Inflation. The Pew Research Center found out that 39 of 46 economically significant countries (OECD plus 8 other major economies) are suffering from significant inflation. In general these countries had low inflation prior to the first quarter of 2020. Inflation was flat for the remainder of the year through the first quarter of 2021 due to declining economic activity associated with the global pandemic. Since that time inflation has continued to increase due to pent up consumer demand coupled with COVID related supply chain issues. Much of the inflation is driven by increased demand for energy (oil/gas) as consumers and businesses begin to come out of the pandemic global economy.
In general there are two ways to reduce inflation: increase the supply of goods and services or reduce the demand for those goods and services. Overall inflation currently is primarily driven by the global supply of oil/gas. One way to fight this inflation is to increase the supply of oil/gas. As I have written in 3 previous essays discussing oil prices, this is going to prove difficult to do in the short run or near future because of the following: the embargo of Russian oil; the short term inelastic supply curve of oil; supply chain issues; the strategic decision made by the largest oil companies to not increase supply so as to avoid the traditional boom bust cycle that characterizes the industry; and the not so distant future of the move to electric cars which will significantly affect the demand for and supply of oil.
If supply can’t be increased, then the other method to fight inflation is to reduce the demand for goods and services or essentially to cut spending. There are 3 major spenders in the economy: consumers, government, and businesses. With higher prices, consumers will naturally cut back on spending by buying less or buying cheaper substitute goods, eating out less, traveling less, and through many other ways. The government can also act through higher taxes. Higher taxes on consumers means there is less disposable income and less spending. Of course, this is politically very unpopular.
Cutting spending by the government is another method to reduce inflation. Cuts in government spending can be measured by the deficit. Cutting government spending will reduce deficit spending. The US government deficit stood at 2.4% of GDP in fiscal year 2015. Spending increased to 3.1% in 2016, 3.4% in 2017, 3.8% in 2018, and 4.6% in 2019. The deficit peaked at 15% of GDP in 2020 and declined to 12.1% in 2021. The high deficits are largely the result of COVID relief spending. Reducing government spending is also politically unpopular. Whose programs get cut? Defense? Healthcare? Veterans? Education? Youth programs? You easily can see why this is unpopular.
The final method is to cut business spending. This is done primarily through the actions of the Federal Reserve System headed by a Board of Governors. It is often simply called the FED. The FED will institute what is called a tight money policy by either raising the reserve ratio, selling government securities to banks, or raising the discount rate. The reserve ratio is the amount of money that banks must keep on hand and are not allowed to loan to businesses. Government securities are bonds or promissory notes issued by the government at a promised rate of return. The discount rate is the interest that the FED charges to other banks that want to borrow money from it. Any of these policies (raising reserve ratio, selling securities to banks, raising the discount rate) will reduce the amount of money that banks have to loan. This means banks can make fewer loans, which means that the money supply has been reduced and money is more valuable. This means the cost of borrowing via interest rates will increase. Businesses are less likely to borrow at high interest rates, thus reducing business spending and lowering inflation. It looks like the FED will be taking action soon to raise interest rates to fight inflation.
The problem with fighting inflation is that it can set into motion the forces that will cause an economic downturn. Taken too far it could lead to a recession. So reducing inflation is a balancing act in which the goal is to reduce inflation while striving to maintain a healthy economy.
See also the following related essays on my blog: A Primer on the Global Oil Market (March 4), A Follow up to A Primer on the Global Oil Market (March 8), and Oil Prices Again: A Brief Commentary (April 2).
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