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WVU Professor Breaks Down Historic Inflation

Prices for gas at an Exxon gas station on Capitol Hill are seen in Washington, DC.
Prices for gas at an Exxon gas station on Capitol Hill are seen in Washington, DC.

Whether it's at the gas pump or at the grocery store, West Virginians have been feeling the pinch of recent record inflation. But understanding why things cost more in a modern, globalized world can get tricky very quickly. Reporter Chris Schulz sat down with West Virginia University associate professor of economics Scott Schuh to better understand higher prices, and how they might come down again.

Schulz: Can you start us off by just telling us what exactly inflation is?

Schuh: Sure, it's a general rate of increase of the average price level in the entire macro economy. So it takes into account prices of all final goods, goods that go to consumers. We look at the average price level for the whole economy, and we then calculate the growth rate of that average price level, taking into account all goods and services. And that rate of growth of that price level is inflation. Because the price indices jump around month to month, we typically look at the rate of growth over 12 months. So when they say it's 9% inflation, it's roughly a 9% increase in goods and services prices over the past 12 months.

Schulz: That kind of leads me into my next question, which is why is inflation so high right now.

Schuh: So there are two schools of thought. One is that inflation is always, everywhere, a monetary phenomenon, meaning that when the rate of growth of money increases, the rate of growth of price of prices increases about the same. A second hypothesis about inflation is that it's related to the degree of utilization of resources in the economy. So for example, how close are we to full employment? How close are we to the potential output level in the economy?

What's interesting about our recent episode, however, is that we've seen an unusually large rate of growth of money in a very short period of time. From 2020 to 2022, the stock of money grew about 40%. That is off the charts high. To people who favor the monetary hypothesis for inflation, they point directly to that and say, ‘Yeah, maybe 5%, or 7%, or 9%, growth of money wouldn't have caused high inflation, but 40% is going to always and it's not going to take very long for that to happen.’ In my opinion I think the evidence is a little bit stronger right now that it's the monetary growth that's causing the inflation.

That said there are also complications going on at the same time about things that people call the supply chain. That whole process of production has different prices along the way. And so while we don't think of those as inflation, they can, if that supply chain gets out of whack, which it seems to be in many places, that can cause the relative prices of different stages of production to go up or down. And right now we're seeing the pass through of that to final goods inflation as well. So that's a complicating factor. And it's very hard to pinpoint exactly how much is monetary, how much is that supply chain.

Schulz: I think the question that everybody who might be listening to this is going to have is how does COVID factor into this?

Schuh: Well, COVID was by far the largest decline in output and the shortest period of decline in output that we've seen, perhaps ever, but certainly in the modern post World War Two era, even more so than during the financial crisis. But it rebounded basically within two quarters, which is an unheard of rate of return to high levels of growth. The health crisis caused us to have to reduce production and people just couldn't go back to work. Well, that's an issue that we think of in macroeconomics as one of potential output. Normally, potential output is fixed there, and it stays steady for a long period of time. It doesn't fluctuate.

Unfortunately, in my opinion, monetary and fiscal policy treated this as if it was a demand shock. And they said, ‘Well, outputs are going down so incomes are going down. So we should give people more income and wealth.’ So there were a lot of fiscal transfers, there was monetary stimulus to reduce the interest rate. And what that caused people to do is want to buy more. That's normally what happens with monetary and fiscal policy when it tries to combat a recession. The problem in this case is we couldn't produce more. So everything sort of fell apart at once. But the real problem was people had plenty of income and wealth from the stimulus, but they couldn't buy or get the goods that they wanted. And so we had, as usual, too much money chasing too few goods, and that causes inflation.

Schulz: The big question is, and this is what you and your colleagues have been looking at, is how this is going to impact different people differently. What have you seen in your, in your research, and in your study, about the different impact of this situation?

Schuh: Yeah, the classic mechanism by which inflation affects the economy is on the side of households and consumers. It affects people who have a lot of money, not people who are wealthy or rich, but people who hold a lot of their assets in what we call money like cash, checking accounts, even savings accounts. The number one thing inflation does is it causes interest rates to rise. You need to keep up with inflation otherwise the real value of that money is going to decline. Their balances are going to devalue in real terms because the price level is going up. What they have in their bank account won't buy as much tomorrow. So this is called the inflation tax on money and it's very hard for many people, particularly lower income people and people who don't have skills or the taste for investing in more risky assets. They lose value during inflation, and that's a big hit on their wealth. At the same time, inflation tends to hit certain types of prices like food and energy, as it's doing now, that are essential items that people can't substitute away from. So when those prices go up, that hits directly into people's budgets, they can't shift to something else as easily. And so people with lower incomes and lower wealth are going to be disproportionately harmed by the inflation because it hits what we call inelastic goods that they have to buy, and that they have to swallow the price increases. So it's a big hardship on them.

