Inflation is a Tax
People almost universally dislike Inflation and taxes. Both are unpopular because they are essentially the same thing, the destruction of money. Both remove liquidity (i.e. money / assets / reduce a number on a screen) from the system (i.e. society) but are governed by different institutions. Taxes are firmly the realm of Congress / fiscal policy (taxes, credits, stimulus checks, first time homebuyer grants, PPP loans, 0% interest government loans, Impact Zone credits, etc). When you pay taxes, the number (i.e. money) on your computer screen decreases, and essentially vanishes into thin air (for the federal system, not as much for state & local taxes). Your tax payment is recorded in an accounting ledger, and that’s that. It does NOT pay for anything. The misconception most people have is that taxes “pay” for government spending (for the federal government anyway); the system does not work that way at the federal level.
Inflation is (supposedly) firmly the realm of The Federal Reserve. It is the Fed’s job to control inflation. Inflation can also be controlled by Congress by increasing taxes. If everyone pays more taxes, or selective people / entities are taxed, that removes money from the system so there’s less out there to drive up prices. This seems like common sense, if there is less money, there is less purchasing power so prices must decline (or stop increasing) to accommodate this new reality.
But increasing taxes is politically unpopular, so it is easier to “punt” action to governmental institutions like that Federal Reserve. Congress COULD control inflation with fiscal policy (i.e. taxes), but it is easier to blame / rely on the Federal Reserve to do it. In essence, Congress is allowing inflation to do the taxing instead of policy. Also, tax policy is sloooowwww. It cannot combat inflation quickly enough in most cases. Hence the fiscal conservatives, who want to avoid inflation at all costs because it is something they meaningfully exert influence & control over.
Inflation can be viewed as a sales tax… you are paying more for the same product. There’s more demand than supply during inflationary environments, so inflation reduces demand by making things cost more. That is exactly what a tax does, makes things cost more. Lawmakers have taxes on cigarettes, soda, gambling, etc… and credits for green energy, education, and healthcare which serves to incentivize “proper” values and behaviors. Inflation does not have “values”, it is a function of people’s behavior along with simple supply & demand.
We had inflation with medical protective gear (PPE) during 2020 with the Covid outbreak. The demand for masks was huge, and the supply was not there. Many people started making PPE, only to have demand dwindle as supply compensated (and demand decreased). Now we are back to pre-covid times… PPE manufacturing has moved back to China and any small US business who shifted to PPE production was lucky to “break even” on the endeavor. The US government could keep PPE production here in the USA, but that would require tax credits, government contracts, and (depending on how you view government) either “government largesse and overreach” or “undeserved corporate handouts” to keep PPE manufacturing alive in the USA.
I’ll pass over more explanation of inflation, but if we view inflation as a tax rather than a sinister evil to be combatted at all costs… why is inflation so bad? In a “free market”, inflation ought to be preferred over taxation, right? The “market” decides what things will cost. Most people will lean one way or another on this, but inflation is essentially a consumption tax, like a European VAT tax. Except this “tax” goes to the maker of the goods, the people working to make the products. Doesn’t sound so bad right?
No one really knows exactly how inflation occurs (not even the Fed). I prefer to view inflation as simple supply and demand. The unknown is people’s reaction to inflation. Most people consume because they want in this moment and can, not because they expect prices to be higher or lower in the future.
When some people feel rich, they will spend. When some people feel rich, they save / invest. If people feel that prices will be higher in the future, wage increases & higher investment returns will be requested to pay for those higher prices. Employers then pay the higher prices (or resist), leading those companies to raise prices causing more inflation, and another wage increase request, and so on up the inflationary spiral. There are wonderful stories about how bond trading, mortgage-backed securities, and financial derivatives of all kinds were INVENTED due to inflationary pressure, during inflationary times. None of us like seeing that number on the computer screen decline… so increased wages are requested, or financial products are created to prevent that anxiety.
Raising Rates to Pump the Brakes
The Federal Reserve is expected to increase the Fed Funds Rate to combat inflation, but it’s a very blunt & imperfect tool that cannot address supply deficiencies. To simplify, the Fed can increase interest rates to make the cost of borrowing money, more painful, so that DEMAND decreases. If a cartel of home builders (or oil) were to come together and control the supply in the “market”, then no amount of interest rate manipulation can FORCE that cartel to act.
You can see how rates effect demand more tangibly through housing; mortgage rates have gone from 2.75% to 4.5% in a matter of a few months!!! The Federal Reserve doesn’t control mortgage rates, but they control how banks and lending institutions “FEEL” about lending money (via the Fed Funds Rate). Remember, most money is created out of thin air when loans / credit is created. When you put down $20,000 towards a house to receive a $380,000 mortgage, that $380K “loan” is money created out of thin air. The SELLER received a check for $400K when you only used $20K of actual cash. The extra $380K (above your down payment of $20K towards the 400K purchase price) that the seller has in their pocket (or rather as a number on their computer screen), was created out of thin air. This is what the banking system does, creates money out of thin air (via “leverage”) and hopes you pay back that loan, so they can borrow at 3%, lend at 6%, golf at 3pm. When interest rates increase, the Fed is telling banks, “hey… stop it, stop creating money out of thin air… or at least slow down and be very selective about it!”
