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Why are prices going up?

Posted 9:16 a.m. Friday, June 3, 2022

The cost of food and gas are high. The big question is whether these prices are a permanent shift.

UW-La Crosse economists explain why the inflation rate is rising and what the future holds

If you’ve pulled up to the pump, started a home construction project, or bought food, you may have noticed that prices are high. Is the price of everything going up? Will these inflated prices ever go down? UW-La Crosse Professor and Economist John Nunley and UWL Associate Professor of Economics Adam Hoffer answers these questions and more.  

1. Are prices going up?

The price of goods and services purchased by a typical American family increased by 8.2 % from April 2021 to April 2022. That increase in prices — the inflation rate — is the greatest 12-month increase in consumer prices in nearly 40 years. 

Prices started to rise around January 1, 2021.  

2. Are the increases more dramatic than we've seen in the past? 

Not yet. The U.S. had extremely high core inflation rates in the 1970s. (Core inflation includes the price change of everything except food and energy). 

In 1975, inflation peaked at around 12%. It fell the following year, but then steadily rose until around 1981, when the Federal Reserve Board, under the leadership of Paul Volker, fought inflation with sharp increases in interest rates. Inflation fell sharply. Then, beginning in the mid-1980s, inflation hovered around 2%-3% (for the most part)until recently.

3. Will this be a permanent shift to higher prices?  

Inflation has not been a short term issue, but it isn't necessarily a permanent shift either, explains Nunley. Policy leaders could work together going forward to ease the burden using different strategies. For example, Nunley suggests ideas that could impact inflation such as:

  • Removing tariffs imposed during Trump administration
  • Removing unnecessary regulations that delay projects
  • Fixing the childcare crisis

4. What does the childcare crisis have to do with inflation?

A significant part of the current inflation is coming from the higher wages needed to attract workers. Declining labor force participation accounts for almost all of the employment shortfalls we are experiencing now. Older workers (55+) and women caring for family members exited the labor force at highest rates during the pandemic. Policies that boost labor supply, such as the provision of childcare, would ease the effects of inflation due to greater labor supply putting downward pressure on wages. It is likely older workers will start to return to the labor market as we transition from pandemic to an endemic phase.

Nunley suggests pulling together to focus on the childcare issue, which would allow more people to enter the labor force and slow wage growth so that the spiraling of prices slows in response.

5. What is causing inflation?

In short, during the pandemic, we saw supply chain disruptions (decreased supply) combined with a massive increase to the money supply (increased demand). Basic economics tells us that less supply combined with greater demand means higher prices, explains Hoffer.

Consumers changing what they bought during the pandemic is a big part of the cause of inflation. People purchased fewer services such as hair salon visits and restaurant meals and purchased more goods such as food and items for home DIY projects. Supply couldn't keep up with the extra demand, and fiscal stimulus. This was, however, fueled by too much fiscal stimulus such as extra unemployment insurance benefits and stimulous checks. So, people changing their buying habits interacted with the checks from the government to accelerate prices, explains Nunley.

High rates of inflation spell misery for most Americans, eroding the quantity of goods and services they can purchase from their jobs and savings. Compounding the problem, inflation acts as a hidden tax, bumping income earners into higher tax brackets. Unfortunately, the most common economic medicine to tackle high inflation is through higher interest rates and a possible recession, explains Hoffer.

6. The relationship between inflation and interest rates

The Federal Reserve (Fed) wields the U.S.’s monetary policy toolbox. Modifying interest rates is the Fed’s favorite tool. If inflation exceeds 2 %, the Fed’s target rate, the Fed can increase interest rates. Higher interest rates make borrowing money more expensive. As loans become more expensive, fewer people and companies will borrow for mortgages, construction projects, or business expansion. The aggregate effect on the economy is a cooling of demand for goods and services. As demand cools, prices will slowly stop increasing.

On May 4, The Federal Reserve announced the largest one-time interest hike in more than two decades. The Fed raised its benchmark rate by half-a-percentage point, following a quarter-point increase in March, totaling a 0.75 percentage point increase in interest rates in 2022. Following these rate increases, the average 30-year mortgage rate increased to 5.25 %, up from only 2.95 % a year ago, explains Hoffer.

A .75 percentage point increase in interest rates is a large change. Typically, the FED raises (or lowers) interest rates by .25 percentage points. So, the change is three times as large as a typical policy shift, explains Nunley.

Intentionally decreasing demand is a dangerous game for the Fed, however. Less construction and less business expansion quickly translate to fewer jobs. The economy can quickly spiral into a recession. In a 2022 research study for Brookings, the authors note that the Fed triggered a recession eight out of the last nine times that they aggressively increased interest rates in an attempt to decrease inflation, says Hoffer.

The goal of FED policy is to get to what economists call a neutral rate of interest (or natural rate of interest). This interest rate, although one never knows exactly what it is, is the real (net of inflation) interest rate that supports full employment and stable prices. Some leading economists say this rate is likely north of 4%. The FED is about 1.6% now. So, the rate hikes will very likely continue at an aggressive pace for a couple years, explains Hoffer.

7. Will the price of homes, cars and other items go down?

There will likely be more large interest rate hikes in the future. A consequence of this will be higher interest rates on cars, homes and other items. Higher interest rates will likely cool the auto and real estate markets quite a bit, as demand will fall. However, supply constraints may keep prices from falling significant or quickly.

