It would be difficult to write a holiday wrap-up blog post series without a mention of inflation, which became the new boogieman in the latter half of 2021 as we’ve seen inflation rising steadily, with the rate in some categories exceeding 7% year over year.

That inflation is suddenly a problem is really quite remarkable given that 18 months ago everyone was terrified of a depression-level event as a result of mass illness, lockdowns, and so forth. But to the credit of our governments, while a lot of mistakes have been made, it’s pretty clear that many of the policies that were instituted–particularly the various financial aid packages that were put together–have done what, at the outset, would have seemed impossible: turned the threat of economic calamity into the kind of boom we all wished we could’ve seen after the 2008 crash.

But like so many of the other topics I’ve written about, this is just another example of an issue that, for my generation, is completely novel. The last time inflation exceeded 3% was way back in 1991! Meanwhile, the prime interest rate, which is a key tool for controlling inflation, is at historical lows (thanks 2008!).

For a generation that has never seen real inflation, this situation is novel, frightening, and deeply frustrating, upending yet another aspect of life that was previously familiar and consistent.

But let’s back up and quickly discuss what inflation is, exactly. No, not the causes, the observable effect that we call inflation.

If we turn to the Investopedia definition:

Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

I think this fits folks’ general model of inflation: prices go up, or, looking at it from a different direction, the value of a unit of money goes down.

But… the price of what?

It turns out measuring inflation is actually pretty hard, and how you measure it depends on what you’re trying to understand.

Suppose your goal is to understand, in general, how far a dollar can go for a household. You’re interested in day-to-day expenditures that reflect everyday costs for individuals and that tend to have the same basic fundamentals in their price movements.

Well, if you’re doing that, do you include the price of houses? House prices are extremely sensitive to supply and demand and their price movements tend to be disconnected from the price movements of, say, a cost of tomato soup. So while the price of a house is certainly important for the large number of home buyers and sellers out there, the change in that price doesn’t tend to reflect the everyday lived experience of inflation.

This points at an important concept when discussing inflation: There is no one single measure of inflation. Rather, you can pick some basket of goods and services and then measure inflation within that basket. And how you select that basket is a function of what you’re trying to understand about the economy.

In the case of the Government of Canada, there’s actually three core inflation measures that are used, with the reason being that:

Since some of the components in the CPI basket are subject to sharp and often temporary price swings that are unrelated to these underlying trends, the Bank uses this set of core inflation measures that allow it to “look through” temporary changes in total CPI inflation.

And I’ll note, these three measures are all based on an underlying Consumer Price Index (CPI) which itself is a basket of goods which is designed with a specific goal in mind (the page has a lot more detail of its purpose and construction).

Alright, so we now know what inflation is, but how about the traditional causes of inflation?

Well, now we get into some deep theoretical territory, and to be honest, I don’t have the time to take a deep dive, here. However, in summary, the dogmatic answer is that an increase in the money supply (i.e. the total amount of currency in the economy) causes inflation. The Investopedia article I linked to earlier does a nice job of diving into the orthodox mechanisms of inflation and is worth a read if you want to learn more. Though I will note that, given the failure of traditional economics to predict the post-2008 low inflation years, there are other theories that are beginning to gain traction.

So why am I getting into all this wonky crap? Well, that gets to the pandemic, and its impact on inflation and the broader economy.

The pandemic has had a deeply disruptive effect on both the supply chains that put groceries on our store shelves, as well as the labour markets that connect businesses with employees.

Beginning with the impact on supply chains, we’ve witnessed a massive demand shock for two major reasons: businesses cut back on manufacturing in anticipating of a recession that didn’t happen, and people have shifted their purchasing from services to goods. The result is that the demand for goods has massively outstripped the supply for those goods.

The issue that really caught the attention of the media was the chip shortage. The lack of availability of various chips resulted in a reduced supply of new cars. That reduced supply of new cars then created an upswing in demand in the used car market, resulting in historically high prices.

