The story so far: The U.S. Bureau of Labor Statistics reported last week that inflation in the United States hit a 40-year high in January. The consumer price index (CPI) in January was 7.5% higher than it was a year earlier. The prices of goods and services as measured by the CPI have been rising at a faster pace since April last year when the CPI rose by 4.2%. The US Federal Reserve has long tried to keep inflation at 2%.
Why are prices rising so fast?
Prices of goods and services in any economy are determined by demand and supply. When there is excess demand in the form of too much money chasing a limited supply of goods, prices rise to prevent shortages. On the other hand, when the supply of goods in the economy increases at a faster pace than the money supply, prices fall to prevent surpluses. American economist Irving Fisher’s ‘quantity theory of money’ is often used to explain how money supply affects the general price level in the economy. In short, prices in an economy can rise when there is a flood of fresh money entering the system, a drop in the amount of goods available for sale in the economy, or a combination of both.
In the U.S. and other countries across the world, the overall supply of goods and services dropped in the last two years or so due to the COVID-19 pandemic and the strict lockdowns imposed to tackle it. In fact, even as prices have risen across the board, central bankers have maintained that the price rise is likely to be transient as the supply of goods and services should return to normal as the pandemic eases.
It should be noted that the supply of money in the U.S. and other countries was also ramped up by their respective central banks through various means to fight the economic slump. In the U.S., for instance, broad money supply (M3) has increased by about one-third since the beginning of the pandemic.
So, both the drop in the overall supply of goods and services and the significant increase in money supply have combined to contribute to the current trend of rising prices.
Why is rising prices a problem?
The prices of goods and services have generally risen over time as governments, with the cooperation of their central banks, have tended to inflate the overall supply of money in the economy. The rate at which fresh money has been created by central banks has generally outpaced the rate at which the supply of goods and services has grown, thus leading to a general rise in prices. However, it should be noted that people’s incomes, in general, have also risen in tandem with rising prices over the long-run. So, rising prices per se need not necessarily lead to the lowering of living standards of people.
The real problem with rising prices is that it affects different people differently. This is because the fresh money that is created by central banks generally does not get distributed across the economy proportionately. Some people receive a larger share of the fresh money, which in turn increases their purchasing power when compared to those who receive only a smaller share of the fresh money.
The rate at which prices rise also affects the confidence that people have in the currency. If people expect the value of their money to deteriorate at a rapid rate going forward, this can push them to spend their money quickly before it depreciates further, thus leading to further rise in prices.
What lies ahead?
Most economists expect the U.S. Federal Reserve to let interest rates rise, which is another way of saying that the central bank will reduce the amount of fresh money it injects into the economy. The yield on 10-year U.S. Treasury bonds rose to over 2% last week in expectation of tighter Fed policy. How much the Fed will let interest rates rise is a question on which there is a lot more disagreement. Goldman Sachs, for instance, expects the U.S. central bank to raise rates by 25 basis points in each of the seven remaining policy meetings this year. It should be noted that a central bank can not only reduce the amount of money it injects into the economy but also suck money out of the economy. But such drastic action looks unlikely as even a slowdown in the injection of fresh money would affect not only markets but also the wider economy by forcing resources to be reallocated to adjust to tighter monetary conditions.
Huge public debt, which refers to the money owed by governments to creditors, is another factor that could stop central banks from allowing interest rates to rise too much. According to the International Monetary Fund, public debt in advanced economies rose from around 70% of GDP in 2001 to over 120% of GDP last year. Central banks have played a major role in financing this debt load by purchasing government bonds in the secondary market at low-interest rates. Many governments may simply not be able to pay interest on their debt if central banks stopped lending money at cheap rates. It should also be noted that money supply rises when central banks create fresh money to buy government bonds.
Critics of central banks believe that the current easy money policy of central banks will have to come to an end at some point. They argue that even if central banks do not allow interest rates to rise anytime soon, they will be forced to do so eventually when price rise gets out of control.
- The U.S. Bureau of Labor Statistics reported last week that inflation in the United States hit a 40-year high in January.
- Both the drop in the overall supply of goods and services and the significant increase in money supply have combined to contribute to the current trend of rising prices.
- Most economists expect the U.S. Federal Reserve to let interest rates rise, which is another way of saying that the central bank will reduce the amount of fresh money it injects into the economy.