For instance, estimates suggest that 2 million too few homes were built in the U.S. following the '07 recession. We can't go back in time and build these homes. The insufficient supply is interacting with the millennial generation starting their careers and families. The millennials are a larger share of the population than the baby boomers. So, that's a lot of people now demanding housing that isn't available, says Nunley.

Whether prices will eventually fall depends on who you ask, says Hoffer. The key question relates to how much of the increase in prices is transitory vs. permanent. Let's assume the inflation rate is 10%. If half of it is transitory, then we have a big problem. A 5% increase in the price level is problematic. However, if 3/4 of it is transitory, then the FED is right at its target inflation rate of about 2-2.5%. The FED believes prices will come down to more normal level, but that it might take one to two years. Other prominent economists, such as a Larry Summers, believe that inflation is likely more permanent than transitory. Time will tell. If prices don't cool in the next year or two, we will then know it wasn't transitory. We are in unchartered territory with the pandemic, recession, stimulus payments and more. It's really hard to predict how things will play out, says Hoffer.

8. Why are gas prices rising?  

The main reason is likely that oil prices have been rising. Oil is a key input to make gasoline. So, when oil becomes more expensive, gasoline prices rise due to higher production costs. When the pandemic hit, demand for gasoline and, hence, oil collapsed. This lowered the price of both goods.

Russia's invasion of Ukraine is exacerbating the problem, as many rich countries won't buy from them anymore given their invasion. That has reduced the supply further. For prices to fall, oil supply will need to rise and/or oil demand will need to fall.

A driver of lower oil supplies comes from the Organization of the Petroleum Exporting Countries or OPEC (a cartel that decides how much oil to pump out of the ground). Members of OPEC and Russia have been cutting their extractions. So, less oil supply means higher oil prices, which means higher gasoline prices. Even if OPEC pumps more and/or we pump more, it will take some time before the lower of oil feeds its way into lower gas prices.   

9. What sectors are we seeing the most increase in prices?  

Building materials and energy-related goods are key areas that are seeing a rise in prices. These goods tend to have more volatile prices. So, it is likely these sectors of the economy would be affected the most by inflation. Health care is an example of something that likely won't be affected too greatly by the disruptions we are seeing. With health care, you would not expect to see the big increases in demand like we are seeing for autos/gas/food.   

10. Will we have a recession?

We are probably already in a recession. Economists typically classify a recession as a decrease in total economic output (GDP) for two consecutive quarters (three-month periods). Total U.S. output shrank by 1.5 percent in the first quarter of 2022. April and May have been economically sluggish and, pending a sharp turnaround in June, a 2022 recession is likely. No one wants a recession. But the good news is that if an economic slowdown cools inflation, we should quickly return to an environment of stable economic growth, explains Hoffer.

Nunley agrees that a recession is very likely. Most predictions say the risk is about 2/3 or 3/4 over the next 12-18 months. Recessions are not always bad, he adds. They indicate a problem, and the problem needs correcting. Once the correction is made, the economy will recover.

11. Who benefits from inflation? 

The biggest benefactors of inflation are people — or governments — that are in debt. Why do in-debt governments love inflation? Let’s take a crazy example. The U.S. Federal government added more than $4,200,000,000,000 ($4.2 trillion) in debt to its books in 2020. Suppose the Federal Reserve printed so much money and prices adjusted so that a loaf of bread costs a $4 trillion. In that case, the government debt that could be used to purchase all the real estate in the state of Wisconsin –— every home, apartment building, and storefront — would be reduced to the point where it could only purchase a loaf of bread.

This example is extreme, of course, but with a quick internet search you can find evidence of governments who tried to use the printing press to solve their debt and spending issues: 100 Trillion Dollar Banknotes from Zimbabwe, images of Germans using hyperinflated currency for wallpaper and kindling during the 1920s, and modern stories of Venezuelans dealing with hyperinflation that exceeded 60,000 percent in 2018 (roughly a 7 percent increase in prices every hour for the entire year). Hyperinflation is one of the few tried and true ways of inducing economic and societal collapse.

In smaller doses, inflation can work in your favor. If you have a fixed rate mortgage, for example, your house increases in value, but your loan balance and monthly payments stay the same. Inflation favors debtors.

Inflation destroys savers and individuals on fixed incomes. As prices increase, any money you have saved in the bank and any income you earn simply buys less. Most Americans feel the pain of inflation because wage increases almost always lag behind the increase in prices of goods and services that Americans purchase. Over the past year, average wages only rose 4.5 percent, so real wages — wages adjusted for inflation — fell by 1.5 percent.

12. What is a healthy inflation rate?  

A 2% rate has been the target. At present, we are about 4 times that rate. So, the FED needs to bring inflation down to a much lower level. Economists debate whether 2% is the appropriate "target" rate instead of 3 % or 4 %. There are varying opinions on this. What economists agree on is that stable price inflation is desirable. We don't want inflation yesterday feeding inflation today, and then inflation today feeding inflation tomorrow, and so on... It can get out of control. 

13. Is the inflation we are seeing good or bad or both?  

Inflation is not in itself bad. Actually, deflation (prices going down) is worse than inflation. The concern is that prices will start rising too fast. This type of thing can spiral out of control. The U.S. had out -of -control inflation in the 1970s. Germany did in the early 1920s, when it was cheaper to burn deutsche marks than wood.