What is 2022 pandemic inflation?

There are times when it costs more to fill up your car, pay the rent or to buy the same things you always buy at the grocery store. You find in 2022 that you are spending more money to live than you used to spend prior to the pandemic and recent events such as the Russian invasion of Ukraine. Those are examples of inflation – which is really defined (in its simplest form) as a rise in prices. Prior to the COVID pandemic inflation averaged 1.5 to 3% or so per year going back to the early 2000s. Starting in 2021 and today, inflation has been anywhere from 6% to 9.5% or so.

When those price increases happen, it almost seems like an alien force has descended on the country to create higher prices for everything necessary to live a comfortable life. News reporters will tell you that the reason for the increase in your cost of living is inflation. Inflation is not an alien force. It is a simple supply and demand problem, as well as excess money in the economy, that leads to higher prices. But there are often many complicated causes to this financial challenge.

Since the Credit Crisis/Great Recession of 2007-2009, the U.S. Federal Reserve has kept interest rates historically low. In addition to that, they have in effected “printed” over 7 trillion dollars in money by purchasing government debt and mortgages (see graphs below), with a major increase occurring since the 2020 COVID pandemic.

 

The low interest rates, and the federal reserve buying up government bonds, tend to increase the country’s money supply, which often lead to higher inflation. In addition the federal government stimulated the economy from 2020 to the end of 2021 in an effort to help the country recover from the pandemic, and the federal government paid out about 4.5 trillion in funds. An inflation problem is essentially too much money chasing too few goods, and it is expressed by the rising prices of the goods you buy.

How does inflation happen?

The Federal Reserve has a number of ways to manage interest rates, but the one that most directly affects the interest rates you pay is the federal funds rate. They also manage interest rates by buying up government debt and/or private mortgages – in effect by “printing” money.

For example, in the year 2000, the average federal funds rate was approximately 6.24 percent. During the recession that followed the dot-com bust and 9/11, the Fed lowered the federal funds rate to approximately one to two percent until the economy started recovering. From 2005 through 2007, the Fed kept federal funds rates at roughly five percent.

Then came the credit crisis of 2008 and the Federal Reserve started dropping the interest rate to keep money flowing through an economy that had experienced massive drops in asset values and high unemployment. From 2009 through 2017, the Fed maintained the fed funds rate at under one percent, with only a few blips to two percent. This made it possible for the largest banks, brokerages, and corporations to borrow money at next to no interest rate cost. Then, during the 2020-2021 COVID pandemic, the federal reserve brought the interest rates down to around 0% again. Add to that the federal government paying out $4.5 trillion to businesses, families, government programs and other agencies in an effort to keep the economy going during the pandemic.

Financial institutions and corporations borrowed heavily during this period of extremely low interest rates, and so did individuals. “Regular” people borrowed money at lower interest rates from home mortgages, car loans, credit card rates, and other forms of borrowing.

All these loans had the effect of adding to the nation’s money supply. For example, if you put $1000 in the bank, that is your $1000 and it shows in your bank account. When someone comes in and borrows $1000, they put that money into their bank account as well and their account shows that they have $1000 and your account still shows you have $1000. Each time someone takes out a loan, new money is created on the books of the bank. That is how your original $1000 magically becomes a total of $2000 — $1000 in each of two accounts. This is how “money supply” works.

When the borrower uses that money to buy something at a store, the store owners put that $1000 in their bank account and they have $1000, the borrower starts paying back the bank, and you still have $1000. This is how the money supply grows when people borrow.

When the money supply grows as a result of loans and other ways the Federal Reserve injects money into the system (from buying bonds/printing money) the result is more money in the system chasing the same number of goods. This means that there is more demand for goods because people and institutions have the funds to buy them. There is data on how much money is in the system, and that is known as M-2 money supply, and that is checking deposits, cash and easily-convertible near money.

