Broker Check

Explaining Inflation

December 16, 2021

Exactly What is Inflation?

One thing you can't get away from right now is talk about inflation. Come to think of it - another thing you can't get away from right now is inflation itself! For years inflation had been relatively tame. We had consistent inflation in the 2 to 3% range and it was not something that many folks were talking about. Now however, as a result of some circumstances that came about during the pandemic we've got substantially higher inflation and those price increases are starting to affect household budgets. So exactly how did this happen? Let's talk about it.

Pizza Town Sounds Like a Wonderful Place!

Let's start with a story about a magical place called Pizza Town. Just as it's name suggests, Pizza Town is a place with pizza. As a matter of fact it's a place with ONLY pizza. The only place to eat there is one small pizzeria. That happens to be okay because the 30 residents of Pizza Town (it's a small place by the way) love eating pizza. Every morning they go to the one place in town to get food and they buy their pizza for the day. Tony, the owner of said pizzeria has a pretty good gig. He makes his 30 pizzas, sells them to the townsfolk for $10 a piece and hits the golf course by early afternoon. Then one day Tony comes out of the back with only 15 pizzas. It turns out that the flour shipment is late. "Supply chain issues" he mutters to his concerned customers. As he starts selling pizzas the people in the back of the line do some quick math and realize they are about to be pizza-less.

"I'll pay $15 for a pizza" one guy says. "Make that $20!" says a guy from even deeper in the line. Suffice it to say that Tony sells all of his pizzas, and for a higher price than normal. So what happened there? There was more demand than there was supply. As we know from Econ 101 - if there is more demand for something than there is supply prices will rise to bring the market back into equilibrium.

Now the flip side of the Pizza Town debacle is that one day a restauranteur heard tell of their plight and rolled his taco truck into the city. All of a sudden the residents had options. No longer did they need to outbid each other for one of the precious few pizzas, now they could eat all the tacos they wanted. All of sudden Tony couldn't sell all of his pizzas anymore. He had to cut his prices! Now we're talking deflation. There was more supply of something (Tony's formerly overpriced pizzas) than there was demand. Because of that, he had to discount his pizzas to sell them. Think of the rack of weird sized strangely styled clothing that lives on clearance in the back of your favorite department store. They have little demand for those items, and so to sell them they've got to lower the price. See, it all comes back to supply and demand!

So Exactly What Happened Here?

Let's get back on track. How does the Pizza Town debacle translate to our economic system? Well, to experience inflation you need one of two things to happen. You need excess demand (more people wanting pizza than pizzas exist) or a supply shortage (too few pizzas). Either one will do it. In our case of course, we got hit with both. As a result of the pandemic and the various lockdowns and government stimulus programs monetary supply increased substantially. Very substantially. As a matter of fact M2 increased over 40% from the beginning of the pandemic. Putting extra money in people's pockets led to excess demand once they were able to get out of the house to spend it. The second whammy was that the government shutdowns broke supply chains. Supply chains are incredibly complex. Think of a single ink pen. It is not created and assembled in any one spot. Parts are made all over, sent to a manufacturer to assemble the pen and then shipped to a distributor, who ultimately gets it to the store. There are lots of steps along the way that can break down and that's with something as simple as a pen.

All of the various Covid lockdowns created various shortages of supply at the same time that we were experiencing increasing demand. That is a two pronged approach to substantial inflation, and to the surprise of no one that is exactly what we have gotten. Eventually as the money supply is absorbed into the system, and the excess demand is satiated all while supply chains begin to heal we will see inflation rates come down. All of that will take time however. In the mean time we all feel like the last guy in line at Tony's pizza place. Hang in there, markets are resilient and our proverbial taco truck is on the way.

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