years, adding $3.5 trillion to the national debt. The federal debt is already at 100% of GDP, and rapidly growing the debt without creating significant economic growth comes with its own set of concerns. Reduced economic output, more interest payments, poorer national income, rapid inflation, and even a debt crisis are among the dangers.
Conclusion
During the post-COVID economic expansion, rising prices are affecting American families by diminishing their real earnings and reducing their purchasing power. There is debate over whether this inflation is a natural product of our peculiar times or is the result of government policy, but the data suggests it is a combination of both.
The reopening of the economy following the global COVID-19 shutdowns has resulted in temporary inflation in major consumer items, as producers face both shortages and higher costs for intermediate inputs, raw materials, and labor, which they pass on to consumers. While this form of inflation is only temporary, it is likely to last until labor shortages subside and global supply systems reorganize.
Increases in household income from government stimulus measures may have exacerbated the strains of constrained supply by igniting greater long-term demand-driven inflation. Inflation could worsen if Congress continues to authorize more government expenditure that raises consumer demand while supply remains constrained. Policies aimed at getting Americans back to work and removing impediments to business investment in American workers would be better for the American people.
Chairman of the Federal Reserve, Jerome Powell, recently acknowledged these inflationary dangers, implying that the Fed may soon begin to reduce asset purchases to combat increasing prices. Unfortunately, monetary tapering or even tightening may not have the desired effect if unprecedented spending levels remain. As a result, Congress should think about the inflationary implications of continuing the current pattern of rising government expenditure.
Is inflation caused by increasing spending?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.
What effect does a rise in government spending have on inflation?
- Consumer confidence rises as the economy grows, causing them to spend more and take on more debt. As a result, demand continues to rise, resulting in increasing prices.
- Increasing export demand: A sudden increase in exports drives the currencies involved to undervalue.
- Expected inflation: Companies may raise their prices in anticipation of rising inflation in the near future.
- More money in the system: When the money supply expands but there aren’t enough products to go around, prices rise.
What effect does inflation have on spending?
As the rate of inflation rises, people are more prone to store products and make financial decisions based on emotions, which can drive prices further higher. For months, prices have been climbing on almost everything. Inflation has reached its highest point in decades.
What are the five factors that contribute to inflation?
Inflation is a significant factor in the economy that affects everyone’s finances. Here’s an in-depth look at the five primary reasons of this economic phenomenon so you can comprehend it better.
Growing Economy
Unemployment falls and salaries normally rise in a developing or expanding economy. As a result, more people have more money in their pockets, which they are ready to spend on both luxuries and necessities. This increased demand allows suppliers to raise prices, which leads to more jobs, which leads to more money in circulation, and so on.
In this setting, inflation is viewed as beneficial. The Federal Reserve does, in fact, favor inflation since it is a sign of a healthy economy. The Fed, on the other hand, wants only a small amount of inflation, aiming for a core inflation rate of 2% annually. Many economists concur, estimating yearly inflation to be between 2% and 3%, as measured by the consumer price index. They consider this a good increase as long as it does not significantly surpass the economy’s growth as measured by GDP (GDP).
Demand-pull inflation is defined as a rise in consumer expenditure and demand as a result of an expanding economy.
Expansion of the Money Supply
Demand-pull inflation can also be fueled by a larger money supply. This occurs when the Fed issues money at a faster rate than the economy’s growth rate. Demand rises as more money circulates, and prices rise in response.
Another way to look at it is as follows: Consider a web-based auction. The bigger the number of bids (or the amount of money invested in an object), the higher the price. Remember that money is worth whatever we consider important enough to swap it for.
Government Regulation
The government has the power to enact new regulations or tariffs that make it more expensive for businesses to manufacture or import goods. They pass on the additional costs to customers in the form of higher prices. Cost-push inflation arises as a result of this.
Managing the National Debt
When the national debt becomes unmanageable, the government has two options. One option is to increase taxes in order to make debt payments. If corporation taxes are raised, companies will most likely pass the cost on to consumers in the form of increased pricing. This is a different type of cost-push inflation situation.
The government’s second alternative is to print more money, of course. As previously stated, this can lead to demand-pull inflation. As a result, if the government applies both techniques to address the national debt, demand-pull and cost-push inflation may be affected.
Exchange Rate Changes
When the US dollar’s value falls in relation to other currencies, it loses purchasing power. In other words, imported goods which account for the vast bulk of consumer goods purchased in the United States become more expensive to purchase. Their price rises. The resulting inflation is known as cost-push inflation.
What are the three most common reasons for inflation?
Demand-pull inflation, cost-push inflation, and built-in inflation are the three basic sources of inflation. Demand-pull inflation occurs when there are insufficient items or services to meet demand, leading prices to rise.
On the other side, cost-push inflation happens when the cost of producing goods and services rises, causing businesses to raise their prices.
Finally, workers want greater pay to keep up with increased living costs, which leads to built-in inflation, often known as a “wage-price spiral.” As a result, businesses raise their prices to cover rising wage expenses, resulting in a self-reinforcing cycle of wage and price increases.
Is deficit spending associated with inflation?
Increased deficits do not lead to higher inflation through monetary accommodation or crowding out, according to the transaction cost hypothesis of separate wants for money and bonds. According to this idea, private monetization turns bonds into near-perfect money substitutes, making deficits immediately inflationary.
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
What happens if inflation rises too quickly?
If inflation continues to rise over an extended period of time, economists refer to this as hyperinflation. Expectations that prices will continue to rise fuel inflation, which lowers the real worth of each dollar in your wallet.
Spiraling prices can lead to a currency’s value collapsing in the most extreme instances imagine Zimbabwe in the late 2000s. People will want to spend any money they have as soon as possible, fearing that prices may rise, even if only temporarily.
Although the United States is far from this situation, central banks such as the Federal Reserve want to prevent it at all costs, so they normally intervene to attempt to curb inflation before it spirals out of control.
The issue is that the primary means of doing so is by rising interest rates, which slows the economy. If the Fed is compelled to raise interest rates too quickly, it might trigger a recession and increase unemployment, as happened in the United States in the early 1980s, when inflation was at its peak. Then-Fed head Paul Volcker was successful in bringing inflation down from a high of over 14% in 1980, but at the expense of double-digit unemployment rates.
Americans aren’t experiencing inflation anywhere near that level yet, but Jerome Powell, the Fed’s current chairman, is almost likely thinking about how to keep the country from getting there.
The Conversation has given permission to reprint this article under a Creative Commons license. Read the full article here.
Photo credit for the banner image:
Prices for used cars and trucks are up 31% year over year. David Zalubowski/AP Photo
What happens when there is a lot of inflation?
- Inflation, or the gradual increase in the price of goods and services over time, has a variety of positive and negative consequences.
- Inflation reduces purchasing power, or the amount of something that can be bought with money.
- Because inflation reduces the purchasing power of currency, customers are encouraged to spend and store up on products that depreciate more slowly.
Why has inflation risen so dramatically?
High inflation can occur in the short term as a result of a hot economy, in which individuals have a lot of spare cash or have access to a lot of credit and want to spend it. If consumers are eager to buy goods and services, firms may be forced to raise prices due to a lack of supply. Alternatively, businesses may decide to charge more because they see that they can increase prices and increase profits without losing clients.