Unless the number of goods increases, everyone will be competing to buy those goods, and so, they will have to pay more money in order to buy what they want. Whether this is food, groceries, a car, a home, or anything. This is how inflation gets started and how the low interest rate set by the Federal Reserve for all those months added to the creation of inflation.

The stock market

The Federal Reserve lowers interest rates when the economy is slowing or in recession. The agency controls short term rates, which impact some loans such as home equity, car loans, credit card interest rates, the interest rate on your savings account or CDs, and others. Home mortgage rates are not directly impacted by the federal reserve as those rates tend to follow government debt – but the federal reserve can “indirectly” impact mortgages. By lowering the interest rates, the Fed is trying to spur economic activity and borrowing to build new businesses and housing and to encourage consumer purchases

Since 2008, the low interest rates (when combined with the Federal reserve printing money by buying up bonds) have also helped to create a boom in the stock market because people and institutions could buy stocks on margin, paying very low rates for their margin loans. There were also very few alternatives as savings account and bonds were paying out 0% to 2% interest. The federal reserve buying up bonds/government debt also caused people and institutions to allocate additional funds to stocks, as the interest rates (due to supply and demand) on government debt were artificially low.

Institutional traders such as hedge funds and arbitrageurs took advantage of these low rates to leverage larger and larger purchases of stock. Large buying interest causes stock prices to rise.

This is another simple example of supply vs. demand. Stock prices rise because there is a limited number of shares of stock of any company that are issued and outstanding in the market. When large buying comes into the market, those shares are chased by an unlimited amount of money. A rise in investment values such as stock is also inflationary because it adds money to the system through margin loans and eventual trading profits.

To slow inflation and get it under control, the Federal Reserve starts to gradually increase the fed funds rate. They are doing this to discourage borrowing. When institutions and people don’t borrow money, they pay down their loans instead. This is one way money is removed from the system, so there is less money chasing the available goods, and prices theoretically should decline.

The pandemic economy lead to higher inflation

The COVID pandemic caused factories, service industry companies and businesses of all types to shut down or operate at reduced levels. Many companies laid off workers. The unemployment rate skyrocketed from about 4% pre-pandemic to about 11% when the pandemic began. This meant that the supply of goods available for purchase in the system declined, but it didn’t make much difference because people were not traveling or buying goods and services (many people also lost their jobs), and businesses weren’t purchasing inventory to sell to their customers. Also, factories were not purchasing raw materials to turn into goods for stores to sell.

When the pandemic started to break, and people began to return to their normal lives and companies brought workers back, all the money in the system went to supporting a new return to an active lifestyle. There were still excess funds in the economy from the $4.5 trillion the federal government spent. This meant people began spending their cash reserves and accessing the money available on their credit cards to buy a limited supply of gasoline and consumer products, as well as to travel.

The future

Fed efforts to slow economic activity to quell inflation by raising interest rates, and removing money from the system via other activities, normally work well. The Federal Reserve has also stopped buying bonds and is now slowly selling their portfolio, which is also removing money from the system as private individuals and institutions are now buying those bonds. If the economy slows too much, businesses begin layoffs, and the unemployment rate rises. This should also have the effect of slowing inflation

However, if prices remain high because the supply of goods and services has not caught up with demand, and people resort to living on their credit cards, and institutions continue to borrow money, the economy could move into a period of stagflation.

The definition of stagflation is an economy that continues to experience inflation, but the output of goods and services does not increase to meet demand and unemployment rises because high costs choke company profits. This happened during the late 1970s and early 1980s, and was relieved by then-Federal Reserve Chairman, Paul Volker, who used excessively high interest rates to limit borrowing and thereby drive demand for goods and services down. Of course, this brought on recession, but it also balanced the supply vs. demand equation and enabled a more normal economic recovery with low inflation.

Inflation has a source. It doesn’t happen magically and is not the result of some diabolical plot. It is the result of people and institutions borrowing money (when interest rates are low) to buy more things. That borrowing money leads to more cash in the system. As consumer and corporate borrowing and buying subside due to the high interest they must pay on the money they borrow, inflation also subsides.