Inflation: What’s Behind It and What’s to Come

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In March, the Bureau of Labor Statistics reported that consumer prices – as measured by the consumer price index (CPI) – rose 7.9% on a year-over-year basis in February.¹ Then on May 11, the most recent report surprised forecasters by coming in higher than expected, with CPI rising another 0.3% in April and 8.3% on an annualized basis. 

CPAs, in both public accounting and industry, are well-positioned to collect, measure, and interpret the financial data needed to navigate organizations through a potentially long inflationary period. Reevaluating operational cost structures, calculating unit cost for products sold and services provided, tracking changes in gross margins, and assisting with pricing strategies to maintain profitable operations are a few important ways CPAs can guide and support leaders and executives. This feature will help you identify and weigh the prospects of a potential inflationary period.

What Inflation Is and Isn’t

The essence of inflation is a general increase in prices accompanied by a fall in the purchasing value of money. 

The Federal Reserve System (the Fed), the U.S. central bank and monetary authority, relies on the personal consumption expenditures (PCE) price index to measure consumer prices when setting monetary policy. However, the most widely used measure of consumer prices remains the consumer price index for all urban consumers (CPI-U), maintained by the Bureau of Labor Statistics. The bureau defines CPI-U as “a monthly measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”²

CPI, however, does not specifically measure inflation; it measures consumer prices paid over a given period. The second element of inflation – a fall in the purchasing value of money – is absent from the CPI calculation and the Bureau of Labor Statistics definition. It is also absent from the definition and calculation of the PCE index used by the Fed. These indexes are useful, but they do not fully capture the nature of inflation because price increases are not the cause, but rather the consequence, of inflation.

To complete an understanding of inflation, it is necessary to consider any drop in the purchasing value of money. Fortunately, the Bureau of Labor Statistics also publishes the Purchasing Power of the Consumer Dollar, which measures the change in the value of consumer of goods and services that a dollar will buy at different dates. The purchasing power of the U.S. dollar currently remains in a century-long decline.³ 

This is perhaps the most insidious thing about inflation: not the increase in prices themselves, but rather the reduction in the dollar’s purchasing power. The implications are particularly harsh, because a decline in purchasing power ultimately means a decline in the value of labor. Workers’ dollars are steadily eroded, and they can purchase fewer goods or services for the same amount of dollars. For wage-earning individuals, this decline in their labor value can only be offset by wage increases or price decreases. 

Temporary price increases are one thing, but the danger of runaway inflation is an entirely different economic risk. Jerome Powell, chair of the Federal Reserve, recently noted, “We understand that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. … We know that the best thing we can do to support a strong labor market is to promote a long expansion, and that is only possible in an environment of price stability.”⁴

What Is Driving Inflation?

In a market economy, the prices of goods or services change frequently, regardless of inflation, depending upon both supply and demand. Some consumer prices, like gasoline, change in real-time based on underlying fundamentals. Depending upon market conditions, large and persistent price increases can be caused either by demand-pull forces (when consumer demand for goods and services outpaces the ability of businesses to supply them) or by cost-push forces (where rising cost of inputs, such as labor and raw materials, lead to higher prices).

During the pandemic, government-mandated health shutdowns of businesses in early 2020 created a massive shock to U.S. and global trade, leading to major supply and demand imbalances worldwide. The knock-on effects ultimately led to price increases for a wide range of items, and few, if any, economic sectors were spared.

Shipping and logistics – It has been widely reported that shortages of labor and shipping containers created global supply chain bottlenecks that led to backlogs at ports around the world. While shipping costs clearly surged, resulting in higher prices, the global supply-side issues were not telling the whole story. At the same time, the volume of goods shipped globally also increased dramatically. The United Nations Conference on Trade and Development confirmed in an April 2021 policy brief that demand was the cause.⁵

Food supply – U.S. and global food production and distribution capabilities were also severely disrupted. Shutdowns of food retailers and processing plants left farmers and producers with nowhere to send product. There were reports of farmers and producers having to scrap product and even cull livestock. However, the U.S. Food & Drug Administration acknowledged it was a demand-side issue.⁶

Energy supply – The war in Ukraine is a humanitarian crisis that may result in a major supply shock. However, the recent trends in energy prices are another indicator of demand-pull forces at work. Despite widely reported supply-side issues, the global supply of energy has not contracted; rather, it has continued to climb. The Organization of Petroleum Exporting Countries expects world oil demand to rise by 4.15 million barrels per day (bpd), or 4.3%, in 2022 following an increase of 5.7 million bpd, or 6.3%, in 2021.⁷ 

It seems supply shocks have been used as the inflation scapegoat, but these statements and recent data suggest that surging prices cannot be attributed to supply determinants alone. So too is exceptionally strong demand and the market effects of stimulative fiscal policy largely put in place to rebound from COVID’s effects on the economy. Individual consumers received thousands of dollars in pandemic relief benefits that were promptly spent or invested. 