But that particular issue had absolutely nothing to do with the the money supply or levels of taxation or any other macroeconomic factors. The issue is that not enough chips were made because a bunch of companies cancelled their orders in late 2019 and early 2020.

So what about the rise in the price of basic goods at the grocery store? Well, again, as purchasing has moved from services to goods–as more people are eating at home, working at home, and so forth–there is a much greater demand for the kinds of goods you get from the grocery store versus those that are distributed through a commercial supply chain. And again, the result is an imbalance in supply and demand, resulting in rising prices.

Now, all that said, not all products have experienced these types of supply chain disruptions, and when they have, many of those issues have been resolved. The result is not all products have seen price increases, as you’d expect with more broad-based inflation. Rather, the issues are concentrated in those areas where the demand shock is still being felt.

All of this makes the current period of inflation weird. Rather than inflation being a result of more traditional causes, it’s a result of massive disruptions in the delicate systems that run our economy. The last time we saw something similar was the 1970s oil crisis, which caused massive inflation due to rising fuel prices.

The problem is inflation can be self-reinforcing. As the perception of rising inflation takes hold, businesses may raise prices preemptively because they expect inflation. Employees may also come to expect rising wages to offset the anticipated increase in prices, which increases the costs for businesses, which are then reflected in, again, increasing prices. In this way, inflation isn’t just an issue of monetary theory, but rather is in the domain of behavioural economics.

And meanwhile, governments the world over have massively increased the money supply, which means that, even without the supply chain disruptions, it’s possible (though far from certain) that we’d been seeing inflation either way.

So how will governments respond?

This is where it gets tricky.

The traditional approach to controlling inflation is by increasing interest rates, and we’re already seeing central banks heading in that direction. The theory is that, by making it more expensive to borrow, you reduce the rate at which loans are taken out. If there’s less borrowing, there’s less new money entering the money supply1, which reduces spending and brings down inflation (again, assuming the orthodox theory of inflation).

But if the inflation we’re seeing now is primary a function of supply chain disruptions, then all we can really do is wait for the situation to resolve itself, and then hope that the flywheel of inflationary expectations doesn’t spin up enough to cause further inflation after those core issues are fixed.

But getting back to the core theme of a lot of these posts, the thing I find most fascinating about this situation is that the inflation rates we’ve seen reported aren’t, themselves, unprecedented. Back in 1991 Canada was seeing an inflation rate of nearly 6% for example, and that was after inflation had been declining through the late 80s.

The issue is that for this generation, like the pandemic itself, or the knock on effects to the various systems we’ve all come to rely on and take for granted, the idea of inflation above 3% is simply unprecedented. It’s a disruption of something that’s been a near constant for nearly our entire lives.

This just piles on another form of uncertainty in a world that’s seems more uncertain than ever. And, for a generation who lived their prime years during the dot-com crash, the 9/11 terrorist attacks, the wars that followed, and the 2008 financial crash, it further reinforces the perception that our governments and institutions and economic systems that run our lives are no longer reliable and cannot be trusted.

That erosion in trust creates the fertile ground that allows demagogues and conspiracy theorists to thrive, with the internet serving as an historically powerful force multiplier.

Now, the flipside is that the disruption in the status quo creates the opportunity for positive change. The change in the power dynamic between labour and capital has the potential to narrow the wealth gap and improve the quality of life for many. The transition to remote work will create new opportunities for both labour and entrepreneurs while also having a positive impact on our climate2. New technologies developed to fight COVID–the mRNA vaccines, monoclonal antibodies, new antivirals–have the potential to transform the way we fight major diseases.

But how this will all play out? That is a very interesting question.

  1. To really grok this it’s important to understand that banks loan out more money than they actually have. For example, a bank might get $100 in deposits but give out $125 in loans. That $25 is made up out of thin air and is a way by which banks inflate the money supply. ↩

  2. I certainly didn’t mind the total absence of business travel over the last two years… ↩