Written by Jacob Amspaugh
Inflation is all everyone talks about nowadays. Frequently, inflation is a warning sign of a coming recession. For example, before the Great Depression, there were record inflation levels. Should we be concerned about a recession with this high inflation in the market? A recession is coming, but before that, we need to understand the background behind inflation.
Inflation refers to a change in the prices of goods and services. It is no secret that prices frequently change because the demand for goods and services constantly changes. For example, the demand for used cars skyrocketed after the pandemic because of a supply chain shortage of microchips from overseas (Preston, 2023). Car manufacturers need to import these microchips to construct entertainment systems in new automobiles (Preston, 2023). Because of insufficient parts to make the car, the number of new vehicles decreased during the pandemic (Preston, 2023). Therefore, when demand for new cars sharply rose after the pandemic, automobile dealers did not have enough supply of new vehicles to keep up with the demand. Some consumers had a pressing need for new vehicles and could not afford to wait for the new cars to get built finally. Therefore, some consumers opted to buy used cars instead of buying new cars if they needed a new vehicle. This sudden new need for used cars caused the demand to rise sharply. With the recent rise in demand, prices rose to match demand since a rise in prices means that demand has increased.
Another essential thing to understand about inflation is that not all inflation is bad. Stable inflation is necessary for the growth of the economy because increases in prices will continue to get producers to produce more and more each year. Prices increase because of increasing demand from the rising total population year after year. One benefit of stable inflation is that consumers can budget their spending better. If consumers knew how much prices were changing, they could adjust their finances to ensure they could afford all of the necessary goods.
When inflation becomes unstable, consumers have a more challenging time budgeting for inflation because it is difficult to budget for unpredictable things. Therefore, some consumers may have to forgo some necessary goods if the prices change too much because they might not be able to afford them.
The current inflation in the marketplace is unstable because the CPI continues to fluctuate unpredictably month after month. When the Federal Reserve, which is responsible for controlling inflation, sees this, they start to panic and work to adjust inflation back to the long-run target number. The way they try to tame inflation is by raising interest rates. Raising interest rates would lower the money supply because more people are inclined to save their money in the bank to take advantage of the high rates. A decrease in the money supply would push demand down because people are less likely to consume if they are better off saving. Decreasing demand means prices would fall. Corporations will see the decreasing prices and begin to lay off workers to preserve their profits. Eventually, wages will decrease over time because corporations can force workers to take lower wages or threaten to discontinue their job due to declining output and demand. When wages go down, suppliers can supply more goods since suppliers have cheaper input costs. Supply and demand would be back in equilibrium, causing inflation to return to the long-run number.
The issue with pursuing this avenue to combat inflation is that it will be very painful for consumers. The intuition revolves around workers ending up with lower wages, making them worse off. Already, 64% of Americans are living paycheck to paycheck, so they cannot afford any wage reduction because they will not have any money to afford food and other necessities (Iacurci, 2023).
However, there are other ways to combat inflation. Another option to combat inflation is to increase supply so that demand and supply are back in balance. The Federal Reserve does not do it because they do not have direct control to increase supply. One of the biggest causes of inflation is the Russo-Ukrainian War. According to the Department of Commerce, the USA imports lots of agricultural products from Ukraine. During the war, Ukraine cannot produce the exact amounts of food as before, so the prices of things like bread have increased considerably. If the war were to end, Ukraine could expand production back to its pre-war numbers. However, the problem is that nobody knows when the war is ending. Also, when the war does end, supply could be so backlogged from previous demand that the supply cannot keep up with the demand.
So, the Federal Reserve is stuck picking between two options. They have to wait for supply to catch up, or they have to hurt consumers by increasing the interest rates. Examining the most recent CPI numbers from February, inflation is not stopping. All food categories increased by 9.5 percent, which is a substantial increase. If the Federal Reserve decides to wait for supply, who knows how much inflation will go up before supply can finally catch up? If the Federal Reserve decides to take action, the action it will take will eventually result in a recession because it will lead to negative GDP growth, which is the hallmark of a recession. Therefore, there is no choice but to admit that we are on a collision course for a recession. It is not a matter of if we are heading toward a recession. It is a matter of when.
Works Cited
“Consumer Price Index up 0.4 Percent over the Month, 6.0 Percent over the Year, in February 2023.” U.S. Bureau of Labor Statistics, U.S. Bureau of Labor Statistics, 20 Mar. 2023, https://www.bls.gov/opub/ted/2023/consumer-price-index-up-0-4-percent-over-the-month-6-0-percent-over-the-year-in-february-2023.htm.
Iacurci, Greg. “School Lunch, Eggs and Airfare: Why Inflation Soared for 10 Items in 2022.” CNBC, CNBC, 13 Jan. 2023, https://www.cnbc.com/2023/01/13/why-inflation-hit-these-10-items-hardest-in-2022.html.
Preston, Benjamin. “Global Chip Shortage Makes It Tough to Buy Certain Cars.” Consumer Reports, 6 May 2021, https://www.consumerreports.org/cars/buying-a-car/global-chip-shortage-makes-it-tough-to-buy-certain-cars-a8160576456/.