Transitional or continuous? Introduced as an economist while attending a friend’s church on a Sunday, a new acquaintance of mine fired his question without too many questions of how to do it. He also didn’t have to tell me he was asking about inflation.
The consumer price index rose 6.2 percent between October 2020 and October 2021, the fastest pace since 1990 and the fifth month in which inflation exceeded 5 percent. My new friend is retired and lives on a fixed pension – when prices go up, his purchasing power goes down. If 6.2 percent becomes the new normal, he sees cat food in his future and is anxious.
Rochester Beacon reached out to Sevin Yeltkin, dean of the Simon School of Business at the University of Rochester, for some guidance. (Readers interested in blaming the problem can read Neil Irwin’s New York Times post here.)
Rochester Bacon: None of us like to pay more for gasoline or heat our homes, but why is inflation important to the economy as a whole?
SEVIN YELTEKIN: If the rate of inflation is the same across all goods/services as well as across all salaries and wages, then stable and expected inflation will not matter. We’ll pay, let’s say, 5 percent more for utilities, but we’ll also earn 5 percent more, so our purchasing power won’t change, we’ll still be able to afford the same things we did before, in the same combination before. Inflation becomes a problem when it is not expected. Many contracts, prices, wages, and salaries are fixed before we know the magnitude of hyperinflation. If inflation is higher than expected, it undermines purchasing power and real income. It also allocates resources from lenders to borrowers (think mortgage rates or fixed-term loans), stifling lending and thus investment and eventually growth. As inflation rises, its volatility also tends to increase, making adjustments to keep real income and purchasing power stable more difficult. As inflation rises, it also tends to become a self-fulfilling phenomenon. If people expect high inflation, or volatile inflation, they write contracts, and make pricing decisions accordingly, i.e. bake high inflation, which then translates into realized high inflation.
Rochester Bacon: Are some price increases more important than others?
yeltkin: Yes. Goods/services that we cannot easily replace are the most problematic. We can’t easily switch to electric cars, or heat our homes with electricity quickly, if gas prices go up. We might be able to switch from bananas to apples if banana prices go up, but if food prices in general go up, again, it’s hard to replace them as a whole. So you have to ask, how big is the private expense in my total budget? Is there a cost effective alternative that I would like and be able to use? Is my income high enough to cover the extra expenses? If the answers to these questions are no, then inflation is really important for those goods/services.
Rochester Bacon: So, if inflation is bad for the economy, shouldn’t someone in the government step in and put an end to price hikes?
yeltkin: Certainly, unequivocally. Historically, price caps have been disastrous, not only in the United States, but around the world and for a variety of reasons any economist could explain. Price is a mechanism that achieves balance between supply and demand. Once you interfere with this mechanism, you create massive distortions. What are the possible scenarios? 1) Firms stop producing as much. They were mostly pricing their goods/services higher because the cost of production/transportation/labor is increasing. If they cannot sell their products at a price that covers those costs, they reduce production. Thus, we end up deficient. 2) Always a black market for goods/services where inflated prices prevail. Those who have the means to pay higher prices and really want the goods, those who want to provide these products at high prices start trading outside the legal maximum. Therefore, caps not only become ineffective, but now create equity issues by creating a divide between haves and have-nots, not to mention all the problems that tend to arise with illegal trade, such as lower tax revenue and increased crime. 3) Once price controls are lifted, a spike in inflation occurs, as the market mechanism attempts to balance supply and demand, eroding purchasing power if wages/salaries are not adjusted accordingly. We have many historical examples of this all over the world, so this shouldn’t even be a consideration. The best way for policy to work is to create an environment for cost-effective, more creative, and possibly technology-savvy solutions to the supply chain, transportation disruptions to develop, as well as removing inefficiencies and providing incentives for innovation.
Rochester BaconThe rate of return on 10-year treasury bills is less than 2%. Why do some expect inflation to be higher? Aren’t interest rates and inflation closely related?
yeltkin: Well, the markets are basically telling you that they a) expect the current high inflation to be a temporary phenomenon or b) expect the Fed to step in and raise short-term interest rates to stop this inflation. Markets still rely on no more than 2 percent of long-term average inflation, which has been an explicit monetary policy goal for a decade. If we believe markets are effective pricing mechanisms, which I do, I will place more weight on market expectations than on individual expectations or bets.
Sven Yeltsin became Dean of the Simon School of Business at the University of Rochester in July 2020. Her distinguished career includes working in faculty positions at Carnegie Mellon University’s Tipper School of Business and Northwestern University’s Kellogg School of Management. Yeltekin’s research extends to fiscal policy design, social insurance design, computational economics, and asset-pricing implications for macro-policy. She received her BA in Economics and Mathematics from Wellesley College, and her MA and Ph.D. degrees in Economics from Stanford University.
Kent Gardner is opinion editor Rochester Bacon and chief economist at the Center for Governmental Research.