Inflation – A Monetary Phenomenon

Nobel Prize-winning economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”⁸ 

Friedman was a proponent of monetarism, which maintains money supply is the primary determinant of gross domestic product (GDP), or economic growth, and the most important driver of prices over the long term. According to Friedman, money drives inflation because growth in the money supply causes acceleration in the growth rate of total spending. Consequently, stopping inflation requires a deceleration in the growth rate of total spending. 

Most economists agree that money plays an essential role in determining economic output. Indeed, the Fed uses monetary policy to influence overall economic performance, including using its tools to affect interest rates and adjust the amount of money and credit available in the economy.

Opponents of Friedman’s views, however, contend that the quantity theory of money fails because the link between money supply and the economy has broken down. Indeed, Powell, in testimony to the U.S. Congress last year, stated that growth in the money supply “doesn’t really have important implications.”⁹ 

They cite, for example, that over the past 15 years an unprecedented expansion of the monetary base and the money supply through aggressive easing of monetary policy has been accompanied by a long-term decline in money velocity. Up until recently, there was no evidence of major or persistent increases in consumer prices. 

Of course, that’s because inflation is being driven by growth in the supply of money and credit. The ill effects of inflation do not show up only in the monetary base or even CPI. Easy monetary policy has steadily eroded the dollar’s purchasing power, and spilled over into credit and asset prices.¹⁰

Excesses Exacerbate the Problem

Much of the discussion over monetary policy focuses on the Fed’s dual mandate to maximize sustainable employment and maintain stable prices. This does not account for the political reality of interest rates and the growing cost of interest payments on the federal government’s deficit spending.

Alan Greenspan, former chair of the Federal Reserve, recently pointed out, “The U.S. has been at risk of sparking demand-side inflation for some time. … Our burgeoning federal debt has been an issue of increasing concern for many years. Even prior to the pandemic, federal debt held by the public steadily outpaced growth in GDP. … Monetizing the debt cannot be a long-term solution, and increases in the money supply relative to the real goods and services an economy produces will eventually lead to higher price levels.”¹¹

Perhaps too many people have forgotten 1979. When Paul A. Volcker became chair of the Federal Reserve, he made fighting inflation the Fed’s primary objective. Volcker clamped down on the money supply to tame inflation. Inflation subsided dramatically, but it came at the cost of a pronounced recession.

Maybe it is too early to go all-in on this conclusion, but it seems current conditions suggest that elevated prices may be unlikely to resolve quickly, and there may be a risk that inflation expectations become unanchored. In February, James Bullard, president of the Federal Reserve Bank of St. Louis, seemed to sound the alarm: “You have got the highest inflation in 40 years, and I think we are going to have to be far more nimble and far more reactive to the data.” He admitted the Fed was surprised by the spike in January CPI, noting, “There was a time when the committee would have reacted to something like this to having a meeting right now and doing 25 basis points right now.”¹² 

To fight inflation before it becomes entrenched, the Fed will need to carefully review its positions on the nature of inflation and monetary policy. If the Fed is too slow or out of step in taming inflation and the expectations for inflation become unanchored, severe economic results could follow. 

¹ U.S. Bureau of Labor Statistics, Consumer Price Index – February 2022, Economic News Release (March 10, 2022).
² U.S. Bureau of Labor Statistics, Consumer Price Index – Home (March 2022).
³ U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Purchasing Power of the Consumer Dollar in U.S. City Average [CUUR0000SA0R], Federal Reserve Bank of St. Louis (March 23, 2022).
⁴ Jerome H. Powell, “Restoring Price Stability,” delivered at Policy Options for Sustainable and Inclusive Growth, at the 38th Annual Economic Policy Conference National Association for Business Economics, Washington, D.C. (March 21, 2022).
⁵ Container Shipping in Times of COVID-19: Why Freight Rates Have Surged and Implications for Policymakers, Policy Brief No. 84, United Nations Conference on Trade and Development (April 2021).
⁶ Food Safety and the Coronavirus Disease 2019 (COVID-19), Questions & Answers for Industry, Food Supply Chain, U.S. Food & Drug Administration (updated on June 30, 2021).
⁷ OPEC Monthly Oil Market Report, Organization of the Petroleum Exporting Countries (March 15, 2022).
⁸ Ben S. Bernanke, “Friedman’s Monetary Framework: Some Lessons,” Federal Reserve Bank of Dallas proceedings, pgs. 207-214 (October 2003).
⁹ Steve H. Hanke and Nicholas Hanlon, “Jerome Powell Is Wrong. Printing Money Causes Inflation,” WSJ Opinion (Feb. 23, 2022).
¹⁰ Alan Greenspan, “Remarks by Chairman Alan Greenspan,” Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research (Dec. 5, 1996, Washington). 
¹¹ Alan Greenspan, “Alan Greenspan’s Thoughts on Inflation,” Advisors Capital Management (Oct. 25, 2021).
¹² Steve Matthews, “Fed’s Bullard Backs Supersized Hike, Seeks Full Point by July 1,” Bloomberg (Feb. 10, 2022).

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Nicholas Boyer is a partner with RKL LLP and chief investment officer/executive vice president of its investment advisory firm, RKL Wealth Management. He can be reached at nboyer@rklwealth.com.