– Penned by Jeevan Joseph
The United Sates is grappling with a spike in inflation that has reached record high levels. The Fed has always tried to keep the inflation in the U.S. close to 2%. However, the current inflation rate of 7.9% is the highest that the country has seen in over 40 years. Given the size and relevance of the U.S. economy in driving global economic sentiments, we seek to dive deep into the factors behind this phenomenon.
The Price Problem
Inflation in the U.S. is seen in the rise in prices of essentials like petrol, food and rent among other goods. Another metric called the core inflation, which excludes volatile items like food and oil, is 6% higher than it was last year. One prevalent school of thought is that the inflation is merely transitory in nature, meaning that this bout of inflation would not contribute to a ‘permanent increase’ in prices and that prices would eventually return to their normal levels. The Covid-19 pandemic and the subsequent lockdowns already saw the overall supply of many goods and services take a downward trend. Thus, the Fed believed that prices would go back to normal as soon as these pressures eased.
During the pandemic, the government of the United Sates also increased the supply of money by around 30% to help combat the effects of an economic downturn. When paired with shortage of supply of goods, the excess amount of money in the economic system contributed to a situation where the prices rise at a very rapid pace. Notably, prices of many commodities are set to increase given that the Russian-Ukrainian standoff is likely to extend for a longer period of time than many analysts initially predicted. The U.S. led sanctions on the Russian energy sector have played a role in tightening the supply of oil, resulting in an increase in energy prices.
The Wage Problem
Historically in the U.S., the rate at which new money enters the market has always been slightly higher than the increase in supply of goods and services. This means that prices would naturally rise each year. However, wages and incomes also increased by a comparable amount, helping to combat the effect of inflation. This time around we need to focus on the key dimension of real earnings. Data points to the fact that wage increases during this period haven’t been compensating for the rise in prices due to inflation. Adjusted for inflation, the real wages are said to have dropped by around 2.5%. Adding to the complexity is the fact that not all the new money is equally distributed among the populace. Some sections of society get access to a larger proportion of the fresh money, whereas other groups receive only a very small share.
People are also likely to spend their money faster if they realise that prices are increasing. The rationale is that if they hold onto their free cash, its value would decrease as the prices of goods are increasing. Effectively, you will only be able to buy less for the same amount owing to inflation. Therefore, for most people it would make sense to spend their money before its value deteriorates. This effect eventually contributes to an increase in prices. The Federal reserve of the U.S. is now contemplating over the option of increasing interest rates to keep inflation in check. Investment banks believe that the Fed may hike interest rates by 0.25% in the upcoming policy meetings. The Fed is, however, cautious about huge increases in interest rates because the government would then find it very difficult to pay off public debt with high interest.
The political fallout of high inflation periods is sure to negatively impact the incumbent president and his party’s approval ratings. A recent CBS survey indicates that nearly 60% of Americans do not believe that Biden is paying enough attention to the economy. The people expect a slew of measures from the president to help them tide over the pressure of inflation. Some of these demands include lowering the price of prescription drugs and a crackdown on anti-competitive moves by large companies. This dimension is especially relevant given that the United Sates is all set for a mid-term election later this year.
As for this episode’s impact on India, it isn’t out of the ordinary for Indians as they have been seeing very high inflation ever since the onset of the pandemic. However, if prices in the U.S. keep rising, imports will become costlier for India. Further, Indian firms trying to raise money outside of India will have to pay more now. Lastly, the RBI will also have to adjust interest rates at home to account for any resulting inflation in India.
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