Inflation – How It Works

Everywhere, inflation is with us – gas pump, groceries, clothes, and even basics, like a toothbrush and toothpaste.  Question – the real question – is why? Why is the value of a dollar earned and saved shrinking?  Politicians want your ear, but here is reality – how inflation works and what to expect.

First, inflation is not a political term – it is pure economics. It describes a change in the real value of money, based on the state of an economy, where the real value of goods and services is outrun by government spending, or people see a shortage of something like food or energy, driving up prices.

Stability matters a lot. Consumers have established expectations, creating consistent demand for certain products. If these are suddenly in short supply, prices go up. Or if demand jumps, overtaking supply, prices go up. 

Another cause of inflation is an overheating economy, one in which growth is rapid, pushing prices up with consumption, as the price of inputs – material and wages – go up fast, everyone working hard.

Generally, inflation is just an increase in prices, which reduces the purchasing power of money.  Of course, most of us want money to be worth what it was when we earned it, and when we saved it, so that we can buy things we expected to be able to buy with it. 

So, how do you restore stability to the currency, create predictability, calm people’s hearts, so they can reasonably expect earning power and their savings to be worth about the same year to year?

The answer: You need to get at real root causes, what created a sudden inflation spike. This is how politics muddies the water – with competing narratives. 

Those responsible for overspending, taking more dollars out of the economy than expected, then trying to pay for that less-productive spending with higher taxes and just printing more dollar bills, tend to upset the apple cart. 

Government overspending does not create the same outputs that leaving dollars in the private sector does.  The so-called “multiplier effect” of a dollar in the private sector, the number of times that dollar changes hands, creating jobs, is far higher than government spending.

However, those responsible for government overspending – and thus inflation – do not like to admit overspending affects the value of dollars people earn and save, so they tout the government program.

A second cause of inflation, of course, is a shortage. Understanding how a shortage occurs is key.  Currently, in the US, we have an imbalance between supply and demand for energy, and of course, all those things are transported to market through the use of energy. This drives prices up, creating inflation.

Why the imbalance? The Biden White House – notably ignoring overspending during the past 14 months on extra federal COVID money, unemployment plus-ups, costly mandates, and regulations – says the inflation we are seeing is because of the Russia-Ukraine war, which triggered cutting off Russian oil.

The truth is elsewhere. Long before Russia-invaded Ukraine, in the first week of Biden’s Administration, policymakers said – we are against fossil fuels and for renewables, and then cut oil and natural gas exploration, drilling, fracking, production, refinement, and transport via the Keystone pipeline.

This was like hitting the US economy, energy independent under Trump, with a roundhouse. The entire economy shivered. Prices – from the start of Biden’s term – began rising. Long before Russia invaded Ukraine, we were suffering a had 7.5 percent inflation rate.

The reason is not mysterious. When demand remains constant, and supply falls, prices jump. When insufficient supply is then met by importing higher cost energy, that compounds the problem. What people could afford, they can no longer afford.

Then – because energy is needed to move things to market, from potatoes and beef to people in “Ubers” – the cost of all these products shoots up. Companies tack on service charges to cover costs.

So, this is how inflation really works and is being created by Biden’s policies.  Yes, they finally cut oil imports from Russia, but that is nothing. The real cause is unrestrained federal spending and federal decisions hammering the energy sector. That narrative is the right one. 

And here’s the kicker, a prediction. These two causes of inflation will not go away on current policies.  They will recede only when federal spending goes down, and US energy production goes up. Higher taxes only slows the economy, taking more from private sector productivity.

To fix inflation in a high-growth or overheated economy, the Fed raises interest rates, which slows accelerated borrowing and cools or flattens the inflation curve. But we are not in a high-growth economy, just one burdened by too much debt and too little energy production. 

So, what will Biden’s policies mean when the Fed reflexively raises interest rates? In a struggling economy, it will mean a slump.  

In short, if you add the real reasons for inflation to falling real wages, rising prices, higher taxes, higher cost of borrowing, you get less spending, hiring, and investment, higher unemployment, and what economists – remembering Jimmy Carter’s dismal days – “stagflation.”

Net-net, the Biden White House, and Democrats have given us a goose egg, an economy that could be growing – led by the energy sector, lower taxes, less spending, and fewer mandates – but instead is being slowed by federal mismanagement. As job creation falls, with real wages, savings, and the dollar, expect some choppy waters. Good news: When those policies are reversed, the economy should take off.