The American public is currently concerned about the growing inflation, where the American dollar has less purchasing power than it did before, and the cost of goods have gone up.
Most recently, U.S. inflation reached 7.9%, a number that hasn’t been reached since 1982 — though in the 1970s, double digit inflation was common as the U.S. economy was in far worse shape than today. What is the cause of inflation and when are prices expected to go back down?
What is inflation?
Inflation happens when prices go up on goods and services. This can happen for two basic reasons. First, prices have increased broadly across a class of goods. For instance, if milk or gasoline goes up in price and there are no less expensive alternatives, people will be willing to pay more as they have no choice.
The other reason inflation can increase is that people have access to more money. One key way this happens is through interest rates. Low interest rates promote the borrowing of money and promote more spending. This drives up the cost of products as people are willing to spend more money as they have access to more credit and less incentive to save.
Governments often lower interest rates to increase economic activity despite the risk of inflation. High interest rates promote saving and make borrowing money less attractive, potentially shrinking the economy. By managing short term interest rates, the U.S. balances the need for a growing economy with the need to control prices and inflation.
During the COVID-19 pandemic, the federal government (through the Federal Reserve) lowered the interest rate to 0% to bolster the economy, which has contributed to the rise in inflation. A 2% level of inflation is considered a healthy level for the economy. Zero or negative inflation is an indicator of a weak economy.
Inflation is also caused by the global supply chain — which is the pathway from where goods are manufactured to when they reach the consumer. At the beginning of the pandemic, many factories shut down or reduced production, and shipping companies reduced their shipping schedules. But as people stayed home in lockdown, their demand for home goods substantially increased. This led to an increase in the cost of raw materials, labor costs, manufacturing, and shipping of goods — because factories and shipping companies had to quickly change their plans to meet a surprising increase in demand.
As the U.S. is recovering from the COVID-19 pandemic, it is recovering more quickly economically than the supply chain that produces goods and services. And because of that imbalance, inflation is increasing.
The war in Ukraine also has an effect on supply chains, as uncertainty due to the war has caused large fluctuations in the cost of oil. Ukraine is a key supplier of raw materials for the technology and automotive industries, and the war has halted the export of those raw materials. In addition, the sanctions on Russian exports have also affected the price of goods exported from Russia.
Wages have also increased in response to inflation, though mostly at a lower rate than inflation. Not all news here is bad: During the pandemic the bottom third of U.S. workers had wage increases that outpaced inflation as employers rushed to hire low wage workers during the economic recovery.
When will the price of goods go back down?
It’s uncertain. As supply chain conditions improve, inflation should subside. Unfortunately, this might not mean that prices will go down — as consumers become accustomed to new prices and are willing to pay them, corporations have little incentive to drop prices. According to the Wall Street Journal, corporations have used the pandemic as an excuse to raise prices and boost profits — with many companies bringing in more profits than they did pre-pandemic.
But the Federal Reserve has increased short term interest rates to a quarter of a percent in an effort to slow down inflation. Federal Reserve Chairman Jerome Powell has said he is willing to increase interest rates further if inflation does not stop, saying that high inflation is detrimental to economic recovery.