INFLATION IS IN the news and at the gas pump. We see it in smaller product sizes and empty store shelves. According to Google Trends, a record number of people have searched the term “inflation” this year. Inflation has even made its way into Halloween spoofs.
While some have suggested that investors are overreacting, I’m not so sure. If higher inflation is here to stay, the implications for both Wall Street and Main Street are profound.
Take the Misery Index, which was invented by economist Arthur Okun in the 1970s. An index of economic distress, it’s the sum of the unemployment rate and the inflation rate. The Misery Index peaked at almost 22 in 1980. Today, it stands at 10. That’s the sum of October’s 4.6% unemployment rate and September’s 5.4% Consumer Price Index.
In three of the last five recessions, the unemployment rate rose to 10% or higher. If the inflation rate were to double over the next few years and the economy tipped into recession, a Misery Index of 20 could once again be in the cards.
Resurgent inflation also wouldn’t be good news for investors. It’s the great enemy of bonds. Holding cash all but guarantees a loss of purchasing power. Even stocks would likely suffer from an inflation scare, at least in the short run.
But what exactly is causing higher prices? According to economic theory, inflation arises in two ways: demand pull and cost push.
Demand-pull inflation occurs when higher demand causes prices to rise. This demand can be driven by increased government spending or cuts in taxes. We’ve certainly had plenty of government spending of late.
On top of that, when the economy shuttered during the pandemic, consumers became forced savers. As the economy reopened, consumers—flush with cash and anxious to spend—have competed for goods and services.
At the same time that demand surged, supply chain disruptions led to widespread shortages of goods. Higher demand and lower supply are a recipe for higher prices.
The other factor driving up prices is cost-push inflation. Rising commodity costs, such as those seen in oil and lumber, are passed on to consumers in the form of higher prices. While not yet widespread, rising wages may also lead to further cost-push inflation.
All this is happening against a backdrop of loose monetary policy. Monetarists, led by the late Milton Friedman, have long argued that inflation is largely a monetary phenomenon: Increase the money supply and you get increased inflation. Monetarists have been out of vogue recently. But given the pandemic-induced ballooning of the money supply, they may yet get the last laugh.