If I asked you to describe inflation, could you do so? Some might say it’s when prices rise. Some would say it’s “bad.” Others might comment that it’s why they can’t afford their groceries, or rent, a car or a home. These descriptions are not wrong, but like the old tale of the blind men and the elephant, they’re not quite complete, either.
Prices are a symptom of inflation; you can’t have inflation without rising prices, but not all rising prices indicate inflation. Prices are set by supply and demand. If more people want to buy something, and the quantity for sale is limited, the price goes up. That’s not inflation, that’s just the market doing what the market does.
The best and shortest description of inflation comes from the legendary American economist Milton Friedman, who said, “Inflation is always and everywhere a monetary phenomenon.” That clears it up, right? Sorry, but here’s what he meant: inflation happens when too much money is chasing too few things (goods and services). Let’s look at an example.
Imagine an estate sale, where Granny’s elephant-foot lamp, Gramp’s velvet Elvis picture, and Uncle Ernie’s bottle cap collection are up for bid. People will arrive and bid what they think the items are worth to them, based on how much money they have. People with more money might bid more, or people with less money overall might bid more if they value the object more. It’s a simple marketplace. Now imagine that as people enter, you hand everyone $500 cash, no strings attached. Suddenly, the man who collects bottle caps is willing to bid more for Ernie’s stash, not because it’s worth more, but because he can. The woman who has always wanted a matching elephant-foot lamp won’t get beat because she runs out of cash, she’ll run it up all the way to $500+ since she can. Nearly all the prices at the auction will increase, even though the goods for sale did not change! Why? Inflation. You handed out cash, and that made too much money chase too few things.
Notice that nobody did anything wrong here. You are free to give away your money, and the estate sale just sold things as they always do, and the people bought things as they always do. That’s inflation.
Is inflation bad? No, not at all. In a perfect market, supply and demand work themselves out and prices could–in theory–become set: neither inflation or deflation. But of course markets are never perfect. And deflation, when (you guessed it) too little money is chasing too many things is really bad. Periods of deflation usually happen when an entire economy collapses; for example, the US experienced years of deflation during the Great Depression. Why would prices going down (a symptom of deflation) ever be bad? Another example:
The economy is deflating. You go to the store to buy a 400″, surround-sound, 3D immersive TV. The price is US $1000. You think, “wait, prices are going down, so next week it will be only $950.” You’re right, so you keep waiting, because it only makes sense. But everybody else is too. So no one is buying anything, and all their money is sitting on the sidelines (“too little money chasing too many things.”). Now the store is cancelling televisions from its suppliers, and the suppliers are laying off their workers, and soon you are out of a job, even though you got a sweet deal on your television.
Both of these examples hit on a key to inflation: psychology. If the price rise or the money supply is a one-time change (I won the daily double, or the government gave me a stimulus check), it’s unlikely to cause more than a temporary price increase, and therefore no inflation. But if there is a supply of money that keeps flowing, inflation can build. A third example:
You go to the store during your lunch hour and they’re changing the prices as you wait in line for the register. “Yikes!” you think, so you grab a few extra items to lock in the price now, and as soon as you check-out, you head back to work. You tell the boss, “I can’t afford to buy dinner on my salary; give me a raise or I quit!” The boss is sympathetic, and you’re a great employee, so he says “yes” and gives you a raise. Other employees line up. “We have the same problem, and we didn’t even get to go out to buy stuff at lunch!” The boss raises everyone’s pay, then starts raising his prices to cover it. A vicious cycle has started. Everybody expects the prices to rise, and pay to rise, which leads to one fueling the other until paper money becomes essentially worthless. This ends in hyperinflation, where people are being paid twice a day in wheelbarrows full of paper money which they then rush out and try to buy something.
To recap, during our recent pandemic, markets got all screwed up (technical economic term, that). Things weren’t literally moving, perishables were rotting before they could be marketed, people could not work to keep things working. This created shortages, at the same time the government was worried about a complete collapse of the economy since so many people were out of work. So the US government (and others) created various monetary stimuli (i.e., artificially increased how much money was available). They sent stimulus checks, froze rents and repossessions, deferred some payments, etc.. This extra money kept people from begging on the streets until the economy could get back on its feet. But it also meant that a lot of money was chasing a few things, which meant (you guessed it): inflation.
Now let’s not be too critical of our leaders (red & blue) here. It’s not like there is an economic control panel that shows just how far to push things. And if you have a panel of five economic experts advising you, you’ll get six different answers. Back in 2008, President Obama was more concerned with moving too far, too fast, and he got a very slow recovery from the financial crisis. President Biden “learned” from that and went big, adding in many long-time progressive programs to the spending spree, because as Rahm Emanuel (who wants to be President someday soon) liked to say, “you should never want a serious crisis to go to waste.” And thus we experienced the inflation that became the hot topic of the 2024 election cycle.
