Ep 15: Inflation Explained

Jessie: You know, Jess, I've been seeing a lot of memes and posts from friends about inflation for a while now. And there's, you know, things like this is a wage shortage, not a labor shortage.

Jess: Ooh, I've seen those too. Or the comparisons about how it was so easy to buy a house 20 years ago on a similar lower salary. Things were just different. Things our parents did.

Jessie: Right. How much easier it was back then. And the prices of groceries and rent still feel so high.

Jess: All right. So it sounds like we should talk about the inflation situation.

Jessie: You're listening to Market Maker, the self-directed investing education podcast that demystifies the stock market by breaking down complex topics from her perspective. We're your hosts. I'm Jessi DeNuit, the investing apprentice learning about the world of investing here with you.

Jess: And I'm Jess Inskip the resident finance expert with about 15 years of industry experience here to teach Jesse and all of you how it all works.

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Jessie: Okay. So Jess, what is inflation?

Jess: It was very difficult to come up with an analogy for this one, but I actually used to teach this and other concepts at one of the brokerage firms that I used to work at. And we had a little activity to explain inflation. So I'm going to take you through that. Very, very exciting.

Jessie: Fun.

Jess: Imagine you're in a conference room, but a very modern one. You sit around this, this large luxurious table as our conference rooms. Naturally, I. am extra and over the top. So prepare yourself. I would get three paper bags so you couldn't see what's in them and they were full of stuff, things you had no idea what was in those three paper bags. And then I had money. It wasn't real money, but naturally because I'm extra and for some reason I'm like, this might flag somebody, but I looked up the dimensions of actual dollar bills and made sure that it was correct. printed it, cut it out, and use that as money. So what I would do to everyone around that conference table is we would have multiple rounds. So I would give $5 to every person, five fake dollars that I printed that were in the correct dimension. And then I'd say, all right, listeners, students, bid for this first bag. They knew that there were other rounds, but they would start bidding. and eventually somebody spends all of their dollars, $5, nobody else can go any higher, they got there first, they get the bag and I say, cool, I'm gonna put it in front of you, you are not allowed to open it. Then I would give them another $5. I say, all right, we're gonna.

Jessie: Everyone got another $5?

Jess: Everyone got another $5. So that one guy who won, he's only got five bucks, everyone else has 10. Then they realized. that they could start pooling their money together. And so then they'd start bidding. And that's when it gets really fun when that realization happens because these are multiple classes. And this is what I did in the summer when I was bored, when I was working at a brokerage firm, complete side note, and this was born. So anyways, we have the second bag. They're pooling all of their money together. Ends up that bag was $12 is the winning bid. put that bag in front of the team now that won and said, cool, give me your fake correctly sized money. And you have won that round. Then I do one more, give them $5 again. And same thing happens. Now they realize there's no more. The people bid it up and this time it was $15. So now I put that bag. in front of those people say, all right, everybody open it. And what they realized when they started opening it is there's the same thing inside of all three bags. And it was whatever I could find around the office. So it's literally just some candy or a mug, like the tchotchkes you would get at trade shows and things like that.

Jessie: But it was all the same exact thing in each bag.

Jess: Correct. Each bag had the same identical thing. And that is inflation. Let's see if we can put the puzzle together from what we learned actually from the, what is the stock market episode and everything. I could have been the fed or I could have even been fiscal policy. I was putting money into the system and the more money that these students had, the more, more that they spent. And that just naturally caused the prices of the same exact things to go higher.

Jessie: Oh yeah. Yeah, that makes sense.

Jess: It's inflation. There we go. All right. We're done with this episode. Just kidding. So much more to dive into. It's the purchasing power of money and how it changes. They had the same amount of money each round. I gave them all $5. That paper bag represented the CPI, the consumer price index that is just full of things that we consume as consumers or individuals from our perspective. So that's the price of gas, that's the price of rent, the price of food, everyday items are found in there, as well as services, travel hotels, things like that. PPI is the producer price index and that is from the producer perspective. And since we learned from the Are We In A Recession episode, the economy is comprised of producers and consumers, therefore we have to look at both to understand the inflation situation.

Jessie: Okay, makes sense

Jess: When the price of things go up, we need more dollars to buy the exact same thing. That's called a decline of purchasing power.

Jessie: The same goods and services and things that we're used to buying, we're making the same money and the goods and services that we've bought for that money are now more expensive. So the price of goods and services and things we consume has gone up.

