INFLATION – 2022/23
Recent conversations with construction CEOs reveal that many industry professionals believe the current inflation spike is only a blip on the economic radar screen that will fade as soon as the supply chain is untangled. I would like to submit, however, that the causes of this most recent inflation spike are far more complex than temporary supply chain snags, and the remedy will take time and a change in political calculus. Let’s take a closer look.
Supply and Demand
The old familiar “law of supply and demand” which dictates that a product’s availability and appeal impacts its price is still the economic law of the land. The price of a given product impacts the willingness of people to either buy or sell it. Generally, as the price of a product increases, people are willing to supply more and demand less. This interaction between supply and demand creates equilibrium in the marketplace, normalizing prices. When price inflation spikes (like we are currently experiencing) an extraneous anomaly in supply or demand has been introduced. Let’s look at both sides of the equation to see what’s happening.
A lot has changed in the mechanism of supply since Adam Smith saw the concept of supply and demand as an invisible hand, an automatic pricing and distribution mechanism, that naturally guided the economy.
- Technological innovation has altered productivity by dramatically reducing the cost and rate of output of most products the economy consumes.
- Foreign sources of production dramatically reduce the cost and increase the supply of labor, thereby increasing the supply of goods and normalizing prices even as demand soars.
- Over reliance on these foreign sources of production has made distribution play an increasingly vital role in supply equilibrium as the source of production is remote from the site of consumption.
This gradual evolution in the fundamental nature of supply distribution has made it more fragile and vulnerable. When COVID-19 reared its ugly head this fragile supply chain was shut down by labor shortages at the source and along the supply line. When supply is shut down, prices rise if demand remains robust. The current mystery is how did demand remain robust when everyone stayed home from work and large segments of the economy were virtually shut down?
For the last 40 years, the world-wide supply of goods has easily kept up with domestic demand resulting in equilibrium keeping the inflation rate between 1.5% and 4% for four decades. However, last month the U.S. inflation rate reached a four-decade high, accelerating to a 7.5% annual rate because unexpected strong consumer demand collided with pandemic related supply disruptions. That finally pushed inflation above December’s 7% annual rate and well above the 1.8% annual rate we enjoyed in 2019 before the pandemic.
Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, said “What started as pandemic-specific inflation has now “broadened out across many categories both on the goods side of the economy and on the services side.”
- Used car prices rose – 40% in one year.
- Food prices surged – 7%
- Fast food restaurant prices went up – 8%
- Grocery prices increased 7.4%
- Energy prices rose 27%
“This reflects supply constraints both in the goods market and the labor market, but it also is a function of still strong demand, particularly from U.S. consumers,” she added.
In a normal market, supply constraints (slowdown in output) would be accompanied by a decrease in demand (unemployment increases) and prices would normalize. However, into this market the federal government injected its well-meaning stimulus program designed to blunt the pandemic’s economic impact by propping up consumers with enormous amounts of capital. The problem was the government couldn’t take capital out of the consumer economy through taxation or the sale of “savings bonds”. The net effect on the purchasing power of the consumer would have been zero. The only way to “prop up” the economy and stimulate consumer demand to prevent dramatic deflation and recession was to simply “print” money. That way there would be “more” money available to temporarily unemployed consumers thus propping up demand.
The Federal Reserve
The Federal Reserve Bank’s number one mission was to control inflation. But since it is the only entity that can create (print) money out of thin air, its emergency mission during the financial meltdown of 2007 and the 2021 pandemic economic shock, was to prop up the economy, preventing complete collapse. Originally intended as a temporary measure, the Fed began to buy the debt of the U.S. government for its own balance sheet, thereby freeing up capital to be used in the economy at large. In other words, the Fed prints money but euphemistically calls it “quantitative easing”. [Note that the numbers below are in “trillions”. Before 2007 few people had even heard the word trillion. Fewer still sense the magnitude of a “trillion” (1,000 billion).] Since 2008 the Fed has injected the following amounts into the U.S. economy.
Assets on the Fed’s balance sheet:
2008 $0.5 trillion
2010 $2.0 trillion
2012 $2.5 trillion
2015 $4.5 trillion
2022 $8.5 trillion
“The Federal Reserve had 7.17 trillion U.S. dollars of assets on their balance sheet as of June 3, 2020, up from 4.17 trillion U.S. dollars, 3.5 months earlier on February 19, 2020. This dramatic increase can be traced to their March 15, 2020, announcement to utilize “quantitative easing” to counteract the deflation caused by the COVID-19 pandemic.” (Statista Research)
Inflation – 2022/23
When planning for 2022, construction executives must take continuing inflation into account. The Fed cannot “wind down” its stimulus program quickly without risking dramatic deflation and collapse but can only tinker at the edges by slowly raising interest rates, which is frankly more a “gesture” than a solution. What’s more, the supply chain problems are not being solved as quickly as many expected. Wise construction professionals will factor considerable cost inflation into their bids for 2022 and 23.
For a deeper look into inflation, read more here: INFLATION
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