So far, 2022 has brought the highest levels of inflation in decades. In April, the consumer price index (CPI) rose 8.3 percent from a year earlier and 0.3 percent from March.
Inflation has affected virtually all sectors of our economy. We’ve seen higher prices at the grocery store, in the housing market and for travel. If you can even find one, new cars’ prices are going through the roof. The increase for Social Security benefits for 2022 reflected this with a cost-of-living adjustment (COLA) of 5.9 percent, the biggest since 1982. The COLA for 2023 is projected to be even bigger.
Let’s take a look at inflation in general—and at the 2022 version specifically.
What Are the Root Causes of Inflation?
At its core, inflation is about supply and demand. If there is high demand for a good or service and it’s in short supply, then the price will invariably be driven higher. More specifically, there are three main drivers of inflation:
- Cost-push inflation results from higher costs driving up prices. This might involve the cost of raw materials or wages. In our current environment, we’ve seen higher costs for both wages, due to shortages of workers in many industries, and many raw materials. An example is semiconductors, a key component for cars and a host of other products.
- Demand-pull inflation is the classic “too much money chasing too few goods” scenario. When there is demand in excess of supply, we get demand-pull inflation. We’ve certainly seen this type of inflation, due in large part to supply-chain issues that have dominated the news in recent months.
- Fiscal and monetary policy can play a role as well. The low-interest-rate environment, combined with the liberal Federal Reserve policy toward its balance sheet that we saw for years, likely helped fuel demand and price inflation in the housing market and other areas over the past few years.
How Does Inflation Affect the Economy?
Inflation can have both a positive and a negative impact on the economy.
Some inflation is good for the economy. The Federal Reserve has typically set its target rate of inflation at 2 percent. Inflation at a mild level like this leads to normal price increases over time and helps stimulate purchasing by consumers who believe that we will continue to see regular, moderate price increases.
When inflation reaches high levels and is widespread, the impact can be very negative. Many consumers will feel the pinch in their monthly budget and be forced to cut back on their spending; this hurts them and the overall economy. High inflation and higher interest rates can go hand in hand. Higher interest rates can make borrowing for major purchases such as a car or a home more expensive and cost-prohibitive for some.
Continued high inflation, if left unchecked, can lead to a recession.
What Happened in 1981 to Spike Inflation?
At the end of 1981, inflation stood at just under 9 percent, a level that was actually down from the double-digit levels of 1979 and 1980. This inflation was fueled by widespread price increases, including increases in the cost of groceries, residential rents, and energy costs.
How Did We Fix It?
This was the first year of the Reagan administration. In response to this inflation, Federal Reserve chief Paul Volcker followed a policy of raising interest rates until they hit 20 percent in some cases. This was part of Reagan’s overall economic policy, which included reducing government spending, cutting taxes, reducing government regulations, and restricting the money supply through increased interest rates.
These policies initially sparked a recession in 1981 and 1982, with unemployment hitting 10 percent at one point. By the end of 1982, inflation had declined to 5 percent and the Fed Funds rate was back at 9 percent. This was deemed a success at the time.
What Is the Inflation Rate in 2022?
According to the Bureau of Labor Statistics (BLS), consumer prices rose 8.3 percent for the 12 months ended April 30, 2022. This is not a seasonally adjusted number. Expectations for the full year vary, with many forecasts in the 6 percent annual range.
What Are the Social and Economic Factors Causing Inflation to Rise in 2022?
Experts point to a variety of factors that have caused the inflation that we are seeing so far in 2022:
Strong demand. The generous $5 billion stimulus package put forth by the Biden administration helped to keep consumer demand for goods and services strong. These stimulus checks allowed consumers who were otherwise negatively affected by the pandemic to maintain their spending in many cases.
Supply-chain issues. Supply-chain issues across a vast array of industries have been widely reported by the news media. There have been stories of cargo ships stuck in ports with not enough workers to unload them. This has resulted in scarcity for many products, fueling higher prices. A key example is the price of gasoline. Shortages and high demand have resulted in near record costs at the gas station.
Raw materials shortages. Related to supply-chain issues are shortages of some key raw materials. In the case of food, some of this has been driven by issues in the agriculture sector, including the impact of droughts here and abroad, the bird flu epidemic, and the war in Ukraine. All of this makes certain ingredients and raw materials harder to get and has served to drive prices up.
Worker shortages. The Great Resignation has been widely documented in the media, and its impact has cut across virtually all industries. The pandemic has led many workers to either leave the workforce or to move on to greener pastures elsewhere. Many companies are having to offer more generous wage packages to attract and retain workers. This worker shortage extends beyond white-collar workers. Many restaurants, stores, and even gas stations are having staffing issues.
Will Inflation Decline or Level off in 2022?
Many experts are predicting that inflation will level off a bit as we move forward in 2022, perhaps ending the year around 6 percent. This is still high compared with what the economy has experienced in recent years.
Predicting the future is tricky at best. The direction of inflation will depend on a number of factors, including the effectiveness of the Federal Reserve’s policies and the ability of companies to solve their supply-chain issues.
In a recent Q&A session, Mohamed El-Erian, chief economic advisor of Allianz, pointed out that a quick drop in the rate of inflation would signal that consumer demand had been severely “damaged.”
What Are Some Possible Outcomes for the Economy Should Inflation Remain at This Rate?
Prolonged high inflation can have a negative impact on the economy and markets. Some possible examples include:
- A continued high inflation rate could push the prices of many goods and services out of the reach of many consumers. Lower consumer demand could adversely affect revenue and profits of many companies.
- Continued inflation may cause the Federal Reserve to keep pushing interest rates higher. This would make it more difficult for many consumers to borrow to finance major purchases such as homes and cars. It could also result in higher interest costs for variable-rate loans, These higher interest costs will serve to reduce consumer demand for many other goods and services.
- Sustained high inflation could lead to a recession if the Fed decided to take drastic action in terms of restrictive monetary policies and continued interest rate increases.
Obviously, nobody knows how our current inflation issues will turn out or how long they will persist.
What Can We Do to Fight Inflation?
From a governmental perspective, the Federal Reserve generally takes the lead in fighting inflation. Its main tools are monetary policy and interest rates. We are currently seeing the Fed use these tools; time will tell how successful the strategy is in combating inflation.
Price controls are another governmental tool. These were notably used in the early 1970s by then-President Richard Nixon. While they initially seemed to work, inflation proceeded to skyrocket to record highs a few years later.
Businesses and individuals can try to make changes in the way they spend and invest to try to stay ahead of inflation. Each situation is different, however.
From: ThinkAdvisor