Inflation, explained: Why prices are rising and who is to blame?

Confused about inflation? You are not alone. Inflation is paradoxically both incredibly simple to understand and absurdly complicated. Let’s start with the simplest version: inflation occurs when prices rise.

It is ‘broadly’ important: at any given time, the price of goods will fluctuate based on changing tastes. Someone makes a viral TikTok about Brussels sprouts and suddenly everyone has to have them; boom, sprout prices go up. Meanwhile, sellers of cauliflower, last season’s trendy vegetable, are practically giving away their goods. Such fluctuations are constant.

However, inflation occurs when the average price of virtually everything consumers buy goes up. Food, houses, cars, clothes, toys, etc. To afford these supplies, wages must also be increased.

This is not bad. In the US, for the past 40 years or so (and especially this century), we have been living in an ideal low and slow inflation that comes with a well-oiled consumer-driven economy, with prices heading up about 2% per year, if that. Sure, the prices of some things, like housing and healthcare, are much higher than they used to be, but other things, like computers and TVs, have become much cheaper – so the average of all things together has remained relatively stable.

When ‘inflation’ is a bad word

Inflation becomes problematic when the low and slow simmering boils over. This is when you hear economists talk about the economy “overheating”. For a variety of reasons, largely stemming from the pandemic, the global economy is in a rigorous boiling pot right now.

Economists use two main gauges to track inflation in the US, and both are at their highest level in almost four decades. The consumer price index for November rose 6.8 percent, while the price index for personal consumption expenditures, which the Federal Reserve prefers, rose 5.7 percent.

And this is where the basic economics course merges a bit with the basic psychology course. There is a behavioral economic aspect to inflation, where it can become a self-fulfilling prophecy. When prices rise for a long enough time, consumers start to anticipate price increases. You will buy more goods today if you think they will cost significantly more tomorrow. As a result, demand increases, causing prices to rise even more. And so on. And so on.

This is where things can get particularly tricky for the Fed and other central banks, whose main task is to control the money supply and keep inflation in check.

How did we get here?

Blame the pandemic.

In spring 2020, the spread of Covid-19 was like unplugging the global economy. Factories around the world closed; people stopped eating in restaurants; airlines stopped flying. Millions of people were made redundant as the business disappeared virtually overnight. The unemployment rate in America rose to almost 15 percent from around 3.5 percent in February 2020.

It was the most severe economic downturn in history.

At the same time, the Fed implemented emergency stimulus measures to prevent financial markets from losing momentum. The central bank cut interest rates to near zero and began pumping tens of billions of dollars each month into the markets by buying up corporate debt. In doing so, the bank likely prevented a complete financial meltdown. But keeping these easy money policies in place over the past 20 months has also fueled – you guessed it – inflation.

In early summer 2020, demand for consumer goods started to pick up again. Quickly. Congress and President Joe Biden passed a historic $1.9 trillion stimulus bill in March that left Americans suddenly flush with cash and unemployment benefits. People started shopping again. Demand went from zero to 100, but supply could not bounce back so easily.

It turns out that when you unplug the global economy, you can’t just plug it back in and expect it to start humming at the same pace as before.

Take cars for example. Car manufacturers saw the Covid crisis starting and did what any smart business would do – shut down temporarily to cut losses. But not long after the pandemic closed factories, it also increased demand for cars as people worried about exposure on public transport and avoided flying.

Cars require a huge number of parts, from a huge number of different factories around the world, to be built by highly skilled workers in other parts of the world. Bringing all these operations back online takes time, and doing it while keeping workers from getting sick takes even more time.

Economists often describe inflation as too much money chasing too few goods. This is exactly what happened with cars. And houses. And Peloton bikes. And any number of other items that became hot ticket items.

How is the supply chain involved in all this?

“Supply chain bottlenecks” – that’s another phrase you see everywhere, right? Let’s go back to the car example. We know that high demand + limited supply = prices go up.

But high demand + limited supply + production delays = prices go up even more.

All modern cars rely on a variety of semiconductors to function. But these semiconductors are also used in cell phones, appliances, TVs, laptops and dozens of other items that, as bad luck would have it, were all in high demand at the same time.

This is just one example of the disruption in the global supply chain. Because new cars have been slow to roll in, demand for used cars shot through the roof, pushing overall inflation higher. In some cases, car owners could sell their used cars for more than what they paid for them one or two years earlier.

What happens next?

Prices and wages are likely to continue rising well into 2022, officials and economists say. But how long and how much depends on countless variables across the world.

Policymakers and business leaders are working to plug the bottlenecks in the supply chain to get goods moving at their pre-pandemic pace. This is much easier said than done. And there is no telling what kind of shocks – a new Covid variant, a shipping container stuck in a major waterway, a natural disaster – could set back progress.

The Fed, for its part, has publicly acknowledged that inflation has been much more of a headache than it had anticipated. The US Federal Reserve will end its bond-buying program, a process known as tapering, in the first half of 2022, and plans to raise interest rates three times during the year.

And when money becomes more expensive to borrow, it can take the heat out of price increases and bring the economy back to that nice, gentle simmer.

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