Inflation has been a common theme on here these past few months, and it is with good reason. Global supply chains have not been repaired yet; instead, the pain has become more acute with shortages in many core areas. Meanwhile, despite higher unemployment, firms are having an extraordinarily difficult time filling positions. Piling more demand into the economy at this time could put us in a precarious place. Think of it as a bathtub with a faucet that is pumping water just a little bit more quickly than it is draining. Eventually, water will spill over onto the floor. It’s here that the analogy fails because we cannot simply turn the faucet off, either. Sudden hawkish moves in monetary policy can bring an economy to its knees. Large shifts in government spending aren’t much better. We have gotten a preview with deficit ceiling brinkmanship in the past as the federal government shut down. The good news is that we still have time to do something about it.
Let’s back up for a second. Supply chain strains will eventually catch up to demand, right? Why are so many people worried about a temporary price increase? Short answer: the length of the backlog is just too long. It will be years before chip supply catches up to demand. Inventory of raw materials critical to production – such as copper – are back on their lows. Despite the solid levels of demand, industrial output is flatlining. That is sending price increases up the supply chain and those prices, unlike commodity prices, are sticky (in other words, they don’t tend to change very often).
Producers, already dealing with pricing pressures from raw materials, are having an increasingly difficult time finding workers as well. When surveyed, contractors complained of being unable to find skilled workers. Part of the problem is that skilled tradespeople are an aging group. Many elected to retire last year during lockdowns and the numbers just didn’t exist to replace them. Eventually, more people will be trained in those jobs as wages rise, but there is no hope of doing that without firms increasing wages as they compete for workers. Wages are also the most ‘sticky’ price in the economy. On one hand, this is good because we want the working class to be better off. On the other, wages are the spark that starts the fire of inflation. The higher wages need to come with excess capacity for production so the higher levels of consumption can be borne by the rest of the economy. As we just discussed, though, we do not have much spare productive capacity because of existing supply chain issues.
OK, so we’ve established that prices are increasing and that it is now much less likely to be temporary. The danger, then, of passing a multi-trillion dollar (15% of GDP) spending package under the guise of infrastructure, is becoming clear. By injecting enormous amounts of cash into the economy now, we are filling the bathtub past the brim and the water is spilling onto the floor. The economy can no longer handle the extra cash (or, as you may see on CNBC, ‘excess liquidity’). The government would be giving consumers more than they could spend without breaking supply chains. At the same time, we’d be bidding on raw materials for physical infrastructure against private companies looking to expand their own capacity. With that competition from the government, producers will have a much harder time getting their products in the hands of consumers, who will have to pay yet higher prices to obtain scarce goods and services. This could quickly get out of hand, and suddenly inflation could be hitting an annual rate of 10%.
Nipping spiraling prices in the bud now would be far better than trying to fix it later. If inflation does spiral out of control, the Federal Reserve may have to quickly hike interest rates and the government will undoubtedly have to cut back on spending. Although debt will shrink relative to GDP, costs of servicing the debt will skyrocket with higher interest rates. Some of the items in the ‘Build Back Better’ plan are important to the long-term growth of our country’s economy, so we do not want to abandon the idea altogether. Instead, we could scale back on the immediate implementation of the bulk of the items and place them over a large timeframe. Infrastructure improvements are needed, but they are long-lived. We can postpone their implementation for a year or two. Other things, such as student debt forgiveness, should be flushed down the toilet. By directly taking away an expense for a significant portion of American households, we’d be causing a bout of inflation. Instead, we should immediately end the moratorium on those payments. It would help reduce the velocity of money (how quickly dollars make their way around the economy – high velocity is like a game of hot potato with money) in the short term and ease supply constraints.
The path ahead is treacherous. Congress is not known for its farsightedness and delaying a spending package means that elected officials would have a harder time touting their successes to their constituents on the campaign trail. If the wrong things are cut – such as job training – we would handicap ourselves in the future – throw the baby out with the bathwater, so to speak. However, this is too important not to do now.