In early 2021, the U.S. government rolled out another massive round of economic stimulus aimed at offsetting the damage done by the Covid-19 pandemic.
There’s a potential side effect that some investors and economists fear could actually hurt the economy even more: inflation.
Inflation is the rise in cost of goods and services. Basically, it’s how much your money loses value over time. Many economists believe inflation isn’t all bad; it typically goes hand-in-hand with economic growth.
Too little inflation, known as disinflation, or falling inflation called deflation, can be a sign of a struggling economy. But too much inflation too quickly, called hyperinflation, can led to economic instability and market crashes.
While many policymakers and economists think hyperinflation as a result of economic stimulus is unlikely, others aren’t so sure.
So what exactly causes an inflation?
The most common theory is based on supply and demand. Basically the more money there is in the economy, the less it’s worth, and vice versa.
In order to stimulate economic recovery from the Covid-19 pandemic, the Federal Reserve and the Federal Government of U.S. did things like cut interest rates and send checks to encourage spending. Spending actually creates money. The Federal money supply grew from about $15.5 Trillion to more than $19.6 Trillion from February 2020 to February 2021.
The degree of growth is unprecedented in the United States. Some worry that the more money the government floods into the economy, the less each dollar will be worth, starting a spiral toward hyperinflation. The closest the United States came to hyperinflation was during The Great Inflation from 1965 to 1982.
During this time, there were four recessions, two energy shortages, and wage and price controls. The Consumer Price Index, or CPI, which measurers inflation by tracking the prices of common goods like food, housing, clothing, transportation, and more, hit a high at one point of nearly 15% year over year growth.
The higher inflation translated to higher interest rates. Mortgage rates climbed to 18.63%. And the unemployment rate climbed to 9.7%. All these factors led to a stagnant stock market; the Dow Jones Industrial Average struggled to move above the 1,000 level for nearly two decades.
So, should you be concerned about hyperinflation?
Many economists and policymakers think the risk is low. In March 2021, U.S. Federal Reserve Chairman Jerome Powell testified before Congress that deflationary pressure over the last 25 years should help offset the risk of inflation.
One deflationary pressure is productivity and efficiency gains from technology and globalization. Advances in computing, telecommunications, and networking have elevated productivity and kept labor costs low. And global free trade has let companies seek lower cost materials and labor abroad and use just-in-time production systems to avoid the cost of storing inventories.
As a result, employment has been relatively soft since the Great Recession and took a major hit from the pandemic. In January 2021, long-term unemployment was approaching 2010 levels, and wage growth for many workers has been underwhelming.
Finally, slower economic growth has helped keep inflation low. Since 2000 and prior to the Covid pandemic, annual U.S. Gross Domestic Product, or GDP, a measure of income for a country, has stayed below 3% annually, keeping inflation low with it.
Considering all these factors, many economists and policymakers see plenty of room for the economy to grow before reaching dangerous levels of inflation.
However, despite low overall inflation, there have been pockets of rising prices. For example, in late 2020 and early 2021, supply chain disruptions and high demand caused lumber prices to rise more than 170% in just 10 months. The rising costs of lumber is adding $24,000 to the price of a new home.
In February 2021, food inflation for the previous year was 3.5%. Some of this was due to supply chain disruptions but also rising oil prices, which increase the cost of transportation.
In March 2021, the CPI rose 0.6% for the month and was up 2.6% from the previous year. Much of this was driven by a 9.1% spike in gasoline prices.
Remember that inflation is part of normal economic growth. Traditionally, the Federal Reserve has an inflation target of 2%. Chairman Powell said the Fed will allow inflation to run hotter than normal to spur economic growth. Powell and U.S. Treasury Secretary Janet Yellen have both said the risk of hyperinflation was small and that the government has ”tools” to address inflation if it does occur.
However, former U.S. Treasury Secretary, Larry Summers, is less optimistic and pointed to the Fed’s past inability to slow an overheated economy without causing a recession.
Harvard economist Greg Mankiw warned that the economy may overheat if inflation exceeds 3% for the next five years.
For now though, the U.S. seem to be in the early stages of inflation, how it pan’s out is anybody’s guess.
One certainty is that the impact of U.S. economic growth does tend to affect the rest of the world from a historical point of view.