President Biden continues to blame the high inflation on supply chain disruptions. Lately, he has put additional blame on businesses that he says are price gouging. The reality is that neither has much of an impact on inflation.
Today’s 7.5% inflation is partially caused by energy price and wage inflation, which are driving up costs for business. But the inflation is mostly caused by excess demand created by huge federal government deficits and a shockingly irresponsible Federal Reserve expansionary monetary policy.
It’s not difficult to see why those are the reasons for the extraordinary inflation. Let’s try an easy-to-understand explanation.
Simply put, prices rise when at the current price, the market is willing and able to purchase more goods than business is willing and able to produce. In other words, suppose at a price of $100, the market demand is for 10 units and the supply is 10 units, so the market is in balance.
Biden Fingers Supply Chain
President Biden would say that because of the supply chain disruptions, only 8 units are produced. So, if the demand is for 10 and the supply for 8, business must decide which 8 people to sell the product to. They make that decision by raising the price until two people drop out of the market. Maybe the price rises to $110.
Biden says that once the supply chain issues are resolved, business will make 10 units again, so the price will fall back to $100.
Biden’s assessment is incorrect because, in total, the economy is now producing about 2% more than was produced prior to the pandemic. That means while there may be shortages of some products, mostly imports and computer chips, there is no overall shortage of supply.
Since total supply now exceeds pre-pandemic levels, the price increase to $110 is because business is no longer willing to make 10 units and sell them for $100. That’s because their cost to produce has risen significantly due to the higher energy cost and higher labor costs. The company originally produced the product at a cost of $90 and sold it for $100. Now the cost has increased to $100, so the price has to remain $110.
Easy Money, Excess Demand
Businesses don’t “price gouge.” Rather, they simply seek the fair market price. After all, how else would they decide which 8 of the 10 consumers should be able to purchase a product,
In addition to the increased cost to produce, excess demand has caused market prices to rise. In the example, suppose at the original price of $100, the market demand was for 20 units. Business has produced only 10. Business raises prices until the market demand is cut from 20 down to 10.
Particularly in markets that are interest-rate sensitive, prices have risen very quickly. Last year, consumers used the free money that the federal government gave to every household as part of the stimulus packages, as a down payment for high-priced goods. That, coupled with historically low interest rates, caused a huge increase in demand in the housing and car markets, resulting in high inflation rates.
$6 Trillion Spend
All of the excess market demand is a result of the current fiscal and monetary policies. The federal government has deficit spent nearly $6 trillion in the last two years. On a $23 trillion annual economy, that led to pure inflation.
Most surprising, and likely the largest contributor, is the Federal Reserve’s shockingly irresponsible monetary policy. For the last four decades, the Fed has always been ahead of inflation. This time, it is far behind.
Instead of ending its expansionary policy early last year when there were obvious signs of a severe inflation problem, it continued to vastly increase the money supply by purchasing $120 billion per month of government bonds—and it continued to keep interest rates near zero, as well.
The resulting easy and cheap credit led all sectors of the economy to borrow money to make purchases, thus creating excess demand.
That excess demand is the real cause of most of today’s inflation. Businesses are not price gouging when they simply seek the market equilibrium price. It’s certainly not their actions that caused the market demand to far exceed their ability to supply.
Brace for 8.5% Inflation
Inflation is already too high. Acton should be taken immediately. The Fed will finally end the bond buying program next month. Then, beginning in March or April, it will raise interest rates probably by 50 basis points. After that, the Fed will raise rates another four or five times this year.
Unfortunately, by April, inflation will be in the 8% to 8.5f% range, so the Fed’s actions are clearly too little and way too late.
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