By increasing rates, the Fed is reducing DEMAND for housing, because people can’t afford as much “house” per dollar because the costs to borrow to purchase that house is much higher. A $380K mortgage at 2.75% is the equivalent of a $305K mortgage at 4.5%… they have the SAME monthly payment, but less cash has been delivered to the seller to recirculate into the economy.
The cure for higher prices, is higher prices.
“The cure for higher prices, is higher prices…” reduces the inflationary spiral into a bit of a chess match, and in chess, speed an initiative trumps all else. Interest rates can move faster than wage increases & asset prices. The inflationary spiral can perpetuate itself, a SHOCK to the system via a doubling of costs (i.e. raising rates), changes behavior which can break the inflationary spiral. But these shocks usually cause recessions (i.e. 2 quarters of declining growth), and when the Fed moves too fast, it definitely causes a recession. People don’t like recessions… most of us prefer the party to go on. Inflation is the noise complaint that happens when the party gets a bit to heated and loud. The Fed are the police to come break it up. In this game, the Fed has the ability to move chess pieces multiple times per turn, while the “real economy” can only move one piece per turn. Of course, the Fed can beat inflation with this power. But, when recessions come, everyone starts singing for their supper again. Everyone is sad and a blame game of who won or lost or was unfairly enriched occurs… until the next party.
Landlords, employers, and the people “who get sang to” during recession feel pain in other ways. Another effect of rising rates is that markets (i.e. stock market, bonds, etc.) start decreasing the value of assets. If you own a bond paying 4% per year today in 2022… and in 2 years the Fed increases rates up to 6%… your 4% bond is worth a LOT less since bonds sold in 2024 will be paying 9% interest per year! So, in anticipation of that, most current bonds are being priced lower (if it happens or not, who knows). Same with stocks, most corporations have debt via corporate bonds, and they will have to issue bonds that pay more interest to get money now. Just like people have to pay more / get less house with higher mortgage rates, corporations are in the same boat with business loans / corporate debt. When asset prices fall, people FEEL poorer and therefore spend a little less in anticipation of a potential downturn in fortune and headwinds for prosperity, imagined or real, the reactions are what makes things real.
Supply Chains are the Problem!
Sometimes it is not even about “demand” for stuff at all, but rather we just make less “stuff” to be purchased. If we previously made 100 houses a day to sell, but only make 50 houses now… when more people than ever want a house… that causes inflation. There are more bidders than sellers. Economists argue about this and are either “supply side” or “demand side” in their thinking. (I believe Jerome Powell is a “supply side” thinker, as are most in his generation).
If supply is the problem, we need to just make more stuff! What does that entail though? I do think this bout of inflation is a supply issue. Covid created the supply side shock, the reaction of lawmakers with Covid mandates exacerbated supply chain issues, and the tight labor market is continuing that supply side shock. People STILL have more money / stronger balance sheets than ever (i.e. M2 money supply). The savings rate has slowed, but I get the sense people aren’t working jobs they don’t want to as much as pre-Covid. Most people have a little time, and money, to breathe and assess. There’s less “marginalized labor” available via people who NEED money to pay the rent. It’s a shame that society depends on this, but much of our “supply chain” relies upon poorly paid labor who work jobs because they have to in order to survive. I can’t imagine anyone willingly taking crap as a customer service rep for $7 per hour and being happy with it.
Well then, you would tell me “Let’s raise wages!”. I refer you to the Inflationary Spiral section. Increasing wages probably doesn’t solve the real issue. Wages would have to keep up with inflation, which usually does not because wages can’t keep pace with asset prices. Remember that there’s a lot of people NEED the system of borrow at 3, lend at 6, golf at 3 to exist… almost everyone does in our modern financialized system. New financial products & systems come along to ensure this happens, and they cannot be regulated away in my opinion. I think our current financial product for this cycle is cryptocurrency, which is different than blockchain technology, but for this go around… serves the function of 3-6-3 like introduction of bond trading did in the 70’s and 80’s.
Someone will Blink
People / society of their own accord can, and will, stop the inflation. For example, when people’s wages increase… do landlords then have to increase rents? The landlord’s mortgage payments (if they have them) did not increase. But a consultant would tell the landlord, “For someone looking for a place to live, they will compare the price of buying a home and paying a mortgage vs renting. Ms. Landlord, you can increase your rent price and it would still be a very competitive!” Sure, the landlord has some increased costs due to higher wage & supply costs, but the larger cost of the mortgage / debt servicing has not changed. Likewise, people can spend less and “tighten their belts” and live more frugally. When people “feel” richer and have more money in the bank, does that require the purchase of more “stuff”?
Nope, and it’ll probably be a bit of both. Businesses become less profitable, asset prices fall, and people slow down their consumption or at least delay a bit of it. I don’t know how inflation ends, hopefully with “productivity”… but at the end of the day, someone still needs to “do the work”: https://fellow401k.com/quantitative-easing-behind-the-curtain/.