Inflation, shortages, and inflation: How money obeys the law of supply

Inflation is back, but it’s not here to stay. The causes that sparked it were unusual this time around, and as these trends unwind, the inflation rate will moderate throughout manufacturing and the rest of the economy. Getty Images

Inflation is back. It hasn’t really been a problem since 1980 or so, when it exceeded 13% for the year. 1981 wasn’t much better in that it subsided only slightly to 10.4%. Since then it has just chugged along, coming in at less than 3% more often than not. In the last decade it was tame: From 2010 to 2020, it averaged 1.73%. This year it has run at nearly 2.5 times that rate, 4.26%.

A better term would be price inflation, in that it measures prices for goods relative to the value of the dollar. Given a steady income, a loss of 2% to 3% of that income’s buyer power over the course of a year isn’t much, but the cumulative effect over many years is more than maddening.

The root cause? Like anything else, money obeys the law of supply. A glut of money floating around in the economy causes the value of each dollar to fall; scarcity of dollars causes the value to rise. Or, in the words of Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.” This view wasn’t accepted widely when he rolled it out in 1963, but eventually it became an orthodox view of inflation’s cause. When the federal government buys or sells bonds or changes the federal funds rate (an interest rate that commercial banks use, which affects all other interest rates), its intent is to change the inflation rate. The government actually wants a little bit of inflation, which it can manipulate. It doesn’t want price deflation because it doesn’t have a policy tool to deal with that.

The Federal Reserve’s tools seem to work. The federal funds rate was nearly 20% for a bit in the early 1980s, taming the stagflation of the late 1970s. When inflation was running a bit hot (more than 5% annually) in 1989, the government added a couple of percentage points to the federal funds rate, bring inflation under control. It didn’t fall immediately, but it leveled off for several months and eventually it subsided.

The recent round of inflation is the other side of the same coin. The global pandemic led to a scarcity of many industrial commodities. A broad, synchronized shortage of nearly everything necessary to power a modern economy has never happened before, and the only possible outcome came to pass: a broad, synchronized, and sustained case of rising prices.

Demand from consumers—many of whom have plenty of money to spend—is also contributing to higher prices. As these cash surpluses are depleted, the demand will wane, easing the upward pressure on prices. Meanwhile, the federal funds rate has been very low in recent months, so we can expect it to climb.

If you’re interested in a more detailed and up-to-the-minute look at the economy and a glimpse of the future, you can attend a presentation by Chris Kuehl at FMA’s Annual Meeting (March 1-3 in Miami) or at our Pipe & Tube Memphis 2022 conference (April 11-13). Find out more at www.fmamfg.org/events.