Perhaps no financial subject causes the worry that the dreaded specter of inflation does. There are valid historical reasons for this: one can simply point to crises in South America, the 1970s in the United States, or even World War II for examples of the ill effects of inflation. Perhaps because of its power to haunt us, inflation frequently becomes a topic of concern and financial journalism whenever an economic crisis rears its head: in fact, The Economist cover on Dec. 10 of 2020 was already asking “Will Inflation Return?” And so we imagine, given the worries from financial journalism about increased aid to those suffering from the economic effects of COVID-19, along with the general (though rather incorrect) assumptions about Democrats being the party of increasing deficits, 2021 will feature a great deal of talk about inflation.
In fact, The Economist cover became a semi-internet event as the wags of Twitter were quick to point out that The Economist has been writing stories about inflation repeatedly over the past 30 years and inflation has not been a problem in that time. However, such pithy dismissals ignore the real concerns of inflation over the longer term. Indeed, while we don’t foresee inflation being a problem in the near term, there is concern as time goes on the deficit spending of the present could cause future inflation. Consequently, this piece will explain inflation, what factors are shaping and will shape the conversation around inflation in 2021, and then what will shape inflation in the longer term.
What is Inflation?
Inflation is simply the fact that one dollar will generally purchase less in the future than it does right now. This is reflected in the fact that a candy bar costs about $1.50, whereas when I was a kid a Hershey’s candy bar could be bought for about 50 cents. In inflation terms, we could reverse this to better understand the phenomenon, however: when I was a kid, you could buy two candy bars for a dollar, and now you can only buy 2/3 of a candy bar. On the surface, this seems terrible—especially, if like me, you enjoy a chocolate bar and a glass of milk before bed—this habit of mine is costing me more than two times as much! (Of course, my allowance is greater than it was when candy bars were 50 cents, and most of us on salary see our salary increase over time in line with inflation).
What many people don’t realize is that inflation is built into the system—currently, the United States targets about 2% inflation annually (editor’s note: how is inflation measured? That’s a trickier topic and beyond the purview of this article, but it goes beyond candy bars). You may be asking yourself: if inflation is so bad, why do we have any inflation at all? Because the alternatives (deflation) are much worse.
A dollar being worth less today than it was yesterday means I’m going to take my money that I’m not using and either spend it or invest it (whereas if my money were worth more tomorrow than it is today—my best risk-free investment would be keeping it under my mattress, which is great for me—spending less on chocolate, eating better—but bad for everyone. For example, our friends and the employees at Madison Chocolate Company who manufacture chocolate would not be helped if I eliminate it from my diet).
And this raises the question of what causes inflation—like everything else in the economic world, the answer is supply and demand. Supply is pretty simply the amount of money printed by the government. On the other hand, monetary demand is one of the thornier problems of economic theory to calculate, because people demand money in a couple of ways—to spend (what is called transactions demand for money), to save, and to invest (portfolio demand for money). If there is more money in circulation (an increase in supply from the government spending more money or printing more money) and the demand for the money stays about the same (people are spending, saving, and investing in normal terms), the money will be less valuable overall and over time. But what we saw in 2020 was not normal, as people were forced not to spend (fear of going to restaurants, unable to travel, etc.) and also chose to save more (worried about losing their job, income, etc.). This meant more savings and less spending. Like my chocolate bar money, this is good behavior personally and bad behavior in big picture terms.
What about 2021 is Causing People to Worry About Inflation?
Two things happened in 2020 that have caused people to worry about inflation. The first is that as a response to the COVID-19 pandemic the demand for savings (M2) increased—people saved more, put less money to “work,” and that meant less money being spent (what economists partially measure as the velocity of money). As a result, the United States government did a variety of things to keep money moving through the economy rather than sitting in savings accounts being saved for the future (remember: less chocolate is good for me, bad for the economy). They increased government spending (the government helped buy things to make up for the fact other people weren’t) and they lowered interest rates. Lowering interest rates means more money will be spent because the incentive to save money is lowered (why am I keeping this money in the bank earning nothing?) and the risk for borrowers is lowered (if I can borrow money at about the long-term inflation rate, it makes sense for me, because my investment doesn’t need to be as successful for this to be a good idea). Likewise, by pumping more money into the economy (either by buying stuff directly or through transfer payments), savers will naturally meet their savings goals and have a surplus to spend (this is the theory anyhow).
Via transfer payments and deficit spending then, the government increased the supply of money. As we’ve seen that will lead to inflation. However, not all of the money made it into the economy—a great deal was saved. That means while there is a lot more money being printed, we aren’t necessarily more money chasing goods and services; therefore, inflation has—overall—been contained.
Short-Term versus Long-Term Inflation
We could see inflation in 2021—say there is a magical virus cure and suddenly, we’re back drinking and eating out and flying around the world all of the time (I’m thinking of 2019 when the Sunday after the negative 40-degree cold snap led to bars and restaurants closing voluntarily, and suddenly, people were all about). We spend all of our savings immediately and all of that extra money printed in the last few years comes flooding back into circulation. However, that seems unlikely—even though we may want to vacation all of the time, some of us have limits on vacation days and so we can’t go around booking trips for months straight. Likewise, with regards to bars and restaurants—hangovers, diets, gout, etc. mean we can’t go around drinking and eating as much as we want—though we’ll likely increase our consumption at bars and restaurants. There is also a natural inclination not to spend savings once developed (humans being creatures of habit), and so we’ll see these savings reduced gradually over time. Finally, many Americans used this money to pay off spending in the past (credit card debts, for example).
As the glut of extra printed money comes back into the economy, the question of longer-term inflation becomes a worry: Are we printing too much money? Economists analyze this in terms of the relationship between Gross Domestic Product (demand) and the amount of money in supply: essentially, if there is more money in circulation than growth of productivity or more money chasing the same quantity of goods and services, you end up with inflation.
Ultimately then, the goal of policymakers is to ensure that the money moves from being saved to being spent at a controlled rate. This means the following will shape predictions of long-term inflation: one, will the US be able to effectively decrease money in circulation by increasing interest rates and encouraging people to put money in the bank (how much am I reducing my savings by)? Two, will the money pumped into the economy have the effect of stimulating the economy and lead to economic growth increasing demand (meaning that the growth of GDP will more or less keep pace with the increase of the monetary supply)? Three, will the United States reduce spending and lower the supply of money from that perspective as well to ensure that there is less money in circulation?
These are three long-term questions that policymakers, government officials, and the Federal Reserve will need to manage in order to make sure I can keep buying the right amount of candy bars for my health and the economy’s health.
– Keith Poniewaz, PhD