Today I saw a news article saying that many investors and people in our economy were waiting for the inflation report to come out tomorrow. This made me curious and I took a look at the historical inflation graphs.
The inflation really started after the pandemic. The pandemic itself caused many countries to shut down their economy in an effort to prevent the pandemic from overrunning their hospitals and saving people's lives. This had the effect of reducing supply globally in many key categories.
During the pandemic itself, the stringency index shows how we were all in lockdown so our ability the buy was hampered. This actually caused disinflation. You can see during the beginning of 2020 inflation actually dropped from around the 2% range down to nearly 0%. Once some of the restrictions were reduced and the three stimulus packages were signed in March and April of 2020, inflation started to rise. Inflation climbed back part of the way but never exceeded 2% for 2020. And you can see there is an inverse relationship between the stringency numbers and inflation.
From 2021 to 2022 the stringency was generally relaxed until most of the restrictions were gone, as we saw improvements in the pandemic situation.
Even though the pandemic was getting better, the economy was still impacted by the shutdown, we saw supply shortages. First, it was medical supplies and personal protective equipment. These by themselves wouldn't impact inflation. But when the shortages extended to shortages in commodities like propane, lumber, and steel in 2021, this would raise the price of those goods and all the goods and services dependent on those goods. Semi-conductors were also in short supply from 2020 and onwards. The supply chain was also greatly impacted which contributed to inflation.
On the other side of the coin, demand began increasing, around the end of 2020 the first COVID vaccines were made available, and 2021 became the year of vaccination. Driving people to go get their first and second rounds of vaccination. As cities, counties, and states spread awareness and promote vaccines, shopping began to expand beyond the necessities. Goods and services became available. So demand increased.
Now market forces where there is a shortage of supply and an increase in demand directly means higher prices.
Given this is the current situation, it makes sense that we're experiencing inflation, there is more cash in the economy due to the pandemic-related stimulus packages, things are in short supply due to resource shortage and supply chain issues, and people, in general, are starting to demand more.
I even questioned the ChatGPT chatbot at OpenAI.com about this.
This helped validate and cemented what I was intuitively thinking, which leads to the idea of fighting inflation by increasing supply. Curious to see what the LLM would produce, I asked the following
Note how it ranks using Monetary Policy, increasing interesting rates to fight inflation as number 5 while increasing supply and encouraging productivity is item 2 and 3 respectively. The government did help with supporting economic recovery in measure 1 by using the stimulus package, but handing out money is only one way listed. Increasing infrastructure projects and incentivizing spending that will specifically increase the goods and commodities that are driving up inflation would be more effective long term.
Even if the list is not ranked, policies or actions that would lead to more of the points being ticked off would surely be more effective than policies or actions that only address one of the points. For example, incentives to produce more of the resources in short supply, would increase the supply, strengthen the supply chain, support economic recovery, and encourages research to improve productivity. Ticks off measures 1,2, and 3. While increasing interest only addresses measure 5 and may actually hurt measures 1 and 2.
The current monetary policy is artificially reducing inflation, but it does not address all the problems, in fact, it may be hurting the supply issue. With higher interest rates, all the companies across the country are reducing spending, eliminating positions, and cutting back. This could lead to less being produced, fewer people having money, and less buying. It does reduce the demand curve but can aggravate the supply shortage. With less demand, companies might react by reducing production, which would help keep the prices high and conserve cash supplies. It is also hard to borrow money from banks as it is more expensive with higher interest rates. So it has the opposite effect that we all want, lower inflation.
If we want inflation to go down, we need to bring back up the level of supply and increase the efficiency with which we can produce these goods. If the government could give semiconductor manufacturers an economic incentive to produce more, build more factories, and have the incentive promote both quantity and efficiency. More dollars per quantity and more dollars for higher ROI. This would let industries figure out how to efficiently produce more. We apply similar incentives across all the goods and services that are suffering shortages, eventually, we'll bring up the supply and re-enter a phase of healthy economic growth. This may take multiple years to take effect as increasing manufacturing capability and efficiency doesn't happen overnight, but we need to make sure these measures are taken since there is going to be a phase of diminishing returns in terms of raising the interest rates, and what will you do when you have to raise the interest rates by 10 percent in order to see the inflation drop the next month by 0.5%?