I understand how debilitating inflation can be. When I was in high school (and buffalo still roamed the plains), the inflation rate averaged over 9% per year; when I was in “college,” it averaged 11% annually! For comparison, the catastrophic post-pandemic inflation the US experienced topped out at 8%, so you’ll find me in the “we made too much of this thing” aisle. And before someone says, “Pat, you’re an expat, you didn’t experience inflation here!” Well, amigo, inflation has been higher in Mexico than in the US throughout the period.
Anyway, while some prices may go down because their spikes were related to the market, no one is proposing (or could achieve) a sustained, across-the-board reduction in prices because (you’re right again) that would involve deflation, which is bad, bad, bad. The federal government, especially the Federal Reserve (hereafter “the Fed”), seeks a stable inflation rate around 2% annually. Just enough to prevent a deflationary spiral, not enough to get into the psychology of wheelbarrow money. They do this by controlling the interest rate for lending. Reduce it and banks lend more at less interest, increase it and banks lend less at greater interest.* More money from banks to people and businesses is the juice that gets things going, less money is the glue which slows things down.
What about tariffs? Will they cause inflation? Let’s apply what we’ve learned! Tariffs are paid at the point a product is imported. They are paid once, at a percentage rate of the value of the good. You could call them a tax, and it wouldn’t be terribly wrong. A small tariff results in a small tax, a huge tariff might result in the item no longer for sale, because it’s so expensive to buy with a tariff added on. So we are talking about a price increase, but is it inflation?
Many things can happen when a tariff is introduced:
- The buyers can stop buying the product, so no money is raised, but also no one pays any more.
- The buyers can keep buying the product and pay the entire extra fare.
- The importer can “eat” some of the tariff, charging his customers some extra, but not the same as the full tariff.
- The foreign producer can lower their prices, resulting in a lower tariff.
Ignoring the first outcome, the other three have an increase in prices. But is it because more money is chasing fewer things? No. In fact, all three generally happen at the same time. WalMart went to its Chinese manufactures and grabbed them by the Yuan, saying if they still wanted to supply WalMart, they were going to eat some delicious tariff tofu. And WalMart decided to raise some prices, too. And people decided whether to keep shopping at WalMart, buy less, or substitute with lower-cost, domestic products.
This was all the market at work, as it should be. Now, a sufficiently high general tariff, across the board in an environment where many products people need are produced abroad (like the US until recently), could send a supply shock through an economy. Supplies would freeze up (like they did during the pandemic), and soon too much residual money would be chasing too few goods. Even if the price rise was one-time due to tariffs, if they were large enough, it could set people into the psychology of inflation.
While most economists insisted President Trump’s “liberation day” tariffs were exactly the kind to shock the US economy into an inflationary spiral, he has since backed down from them. The tariffs left are much greater than anything the US has experienced in ninety years, but not so great they should spark inflation. But that’s a debatable point. The data so far shows producers ate some of the tariff and importers/wholesalers ate some, but there’s still some tariff cost to go around. Guess who’s next in line? Us.
Each month, the federal government announces updated inflation numbers, including revising previous announcements. There are two numbers you need to watch: the overall inflation rate, and the core goods inflation rate. The former adds in many things, including things like groceries and gasoline, which can shoot up or down any given month. The latter number only counts more stable products, so it isn’t as affected by external forces. In today’s partisan environment, the two sides choose to focus on whatever element best fits their political arguments, so I recommend you ignore them (the partisans, not the data). Here are the keys: is the overall rate consistently changing up or down, in an identifiable pattern? And is the core goods rate making large/sudden moves (up or down)?
The overall trend here is a slight rise for the most recent data.
And here is a slightly more pronounced rise. Anyone saying anything definitive about this data and (1) tariffs , (2) stagflation, or (3) a recession is playing politics, as there isn’t enough definitive data to make a trend. It’s like calling the outcome of a baseball game by the strike count (“That’s a strike, looks like the Orioles are going to win. No, wait, that’s a ball, now it’s the Nats’ game to lose!”). The bottom line is the US economy is at an inflection point, which is why everybody is trying to predict what happens next (or pre-emptively blame someone else).
The real fear is tariffs cause a moderate increase in prices just as the Fed starts to reduce interest rates, and we have more money chasing fewer things. That sounds a lot like too much money chasing too few things, just as tariff prices increases hit.
That way bad things lie.
*This is a gross simplification of all the Fed does, but you’ve suffered enough for one post, haven’t you?