74th Edition
What is the optimal rate of inflation? The Fed believes it is 2%, but they are wrong. Let me explain why. Inflation has been persistently high averaging 5.6% over the past three years. While it has been declining, there is no guarantee it will get to the target 2% and more importantly remain at that level. What would the impact be if it averages say 4% over a ten-year period? It would mean that on average, goods and services would cost 50% more. In order to maintain the same standard of living a person would have to increase his or her annual income by the same percentage (50%). How many people can do that? Certainly not everyone, and for a large percentage their standard of living actually declines.
Moreover, the rate of inflation, or the consumer price index (CPI), is misleading. It is an average, which means some items are above while other items are below the average. Due to the laws of economics, price increases are impacted by demand. The higher the demand the higher the inflation for those particular goods and services. And vice versa. In a nutshell, the pressure on our standard of living from prolonged inflation is actually much greater than described by CPI statistics.
What would happen if the Fed achieved its sought after 2% inflation rate? This would mean over the next 10 years our standard of living would decline by over 20%, unless we can offset inflation by earning more income. Again, not everyone can do that. Worse over, the same laws of economics apply, intensifying the pressure on standards of living.
What causes inflation?… Several obvious things like supply/demand imbalances and supply chain disruptions. But what often is understated or ignored is the impact an inflation-mentality-cycle has on future business decisions regarding supply and demand, and pricing. Basically, in a free-market economy, a company will raise prices in order to maximize total revenue, over the long term. The time frame is critical. While greed might lead to higher revenues in the short term, the long-term impact might be just the opposite. Since greed is always part of the human psyche, business decision makers are challenged to avoid this temptation when determining optimal prices for their goods and services. Fortunately, over the long run, supply/demand forces serve as natural controls to excessive greed, but admittedly it is not a perfect system. Nevertheless free-market capitalism has proven to be the best economic system ever devised for promoting ongoing innovation and creating sustainable economic growth.
Back to an environment dominated by an inflation-mentality-cycle. During a period of above average inflation, consumers will push demand temporarily higher in anticipation of future inflation. This inflated demand causes more inflation. Prices for the most popular goods and services accelerate even faster. This phenomenon is one of the primary reasons the Fed was so wrong on inflation being transitory, which it absolutely was not.
What causes deflation?… Two forces can cause deflation, one which is desirable the other which causes severe economic harm. The first is innovation. For example, some entrepreneur discovers a better mousetrap causing a drop in demand and eventually price of the obsolete previous model. Meanwhile, prices for state-of-the-art mousetrap might increase in the short term due to higher demand, but will eventually fall when competition increases. A similar dynamic occurs when a more efficient way to manufacture an item is discovered. Lower production costs often translate into lower consumer prices. Innovation happens continually, but not uniformly, throughout a free-market economy. Through the ebbs and flows of supply, demand, and continual innovation, deflationary and inflationary forces tend to balance out over the long run.
The second way prices can actually decline is through a severe economic recession or depression. Higher unemployment and heightened concerns about the future lead to a significant drop or even a short-term collapse in demand leading to a precipitous decline in prices and overall economic output. Obviously, this isn’t the preferable way to reduce inflation.
What factors promote entrepreneurship and innovation, and which factors do the opposite? A free-market economy, with ample access to capital is the best economic system to promote innovation and discovery, which is vitally important to keeping inflationary pressure in place.
Conversely, government regulatory over-reach, corruption, and bureaucratic inefficiency tend to stifle innovation. Even worse, they tend to upset the natural balance between supply and demand. In essence, the higher inflation we have all lived through in the recent past has largely been the result of ineffective and ill-advised government monetary and fiscal policy.
What does this portend for the future?…. As long as the government continues to spend beyond its means, causing the deficit to expand exponentially, and as long as corruption exists in the government and the corporate sector, inflation is going to remain a serious issue. Worse over, the current inflation-mentality-cycle will also persist. And worst of all, people who can’t raise their incomes to offset inflation will continue to suffer from a lower standard of living.
What happens then?…. Those who fall behind put more pressure on the government to fix the problem which leads to all the ineffective policies that caused the problem in the first place. Does all this sound alarming? It should.
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Michael Kayes
*These views are my personal opinions and are not the viewpoints of any company or organization.