The Economist's Bogeyman - Inflation - Linden Financial Consultants

For this week’s Mulling Over Money Matters, I thought we would talk about inflation from an operational perspective. I initially thought this would be a quick one to write but boiling the nuts and bolts of inflation down into bite-size pieces isn’t all that easy. Let’s give it a try…

What is inflation, anyway? From a purely economic standpoint, inflation is a change in price level over a period of time (usually a one-year period). That sounds pretty straightforward..perhaps or perhaps not. That simple term, “change in price level,” is really a delicate balance (or lack thereof) between the amount of money out and about and the goods and services being traded (using that money). Inflation is really a measurement of the trend in those price levels—moving up or down like a wave rather than specific points in time.

Who controls the amount of money out and about? That’s the government. Things like stimulus checks and enhanced unemployment benefits introduce cash into the system. On the flip side, to pull cash out of the system, the Fed will buy back various treasuries (bonds) to take them out of circulation. Another, more familiar, way to control the money supply is to alter the interest rates. Increase the interest rate and people/businesses borrow less money, which really means they spend less money. Lower the rates and, as the theory goes, people/businesses will spend more money. Is this an infallible way of controlling money supply? No, but you work with what you’ve got.

Who controls the goods and services being traded? That’s all of us and all of the businesses producing all of the things and services we each feel is important to us. And it’s not just the stuff we buy, it’s also all the transportation that is involved in getting that stuff to us. We all know that our food travels about 1,500 miles before we purchase it, throw it in our cars, and drive another few miles. Less obvious is the fact that things less perishable can travel thousands of additional miles and every one of those truck-to-container-to-train and/or ship-to-container-to truck transfers adds to the cost of that item. The recent Suez Canal debacle and the 300+ container ships full of goodies for us to buy is a perfect example. If Huggies diapers contain nearly a dozen different components, there’s a pretty good chance at least a few of those components travel a serious distance before reaching the factory and if that cost goes up so does the cost of those Huggies.

So if those are the mechanics, what’s a real-life example? Let’s start with a simple one: if people buy more potatoes than bananas, then the price of bananas goes down (there is an excess supply of bananas) and the price of potatoes goes up (there is a shortage of potatoes). In its basic form, that’s inflation.

OK, how about something a little more complicated: I need a new sump pump. When I go to buy the same model I purchased three years ago, the price has doubled. Part of this increase is a result of the transportation costs increasing for the parts that come from way far away (transportation cost), part of the increase is a result of more people building houses in wet areas and needing a pump in their basement (lack of supply), and part of the increase is an increase in the actual cost to make the various parts and assemble the pump (production cost).

And there you have it. Whether our inflation is low (as it currently is here in the States) or soaring (see various African countries as examples), it isn’t just one reason or one government policy that causes the inflation. It’s a bunch of different things working together (or against each other) that results in what we pay for the things we buy. That also means that there is no one solution to keeping inflation low—something to remember when one of the talking heads on what we humorously call “news” spouts off about this or that governmental policy.