Schulz: Does that disproportionate impact also carry over into the business sector? For smaller businesses, say?

Schuh: Well, certainly for businesses that maybe say are sole proprietorships, or home businesses or smaller things, they actually have a lot of characteristics that are similar to the typical household. But by and large, business firms don't have that problem, in part because they manage their assets better, they have people on staff that can do that. So they're more inclined to be invested in things that would earn a higher return than cash, they would not hold on to cash in an inflationary environment.

What really hurts the businesses with regards to inflation is the difficulty with understanding whether the overall rate of inflation is directly related to their business. So they have to determine, ‘Is my price going up because of inflation? Or is price going up because the relative demand for my product is going up?’ And if they can't discern that correctly, they may expand output too much, and then crash more later.

One last thing is because of the supply chain, the issues coming overseas, they have to be able to forecast ‘How much are my inputs going to increase? How much can I reasonably commit to produce in light of that uncertainty? How long will the product get here?’ That that sense of uncertainty, which is caused particularly by the supply chain oriented contributions to inflation, are very difficult for firms of all types to manage.

Schulz: This level of inflation that we're currently seeing, 9%, how does that end? When does it end?

Schuh: Well, most of the time, inflation ends through one of two things, or both. One is a contraction of the monetary money supply. That's beginning, the Federal Reserve is starting to raise interest rates. The way they're going to do that is by reducing the amount of money supplied to the economy. The Fed contracting the money supply has virtually always ended in lower inflation. The history of the Fed has been that it typically raises rates too late and often a little too much so that there ends up being a recession.

The second force that brings down inflation is a contraction in output. This is both the monetary and the utilization theories of inflation playing together and building one off the other. As the money supply contracts, interest rates go up. But then because interest rates are higher, people start buying fewer cars, fewer homes, and they start worrying. And then we have a recession, and then demand declines below potential output. And then we have additional downward pressure on prices. So it's a monetary contraction, followed by a decline in output, usually a recession, that will bring inflation down.

Schulz: Nobody wants a recession, I don't think. These cycles seem so extreme. In my lifetime, we've seen the Great Recession, and now this. It seems like the periods between these cycles are getting shorter and shorter. Is there something that can be done through policy, or more broadly, to kind of normalize things a little bit more?

Schuh: That's interesting, because from a macro economist's perspective, there's almost universal agreement that recessions have become much less frequent in the last 40 years. The average duration of an expansion has been increasing over time. Some of that credit probably goes to better monetary policy, for sure. There are other things in the economy that I think have adjusted like, for example, the ability to manage the supply chain and to reduce large buildups of excess inventory. That's been a real private sector development that has helped reduce the amount of business cycle fluctuations.

But what sticks in most people's minds is the last two have been ginormous. One was a financial crisis, which by the way started back in 2007, or eight, and was over by 2010. So it's now over a decade old. And there was a very, very long period of economic growth and expansion with no recessions. And then we've had this pandemic, which was unusual in so many different regards, because it wasn't really economic, in a sense, it was health oriented and as we talked about was faster and deeper than usual. So we actually see fewer recessions. But the last two have been so big that they stick in our minds as being really bad recessions. And they are, but they're very uniquely different. So there's not a one size fits all forecast for what to do, what's going to happen, what to do about it. They're each both very different.

Schulz: Is there anything else that we need to know about this?

Schuh: One thing that's really important is to make sure you keep abreast of what's actually happening, keeping an eye on that inflation rate and trying to manage your financial resources around that. For example, the Treasury Department recently launched a new type of bond that is ideal for households. It's a savings bond, similar to what other people have used, but it pays interest based on the rate of inflation. So that might be something that people might want to check out and see to help guard against the issues of the inflation tax that we talked about before. Anytime we're on the border of a recession, there's a concern that the probability of becoming unemployed is rising. Bearing in mind as you plan your expenditures, and your savings and your investments, that that's a possibility. It may lead some people to maybe increase the amount that they save during this period of time in case they become unemployed for a season.

North Central/Morgantown Reporter, cschulz@wvpublic.org, 304-284-1497, @SchulzReports

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