When matters of prices are being discussed, one often hears something to the effect that whatever a price may be, it is the “right” one because markets are free and respond to the forces of supply and demand. There is a kernel of truth in that. That conclusion is reasonable in markets for commodities such as natural resources, crude oil for instance. The competitive supply and demand model is a reasonably good approximation of how the world price of oil is determined.
Currently the prices of oil and the goods and services to which it is an important input are rising rapidly, a major factor in our 8.5 percent inflation rate. Rising oil prices aren’t the only problem though. There is a perfect economic storm spinning up our double shock inflation, simultaneous negative shocks to aggregate supply and demand.
Rising prices are supposed to motivate firms to increase production and consumers to buy less. In competitive, frictionless markets and ordinary times buyers’ and sellers’ responses to the incentives of prices tend to cause prices to return to their normal levels fairly quickly. When there are shocks to the mechanism of supply and demand that prevent it from working correctly, prices can begin to spiral upward or downward. Disruption of world oil supply due to Russia’s invasion of Ukraine, of course, is the main supply shock.
Oil producers outside of Russia can’t just turn the tap to increase production to make up for the loss of Russian oil, even if there are idle wells. Much more so if new wells have to be found, drilled and brought on line. The same applies to oil refiners. As a source of inflation, falling world oil supply is being aided and abetted by clogged supply chains which were already in place before the war in Ukraine. And throw in wage pressure as employers try to fill the more than 11 million vacancies they have. Apparently, many people who were put out of work by the pandemic decided not working was more fun than working and have not (yet) returned to the workforce. Most economists didn’t see that coming.
Falling world oil supply is happening at just the time demand for many goods and services has been rebounding from the pandemic. People finally being able to get out of the house and travel, go to restaurants, buy things and otherwise get back to normal increase demand for a wide range of goods and services.
Adding to demand pressures is all the money that was, rightly, pumped into the economy to soften the blow to the public in the first year of the pandemic. As Milton Friedman once said, inflation is always a monetary phenomenon. To be sure, there are non-monetary factors that may feed inflation, all else the same, more money sloshing around in the economy means prices will rise sooner or later. All that Covid stimulus money is doing its stimulating thing, increasing consumers’ spending adding to inflationary pressure.
All of this means aggregate supply is lower while aggregate demand is higher, the double shock. Inflation is the inevitable result. Given all the other events that were converging before Putin invaded Ukraine, most economists predicted inflation would tick up for a time but would pretty soon return to its former level of about two percent. Oil market disruption and the great retirement have turbocharged and prolonged inflation.
The President can do virtually nothing about the world price of oil or citizen’s spending choices. The other, double shock factors; supply chain issues, wage pressure, pent up demand, and a flood of money in the economy were all primed to strike regardless of who is the President.
Supply chains are beginning to unkink, oil producers outside Russia are beginning to produce more and the Fed is beginning to deploy its inflation fighting measures. This bodes well for predictions that inflation will begin to come down soon. That assumes utin will not unleash his nuclear weapons as he has threatened to do. In that case, don’t sweat inflation!
Remember the part about high prices providing incentives for consumers to change their buying behaviors? Do that before you yell at the government. This episode of inflation is mostly the result of supply chain disruptions and choices private businesses and consumers have made in the past and now. This is not an inflation created by our government, other than the Covid relief packages and Russia sanctions. But there was no choice about either of those, as I see it.
Patrick Taylor lives in Ridgeland.
