I remember walking to my local grocery store at the beginning of 2020 with $100 in my pocket. I had this fat list of groceries I needed to buy for the week, hoping that the $100 would cover all the items on my list. And to my surprise, it did. I was even able to get some late-night snacks for myself!
However, three years after, I realized that my $100 bill did not stretch as far as it used to. That’s because inflation had begun eating up my purchasing power.
It was COVID that kickstarted the rise in inflation. As the government resorted to a full lockdown policy to prevent COVID from spreading and covering more deaths, many businesses had to halt their operations, leaving many individuals unemployed. The demand was falling rapidly, which led the Fed to decrease the interest rate to boost the demand. This decrease in interest rates flooded the U.S. economy with money that soon started to drive up inflation numbers.
The lockdown policy also contributed to supply chain disruptions, leading to a shortage of goods and services. This, in turn, fueled the inflation numbers even further. This had been a significant issue, as the supply chain disruption caused shortages of everything from computer chips to toilet paper.
Then Russia decided to invade Ukraine, worsening the global supply chain disruptions. As a result of the war, the prices of essential commodities, such as fuel and food, increased in the United States, but not only. All these factors then contributed to the sharp increase in the inflation numbers you see in the below chart from FRED.
Inflation, measured by the Consumer Price Index (CPI), reached 9.1%, the highest rate of inflation the U.S. has experienced since 1981. Fingers crossed, it stays that way. But what would happen if the U.S. was to undergo another round of inflation? Can the U.S. economy weather another round of inflation?
The answer is yes, but it would not be easy, and millions of Americans would suffer horrible consequences. To begin with, the Federal Reserve has all the tools to stop inflation at its disposal. The Federal Reserve can increase the interest rate as it has done to make borrowing more expensive and cool down inflation. The decline in the inflation rate you see in the chart is in great part due to the increase in interest rates by the Fed.
In addition, the U.S. government can step in and tackle the supply chain disruptions or other issues that drive the prices up. And this is what happened with the oil prices last year. When oil prices threatened to fuel inflation further due to the Russia-Ukraine war, Biden released millions of barrels from the U.S. strategic reserve. The increase in the supply of oil helped cool oil prices down, which in turn, slowed down inflation even more.
However, there are significant downsides to trying to control inflation. If the Fed keeps increasing the interest rate, it can trigger a recession or a financial crisis. According to the International Monetary Fund forecast, the U.S. economy will slow down to 1.4 % in 2023 as a result of the monetary tightening by the Fed1. In addition, the International Monetary Fund predicts that the unemployment rate will increase to 5% by the end of 2023.2
The increase in interest rates has also caused turmoil in the financial markets. As a result of economic uncertainty and high-interest rate throughout 2022, major tech stocks lost significant value. The tech-focused NASDAQ index value went down 33.1% in 2022. Then we have the fall of Silicon Valley.
As the interest rate went up, the bonds that Silicon Valley Bank had bought significantly decreased in value. There’s an inverse relationship between interest rate and the bond’s price; as the interest rate went up, the bond’s price went down. Additionally, SVB had fewer loans compared to its deposits. This prevented SVB from meeting client withdrawals, as it needed more assets to cover them, ultimately leading to SVB’s failure.
Days later, the Signature Bank was shut down by regulators due to concerns that the bank might not be able to meet client withdrawals. Now, imagine if there was another inflation round and the Fed had to keep increasing the interest rate; many more banks would be exposed to similar interest rate risks. The consequences of this could be huge and possibly lead to a financial crisis.
On the other hand, the government would also have to spend from its budget to help tackle inflation. Addressing supply chain disruptions or aiding families with rising inflation requires a government budget dip. This could lead to further deterioration of the national debt, potentially leading to long-term consequences. The U.S. government breached the $30 trillion mark for the first time in history last year.
To sum up, while the U.S. economy has the right mechanisms in place and they are indeed effective at tackling inflation, weathering another round of inflation would cause other economic problems. It would require a significantly delicate combination of policies and measurements to address another round of inflation. And most likely, the consequences would be greater than the ones experienced during this round.
References:
1. https://www.imf.org/en/News/Articles/2023/01/31/tr-13123-world-economic-outlook-update
2. https://www.imf.org/en/News/Articles/2022/07/11/CF-US-Economy-Inflation-Challenge
