Transitory Inflation - Part 2

Inflation is happening! Oh, God! What are we going to do?

That is not an unusual reaction to inflation, even among the experts. In fact, it is such a dreaded event that we have appointed economic experts to help save us from its ravages – The Federal Reserve. One of their jobs is to keep the Inflation beast under control, the other primary job is to keep the nation’s employment up. I suppose an ironic implication of their job is that if they do it well, they can keep their jobs. So as stated in Part 1, consumer behavior is a key ingredient in the process of inflation.

As a key factor in Inflation, it is worth noting some comments that have been made about consumers. H. L. Mencken: “Nobody ever went broke underestimating the intelligence of the American people.”, P. T. Barnum: “There’s a fool born every minute.”, and A. Greenspan: “The number one problem in today's generation and economy is the lack of financial literacy.” Given the importance, if not criticality, of consumers in the US Economy this is not exactly a comforting view of consumers especially if we rely upon them to sustain our economy. Regardless, consumer behavior will be a major contributing factor to how inflation plays out.

Now I don’t want anyone to think that inflation is only caused by consumers, but without their part in the play, there is no inflation because there is no Demand without them. So, it is worth understanding what the relationship is between the Consumer and their Demand, and how that relationship itself has cause and effect implications.

Under the Supply and Demand model, we can certainly think of various situations where Supply would create inflation that no one would think as being within the control of consumers. If food became unavailable, its cost is going to rise (inflation) even if the consumers were seeking less (lower Demand) than they had previously used. But not having enough food to sustain a population, especially the US’s population today, is very different than food shortages have been in other times or circumstances. Today’s food shortages are often narrow to a food category rather than the entire spectrum of all food commodities. Putting this into the context of inflation, food prices may go up for some food items, but it doesn’t require nor mean all food items must increase; and certainly not increase uniformly. For the price to rise means that consumers will continue to seek out any items that are limited or scarce at those higher costs versus seeking out alternatives. In most cases today, consumers have a significant ability to control inflation more directly and extensively than was possible in other inflationary periods.

Now, this same inflation effect for “food” can also come into play for many other items. The COVID pandemic has caused some scarcities and that has produced some inflationary consequences. The supply of lumber declined and the cost of lumber went up. Of course, that price went up because the Demand was both returning to levels from the decreased Demand COVID produced and it went up more from all the pent-up Demand that had been delayed due to COVID. Is the cost lumber still increasing? No.

The price of lumber is dropping. Why because Supply is increasing as the Supply and Demand model would predict given the production of lumber has been stimulated by the higher prices. Was that spike in lumber prices a ‘transitory’ period of inflation?

The cost of used cars also rose during the pandemic. Why? Because new car manufacturing was reduced significantly because of supply-chain disruptions and reductions in manufacturing. The cost of used cars is reacting to consumer demand particularly since the supply of new cars remains diminished because of the availability of parts, especially computer chips that are not available in the necessary quantities. Will the cost of used cars continue to rise? That will depend upon how quickly new cars become available, and if consumer demand remains at levels that sustain those prices. When the new car market returns, the cost of used cars will drop. There will be deflation in the used car market, their prices will drop. One might consider that used car inflation is ‘transitory’.

Numerous items have risen during the COVID pandemic and as the recovery has been, well recovering, food prices on some items have increased. Fuel prices have increased, other items have increased. The underlying cause for these increases is that Consumer Demand is increasing or staying the same even as the prices increase because Supply has been reduced. Given much of the Supply is reduced because disruptions on the production side.

But what can consumers do? Are consumers helpless in a consumer driven economy?

Consumers can’t both be the force behind the economy and helpless to have some control. To some extent the Demand for some items were because Consumers made a choice to purchase items at a higher price. They were willing to pay more even when they may have deferred the purchase or go with a substitute for the higher cost items. Those choices are not always without consequences, but not every item whose cost has inflated had to be purchased. It was a choice and it contributes to the creation of inflation.

We all know what will happen to the price for food as supply-chain problems and disruptions are removed. The Supply will increase, competition for Consumers will increase, prices will drop as producers try to gain market-share through lower prices. Inflationary prices will only remain higher as long as there is no need to compete for customers. Similarly, of Consumers seek out substitutes for higher priced items, the prices of those items will drop because Demand will decrease.

Consumers can help control inflation to a degree, but to do so requires that they act in aggregate to affect that control. This is not easily done. Oddly, in a Consumer Economy the process that helps motivate Consumers to act in their own interests is Inflation. The increased cost of items should cause informed Consumers to modulate their spending, to promote competition and innovation that provides those Consumers with other choices, and make investments in production to enable providers to meet demand. Inflation is ‘transitory’ by the very nature of economic processes. What people have difficulty with is that there is no fixed time interval for inflation to occur during and be eliminated by market responses.

Of course, Consumers don’t act based on an understanding of Inflation and the Supply & Demand model. If Consumers panic and buy out of fear or greed (speculation) than they may actually cause Inflation that becomes higher than it need have been from a scarcity or supply-chain disruption.

Is the COVID Inflation ‘transitory’? Yes. It will not persist and diminish as soon as Supply is restored; whether by production or displacement. No, it won’t be ‘transitory’ because the economy that we will have going forward will not be the same economy we had before COVID nor would have had if COVID had not occurred. If this seems contradictory, you are experiencing the complexity of economics. It is by its very nature an ever-changing system.

The Supply & Demand model explains factors that influence economies and economic processes, but it is not a model that applies to a static system or creates a path to a particular outcome. It provides a means to understand the influences that actions and decisions will introduce into the process, but like many models does not and cannot account for all the complexity of reality nor the chaos and uncertainty which is inherent in societies and markets.