How Supply Shocks Create Stagflation (and Why We’re Headed That Way)

By: Justice Clark Litle

Aug 07, 2020 | Educational

Inflation is a funny thing. It comes in different varieties and can show up in different places. As such there is no “one size fits all” version of inflation. The classification really matters.

Take the difference between asset price inflation and wage inflation, for example. It is often the case that one exists without the other. Equity and real estate values can go up, while wages stay flat or stagnant.

You can also see the reverse — though we haven’t in a long time — where wages rise in a bear market for real estate and paper assets.

How could a situation exist where wages are going up while asset prices are not? Easily.

Picture a world where taxes have gone up, and the minimum wage has gone up, and the power of union negotiators has returned (via government legislation), even as high-demand professions face a skilled-labor shortage.

Then, too, you have cost-push inflation — where prices are rising because raw materials and input costs have increased — and demand-pull inflation, where prices are rising due to increased demand relative to supply.

There are more distinctions, too. The above is just a sampling. And if that weren’t enough, there are different kinds of deflation, too — some good and some bad.

One of the worst forms of inflation comes from “supply shocks.”

A supply shock is what you get when a commodity, good, or service that is widely used — in significant quantities — suddenly becomes scarce. The unexpected cutback in supply is like a shock to the system, hence the phrase “supply shock.”

The most famous supply shock example is probably the 1973 oil crisis, when OPEC restricted supply to various oil-addicted Western countries, as retaliation for the West’s support of Israel in the Yom Kippur War.

The OPEC-driven supply shock was especially painful because it created “stagflation” conditions, the awful combination of a stagnant or recession-hit economy with price inflation at the same time.

In a supply shock, higher prices for an essential good can hit the economy like a tax. This hurts because taxes are deflationary, to the extent that taxes slow down business activity and spending elsewhere.

Take food and fuel, for example. Every family has to eat, and many families have to drive a fair amount (for work-related activities and so on).

This means that, when food and fuel prices rise, the extra costs have to be borne by most families. The costs are non-optional, in the way a tax is non-optional, and funds that could have been spent on other things are force-allocated toward food and fuel budgets instead.

This is how you get stagflation: Rising prices in one area lead to stagnation and slowdown in other areas.

Supply-shock mechanics are a concern now not because of OPEC, but because of the pandemic.

The United States is experiencing bottlenecks and supply-chain disruption due to COVID-19 related issues, and those disruptions are collectively driving a food-price supply shock.

In the month of April, the U.S. Bureau of Labor Statistics reported the largest single-month jump in grocery prices since 1974. A few months down the road, the picture hasn’t improved.

“Long-standing supply chains for everyday grocery items have been upended as the pandemic sickened scores of workers,” the Washington Post observed, “forced factory closures, and punctured the carefully calibrated networks that brought food from farms to store shelves.”

Year-on-year data from the Bureau of Economic Analysis, the Washington Post reports, shows beef and veal prices up 25.1%. Egg prices are up 12.1%, and pork prices 11.8%.

Some parts of the food supply chain are recalibrating — milk prices have fallen below pre-pandemic levels, for example — but others are not.

In addition to workers getting sick, and the expensive prospect of COVID-proofing various food-related jobs, food supply chains are too complex to respond quickly to major shifts in the composition of demand, e.g. lower demand for bulk-packaged restaurant deliveries and spiking demand for consumer-oriented groceries.

All of this translates to persistent food price inflation that could last for quite some time.

If the overall economic backdrop is deflationary, food chain bottlenecks and supply shocks could further contribute to deflationary conditions elsewhere — through the phenomenon of higher food prices acting like a tax.

That reality, in turn, could lead to a demand for more “helicopter money”-style stimulus and emergency payments direct to consumers from the government.

Whether these ongoing payments are justifiable or not — and they may well be 100% necessary, to keep millions of Americans from going hungry — the overall effect could be to drive food costs even higher (via sustained demand for reduced supply), while adding to the currency supply.

In this sense, as in multiple others, the U.S. economy seems destined to revisit the 1970s — the last decade we know of beset by supply shocks, price control experiments, rising levels of union clout and forced wage negotiations — and stagflation.


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