Thread by @tim4hire

Okay, so part 2 of a 🧵on inflation (for part 1, see embedded tweet). Same caveats apply. This part will discuss some of the sources for the inflation we're experiencing and what can be done about it.
#cdnecon #cdnpoli
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https://twitter.com/tim4hire/status/1537433095598530561?s=20&t=NfB8f5NDE90jFWKl_vIvfg

As has been widely reported, a main driver of the rise in CPI has been energy prices, primarily gasoline. The steep rise in crude oil, particularly because of Russia's illegal invasion of Ukraine, and tight refining capacity, have caused those prices to shoot up.

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In addition, some other commodities and goods are seeing high prices due to supply chain issues and other supply constraints/concerns. The pros call these "cost-push inflation."

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In essence, these are changes in real prices. If the supply of a good is reduced for some reason, buyers bid up the price in order to secure a share of that reduced supply. As not everyone can get what they want, those willing (and able) to pay more get to buy it.

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This is Economics 101 in action. It may or may not be fair (depending on your views), but it's how markets work.

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Regardless of the reason for the price change, though, it is measured as a change in CPI and so is reported as inflation. This is why people are saying a large amount of Canada's inflation (and inflation in other countries) is being caused by factors outside of Canada.

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For households (and for businesses), the higher prices of some goods and services create challenges. You can: (1) reduce how much you're buying of the now more expensive good/service; (2) reduce how much you're buying of other goods/services; and/or (3) increase your budget.

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Businesses can try to increase their budgets by raising the prices of the goods/services they provide (at the risk that this may turn off some of their customers). Households have fewer options, other than asking for wage increases from their employers (who may say no).

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It is hard for most people to reduce how much they're buying, at least immediately. For instance, I can't easily change the car I'm driving to an EV or even more fuel-efficient one. So, right now I am putting less into savings/debt payments while I adjust/hope for Lotto win.

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From a macroeconomic point of view, you don't want to have lots of peple and businesses suddenly unable to pay their bills at the same time. If that happens to too many at once, it can cascade through the economy and lead to a recession.

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To prevent this, central banks will tend to ensure there is a bit more liquidity in the economy (to grease the economic gears, so to speak), to make it easier for people to get cash (even if they have to borrow to do so) so that they can still pay their bills on time.

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BUT this can only ever be a stop-gap measure. Remember, the initial cause of the price rises was the fact that fewer goods/services were being produced. Somebody, somewhere, is going to have to end up with less than what they had before.

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If all of this extra liquidity continues to slosh around the economy, you end up with demand-pull inflation. Too much money chasing too few goods. The inflation ends up more entrenched in the economy and thus harder to deal with.

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Central banks have limited tools to stop this from happening. It's not as if the Bank of Canada can suddenly increase oil production (to bring down crude prices). It can only increase interest rates.

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Higher interest rates slow down economic activity (less borrowing to buy houses/cars, invest in new businesses/expansions, etc.), and this in turn causes businesses to hire fewer workers (more unemployment).

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It also means those who still have jobs won't be as succesful at raising their wages. This, in turn, reduces the cost pressures that businesses will try to pass on by raising their prices, which, when multiplied by the economy writ large, helps temper inflation.

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Initially, central banks thought the price rises in 2021 were "transitory." That is, they thought that the factors that had caused supply of many goods/services to drop would end quickly, causing the inflation to return to normal without any need for intervention.

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However if a price rise lasts long enough, workers, especially when labour markets are tight, will demand bigger raises. And once people's wages rise, it becomes really hard to cut them, meaning that this cost increase has become entrenched.

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Because unless the economy starts producing more, higher wages mean higher costs to businesses which will in turn raise their prices which in turn causes workers to demand still higher wages and the cycle increases with rising inflation.

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This is the cycle that the Bank of Canada and other central banks are trying to avoid. The current view is that there must be short term pain in order to avoid longer term pain.

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It should also be apparent from the above that the pain is not shared equally (i.e., those who are unemployed tend to get screwed by this). Monetary policy is a blunt tool. While there may be ways to address distributional factors, this is beyond the scope of this thread.

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