by Nathan Robbins
December 8, 2022
The holiday season is upon us, bringing colder weather, awkward family gatherings, and… rising prices. As this year’s inflation ticks up towards the double digits, Americans have found themselves struggling to afford essentials like food and energy. But why have prices risen so steeply, and can we expect things to change in the new year?
Most prices are driven by the interaction of supply and demand. Accordingly, the causes of inflation are generally broken down into two main categories: cost-push and demand-pull. Cost-push inflation occurs when costs to manufacturers and suppliers increase, reducing the amount of goods and services they supply. When consumer-driven demand for goods and services increases, demand-pull inflation results.1
Over the past two years, a cascade of global crises have been the catalysts for both cost-push and demand-pull inflation. The coronavirus pandemic in particular has caused a flurry of compounding inflationary pressures, and the war in Ukraine has thrown a fragile world economy even further into chaos.
First in the tangled web of Covid disruptions were widespread lockdowns and stay-at-home advisories. As health mandates and shifts in demand put new pressures on manufacturers, the production of many goods was severely impeded. Semiconductor chip manufacturers in Taiwan and South Korea, for example, faced facility shutdowns and demand surges, which kickstarted the global microchip shortages we’re still experiencing today. Food prices rose as labor turnover and additional safety investments drove up production costs.
As consumer demand shifted suddenly from services (like restaurants and travel) to goods (like computers and medical equipment) during Covid lockdowns, global shipping lines into the U.S. were overwhelmed by the influx of imports. Outdated software, a lack of crucial infrastructure and equipment, and chronic understaffing exacerbated the problem. Freight companies are still struggling to correct for compounding bottlenecks, hampered by their long standing shortcomings. The result? Crucial goods—some already facing production shortages—are getting stuck in warehouses, far away from manufacturers, retailers, and consumers.2
Russia’s invasion of Ukraine has thrown another massive wrench into the already unsteady global economy. Both Russia and Ukraine are major exporters of wheat and other grains, together representing 30% of global wheat exports.3 According to Ukraine’s government, its grain exports have fallen by more than 50% since the start of the war. Sanctions on Russia have restricted its ability to export oil and gas, contributing to catastrophic shortages in Europe, which relied heavily on Russian exports, and increasing global energy costs.4
Scarcity isn’t the only thing that has driven prices up. Since the start of the pandemic, the U.S. government has spent roughly $5 trillion on Covid relief funding to individuals, businesses, and state and local governments—more than double the global average as a percentage of GDP.5 It stands to reason that, on top of an already recovering economy, the money placed in consumers’ pockets (including $1400 checks direct to families) would drive up demand, and therefore prices.
The American Rescue Plan (ARP), a $1.9 trillion stimulus package signed into law by President Joe Biden on March 11, 2021, has faced especially intense scrutiny for its effects on inflation. Republicans blame “Biden’s massive deficit spending” for the current inflationary crisis. Biden has rebutted that it is due to the pandemic and the war in Ukraine, not “because of spending,” that prices are rising. Though experts disagree on exactly how much the ARP has contributed to inflation, the general consensus is that it has added a few percentage points over the past year. In a report from March 2022, the San Francisco Federal Reserve produced an estimate of 3%, but cautioned that the economic effects of no stimulus—like economic slowdown and deflation—may have been harder to deal with.6
If one thing is clear, it’s that clarity is hard to find in analyzing inflation. From factory closures to fickle consumers, inflation’s causes are myriad and densely intertwined. The sheer complexity of the global economy makes it difficult to pick out any one thread in the enormous patchwork—and the reality is that it isn’t any single thread, but the multitude that coalesce to create the huge price movements we’re seeing today.
While the causes of inflation are dizzyingly complex, the solutions are surprisingly straightforward. Two bodies are responsible for managing inflation in the U.S.: the Federal Reserve and the federal government.
The U.S. federal government uses fiscal policy to affect economic activity in the United States. Fiscal policy includes changes to taxes, transfer payments (like Social Security and Medicare), and direct government purchases. When the government decreases taxes, or increases transfer payments or purchases, it’s called expansionary fiscal policy, and when the government increases taxes or decreases spending, it’s called contractionary fiscal policy. Expansionary fiscal policy (like the Covid stimulus bills) tends to spur economic activity, which is useful in a recession (like that caused by the Covid pandemic), but increases inflation; in a period of already-strong economic growth, contractionary fiscal policy can help to slow down the economy, tamping down inflation.7
While the federal government has fiscal policy tools at its disposal, most of the short-term action to control inflation is undertaken by The Federal Reserve, the central bank of the United States. The Federal Reserve enacts monetary policy by controlling the supply of money in the U.S. It regulates inflation by adjusting the Federal Funds Rate, a baseline interest rate that sets the standard for the rest of the market. The Fed can’t just wave a magic wand to change the Federal Funds Rate; instead, it does so mainly through open market operations (OMOs). To conduct an OMO, the Fed buys or sells U.S. treasury bonds. When the Fed buys treasury bonds on the open market, it injects money into the economy, increasing the money supply. Conversely, when the Fed sells treasury bonds, the money used to buy them is taken out of the economy, reducing the money supply. As the money supply increases, interest rates fall; as the money supply decreases, interest rates rise. This makes sense, since interest rates are essentially the price of borrowed money; when money becomes more scarce, lenders charge more for the limited supply.8
From 2020 to early 2022, the Federal Reserve adopted a policy of aggressive bond purchasing in the hopes of easing pandemic fallout by encouraging lending and investment. By May 2022, it had more than doubled its holdings of treasury bonds, from $2.15 trillion in March 2020 to $4.98 trillion.9, 10 The steady influx of money into the economy kept interest rates very low; from May 2020 to February 2022, the Federal Funds Rate hovered between .05 and .1% (Figure 1). However, as inflation has crept steadily up to unsustainable levels, the Fed has reversed course to counteract it. In March 2022, the Fed approved the first sale of treasury bonds since December 2018. Since then, it has continued to raise interest rates in the hopes of tamping down inflation.
Figure 1: Chart showing the Federal Funds Rate11
After nine consecutive months of rate hikes, the current Federal Funds Rate target sits at 3.75-4%. The effects are higher interest rates across the economy, slowing economic growth, and, hopefully, lowering inflation. Indeed, the Fed’s strategy does seem to be working; inflation (as measured by the Consumer Price Index) is down from a high of 9.1% in June to 7.7% in October, thanks in part to reduced demand from rising interest rates.12 However, many are worried that the Fed’s aggressive policy is shortsighted, and will result in worse economic problems than inflation should it continue—some even warning of a looming recession. While Fed Chair Jerome Powell acknowledges that a soft landing free of recession grows less likely with more rate hikes, he told reporters on November 2 that “[the Fed has] some ground to cover with interest rates before we get to that level that we think is sufficiently restrictive.”
As with everything in economics, interest rate hikes represent a tradeoff; to counteract inflation, we must make economic sacrifices. Both recession and high inflation are unsustainable in the long run, so the best thing we can do right now is find a healthy in-between. While the future remains uncertain, it is far from hopeless.