Insights for Tube, Pipe, and Profile Manufacturers – Issue 2

Inflation, A Monetary Phenomenon

Inflation remains front and center in the news cycle. When will it end? Hard to say.

Economist and statistician Milton Friedman is perhaps best known for his simple assessment: “Inflation is always and everywhere a monetary phenomenon.” Stated another way: Every additional dollar put into circulation devalues every dollar in circulation. Why? The dollar, like any good, obeys the law of supply and demand. When the dollar’s supply increases, the dollar’s value decreases. When the dollar’s value decreases, prices rise.

In a recent opinion piece published in the Wall Street Journal, “Why Inflation Is on the Way Down,” Donald L. Luskin, chief investment officer of TrendMacro, makes a case that the growth of the money supply and the rate of inflation in the pandemic era have a correlation that is nearly perfect. The growth of the money supply, year-to-year, took off in April 2020, and core inflation, as measured by the consumer price index (CPI), took off 13 months later. The following graph shows changes in the money supply (M2) since 2017. It also shows the CPI shifted forward by 13 months, and indeed the alignment is right on the money. The article goes on to state that the growth in the money supply peaked in February 2021, and inflation peaked 13 months later. Also true.

However, Luskin may have spoken too soon. Inflation did peak 13 months later, and then fell, but only for one month. Since then, it has increased.

Inflation, A Shock Phenomenon

Another view is that a shock to a previously stable economy can lead to inflation. In the July 22 edition of a daily newsletter, Armada Flagship Brief, economist Chris Kuehl cites two crises as the sources of inflation these days. One is the program of sanctions against Russian supplies of oil and natural gas; the other is the series of supply chain constraints, results that (mainly) come from the lockdowns in China. Many nations can’t tolerate the thought of funding Russia’s war in Ukraine and have reduced or eliminated Russia as a supplier. Meanwhile, the government of China still thinks that the best way to deal with Covid-19 is to try to stomp it out by shutting down industries and forcing people to quarantine at home.

Inflation is always troublesome. When inflation comes from supply shocks involving fuels, it’s especially pernicious in our economy, for two reasons. First, the U.S. is heavily dependent on both natural gas and petroleum, consuming about 25% of the world’s supply of these commodities. Natural gas is used extensively in manufacturing for heating and dehumidifying, and it’s a feedstock for fertilizers, synthetic materials, and medications. Petroleum likewise is a feedstock for many industrial products. Second, petroleum has a large role in transporting goods—raw materials, semifinished goods, and finished goods. Therefore, increases in the prices of these commodities have the potential to drive up the prices for essentially every manufactured good, affecting the costs of production and logistics. 

The graph of the CPI and the graph of the price of petroleum are similar, which sheds light on petroleum’s role in inflation right now.  The following graph shows changes in the price of petroleum and changes in the CPI without a 13-month shift.

Stagflation, A Rare Phenomenon

The basic view of economics, as taught in Econ 101, is that inflation takes place only, or mainly, during economic expansions. If the economy grows too quickly, price inflation can get out of hand; the government pulls some cash out of circulation and raises interest rates to moderate the rate of growth and to subdue inflation.

But, prices can rise while the economy is stagnating, which led to the word stagflation. It happened in the U.S. in the mid- to late 1970s timeframe, driven in part by the price for gasoline, which jumped by 50% in about a year. According to the consumer price index, inflation peaked around 12 percent in 1975 when the economy was in recession.

The following graph includes the money supply (M2, which includes cash, checking account balances, savings account balances, and very-short-term deposits that can be converted to cash quickly) and the CPI. The entire graph runs 20 years to illustrate the extremes in inflation in the 1970s and early 1980s. Inflation peaked in 1975 and 1980 when the economy was either in recession or growing slowly.

Note that inflation was problematic throughout most of the 1970s. It hit a trough in 1977, but even then it was running somewhat hot, around 5 percent annually. That’s about double the rate of inflation over the last 40 years.   

Many recall that Paul Volcker, the Federal Reserve Board Chairman appointed in 1980, rolled up his sleeves and took inflation by the horns. The federal funds rate shot up to nearly 20%. For many, large loans and mortgages were simply unaffordable, which caused automobile sales and construction spending to crash. The strategy of the Federal Reserve Board worked; inflation was subdued by 1983 or so and it would remain tame for about 40 years. The bitter medicine was the national unemployment rate, which exceeded 10 percent. Automotive sector veterans might recall that, in the Detroit area, unemployment exceeded 20 percent at its peak. 

The last graph is a combination of the previous two graphs.

Stagflation Again?

People are using the word stagflation again. Certainly inflation is running rampant, at rates not seen in 40 years. Is the economy stagnating? It might not be in bad shape yet. The unemployment rate is still low, consumer spending keeps right on increasing, and durable goods manufacturers are reporting more new orders and more shipments heading out the door.

However, a price shock can last a long time. For some goods, consumers might be able to substitute a different good or adjust their spending habits, but when the commodity is petroleum, neither of these are likely. According to Kuehl, inflation will abate only when energy prices fall back to a normal range and supply chains are able to keep up with demand.