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The Causes of and Cure for Inflation in the American Economy

Alex Hsu, Georgia Tech Scheller associate professor of finance, explains the causes and effects of inflation and how to fix it.
Alex Hsu, Associate Professor of Finance

Alex Hsu, Associate Professor of Finance

Forty-one years. That’s the length of time since Americans experienced inflation as high as it is now. In 1980, the inflation rate was at 13.5 percent. Over the last twelve months, the inflation rate rose to 6.2 percent in the U.S., up 5 points from the 1.2 percent average in 2020. The consumer price index, which measures how much consumers pay for a range of goods and services, rose 0.9 percent last month, solidifying that we’re indeed in an inflationary period.

And the U.S. is not alone. Other countries are also experiencing inflation, but the U.S. is experiencing it more severely because of its strong economic recovery and complex supply chain, according to Alex Hsu, Georgia Tech Scheller College of Business associate professor of finance. We sat down with Hsu to learn more.

What Is Causing Inflation?

“I think 2020 to 2021 is a perfect storm of supply and demand shocks for the U.S. economy,” Hsu explained. “The pandemic caused a sudden stop and re-open of the economy we have not witnessed in more than half a century. Producers populating our supply chain do not shut down and restart quickly under complex inventory and logistic constraints. At the same time, government rescue packages installed at the depth of the Covid-19 recession were much larger in scale compared with those used for the 2008 financial crisis. This led to a strong recovery of the U.S. economy and the meteoric rise of the stock market. The difference in timing of supply and demand trajectories is the major driver of the high inflation figures we are seeing now.”

Getting a product from manufacturer to consumer is a complex process. Cut out one part of the process and you sever the chain. Meanwhile, the U.S. workforce decreased, due in part to job losses, the early retirement of baby-boomers, worker demand for higher wages, a slow re-entry into the workforce, and an unskilled labor force.

“Our ports are not big enough to handle all the freight coming to the country and we also don’t have enough truck drivers to deliver those containers to distribution centers. As a result, goods are not arriving on shelves for people to purchase,” noted Hsu. Since the Port of Los Angeles (considered the largest port in the U.S.) and the Port of Long Beach are the top ports for transpacific trade, and our largest trade partner is China, most goods are coming through these two ports. Demand for goods with a backlog of supply increases prices. Inflation follows.

How Much Power Does the Federal Reserve Have in Creating and Controlling Inflation?

While President Biden has ordered the release of some of the U.S. strategic petroleum reserves to alleviate gas prices, he can also provide funding to expand ports, railroad networks, and highways. But this will take time to take effect. The Federal Reserve (the Fed) has more power to curtail inflation.  

The Fed has two basic duties: keep prices stable and maximize employment. According to Hsu, the Fed can raise the short-term policy rate when inflation is above 2 percent. This will impact rates of all maturities on the yield curve, which will cause borrowing costs to increase for corporations (bonds, bank loans) and households (mortgages). Inflation should fall when this occurs.

“The Fed has been buying long-term Treasury bonds to bring down the long-end of the yield curve in the aftermath of the 2008 financial crisis through what is called quantitative easing (QE). In the process, the Fed has flooded the economy with dollar reserves, or liquidity. As a result, borrowing cost has stayed low for historical standards over the last decade. Moreover, this liquidity has been invested in the financial market, fueling the bull market, which in turn led to stronger purchasing power by households,” said Hsu. 

In fact, Fed Chair Jerome Powell recently announced he was reducing bond purchases which tend to lower long-term borrowing costs. That’s if the new Omicron variant doesn’t further exacerbate supply chain disruptions, employees return to work, or there is a reduction in American’s spending.

However, Hsu sees another threat. “The real threat, in my opinion, is the overheating of the financial market because of loose credit conditions,” he stated.   

Rumors about increasing interest rates have circulated for a few years now. Increasing them would help, but the Fed faces a delicate dance with the stock market. While the Fed is actively winding down QE (tapering) for some time now, a drastic policy move of cutting down QE or raising the rates too quickly could bring the market to a halt.

Who is Benefitting from Inflation?

Certain corporations also reported record earnings over the last quarter. According to a recent National Association for Business Economics (NABE) survey, most companies (two-thirds) are passing on their increased costs to consumers.

Companies feeling the luckiest include transportation, utilities, and information and communications. Oil and gas companies have also increased their prices - some due to Covid-specific variables - while others have simply increased their prices to meet consumer demand from a smaller inventory.

Are Higher Gas Prices Part of Inflation?

There is a disconnect among some Americans between the incredibly quick rise in gasoline prices and our supply chain problems, but all roads lead back to the pandemic. During the pandemic, Americans weren’t driving. That caused oil and gas companies to scale back production in the U.S. and abroad.

OPEC and Russia were also hit due to a lack of demand, so they, along with the U.S., cut back on drilling and production of crude oil.

A year later, American are on the road again. While OPEC hasn’t released more reserves, it’s charging more for what it has. Furthermore, it takes time to ramp up oil production in the U.S. With supply chain disruptions, a reduction in drilling and refineries decreased production while crude oil prices increased. Experts agree that Americans won’t see any relief from high gas prices until the spring or summer of 2022.

What Can We Do to Stop It?

“I think moderate inflation is here to stay, and this is good for the economy,” Hsu explained. “For a healthy economy to keep growing, we should expect to see some inflation. That’s why the Fed’s target inflation is 2 percent rather than zero. We are seeing some real wage growth recently due to state-level minimum wage raises and large, private employers paying workers more. Amazon and Walmart are prime examples. As workers are paid more, their purchasing power increases, and this should result in upward pressure on prices.”

Hsu doesn’t think inflation will rise more than 3 percent beyond 2022, based in large part because supply restrictions from the pandemic will ease. He also sees the Fed raising interest rates and bond prices, which will cause corporations to scale back. “This is not the 1970s all over again,” he asserted.

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Alex Hsu
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