Jess: You could say that the $5 that I was giving everybody with every round. was actually a pay increase. That could be what that was. But we want steady inflation. We want people to have, and this is this, they call it like a spiral. So it's this constant push-pull chicken before the eggs scenario that a lot of people don't really agree on. But if you have more money, you're more likely to spend it. And if you're more likely to spend it, that will cause the prices of things to go up. But you just don't want it to go up. too fast. So the textbook definition is too many dollars chasing too few of goods causes really high inflation. And so it just needs this type of balance. It's not, it's not black and white. Unfortunately, I don't even think it's gray. It's rainbow. It's just, there's a lot you have to put in together. That's why the feds target is 2%. You might hear that in finance media all the time. The fed targets 2% inflation. increase year over year. That is absolutely healthy. You want growth, but you want wage growth too. You want prices to go up. Ideally, you want wages to go up more than prices, but you want steady inflation. You want slow and sustainable growth. You don't want it to go way too fast because that causes hyperinflation and that really has a bad impact, especially on the lower income levels. And you don't want it to go too slow because then we're not growing collectively as an economy.

Jessie: So then What really causes inflation is a change of supply and demand for products and services or too much money?

Jess: Yeah. Everything is supply and demand. We'll start with cost push theory. So cost push theory means that if the cost of something goes up, like operating expenses, the cost of labor, the cost of lumber, the cost of gas, that is an operating expense. Let's go back to that paper bag scenario. I have to buy those paper bags, say this is completely real. And those paper bags I sourced from China, as are lots of things. And the cost of receiving that paper bag went up by $1. Well, I probably, if I was selling those paper bags, I'm going to increase the price of that because the cost to produce those bags or get them are higher to me. And that's the cost push theory. It means that... my cost to produce my goods and services has increased. Therefore I am going to pass that on to whoever is buying it.

Jessie: To the consumer.

Jess: Yep. Exactly.

Jessie: Right. Okay. That makes sense.

Jess: Yeah. Like global supply chain issues, there was a lot of factory shutdowns where they were making Apple products over in China. That's called a supply chain issue, but there was also a lot of demand for those iPhones. But they were unable to meet that demand due to supply chain constraints. Like that's going to cost more to produce that phone because they got to wait. You have an increase in your operating expenses in some way, shape or form. Just like you said, it could be a supply chain issue, could be a shortage of some sort. There were rapid fires, no more lumber. The price of lumber is going to go up because now it's a hot commodity. Things like that.

Jessie: Right.

Jess: Oil, that's why it's going up. OPEC agreements to cut production. There's less production of oil, even though we need to get over to this clean energy act. And there's other policies that are pushing towards that. That has a trickle down effect on a lot of companies that have to factor in gas prices into their everyday operating expenses, most notably higher airplane prices.

Jessie: Right. Like a ripple effect. So many things are affected by one little part, one little thing.

Jess: Exactly. And what's important to know when you say, okay, well, what actually caused inflation? It's not one thing and not everything is swimming in the same lane. So things are going to be resolved at different times.

Jessie: So you talked about the cost push theory. We know what that is, which is increase of cost of labor operating expenses requiring increase in prices.

Jess: So demand pool, that just means we have more money in the system. That is what I did with the bag game is I gave more money. I created higher demand. Therefore, the prices increased in value. Great example, Taylor Swift concert, Swiftonomics, so exciting. It happened though, everyone wanted to go to her concert, higher airplane prices, higher hotel prices, because there was a lot of demand. And because of that high demand, they raised prices and people are willing to pay it. Therefore prices remain high.

Jessie: Right. So that's what demand pull is when there's like a demand for something like going to a concert or someone you really want to see and you have to travel there, you're willing to like pay whatever it is to go because you've already bought that concert ticket in this situation. So like, you're going to have to buy the, you're going to have to get there.

Jess: Yeah.

Jessie: Is it that the companies like realize that's what's going on? So they raise the price. Are they raising the prices because like, there's like a limited amount of seats on the airplane or is it both?

Jess: All of the above. They want to price their product at the optimal price, the highest price that consumers are willing to purchase it up.

Jessie: Which sucks.

Jess: Yeah, it does. But that's the business lens. The other form of what causes inflation or a theory that economists utilize is called built-in inflation. And that's the natural one. The chicken and the egg thing is just increasing wages. slowly and naturally increases prices. That is good as long as it's at that 2% year over year sustainable rate.

Jessie: So it's good to have a 2% increase year over year in inflation. So if that's what the Fed is targeting, this like 2% year over year increase in inflation, why wouldn't companies also be forced with some kind of fiscal policy to make sure they're giving all of their workers a minimum 2% wage increase?

Jess: That's a really good question.

Jessie: If we see that companies aren't giving raises, but they're profiting, they're making more money, you would think that that's like, eventually going to cause some issues. And then it does. I know it's not everyone. I know some people are making more money and some people aren't. And that's probably the issue.

Jess: That's part of it. And that's definitely adjusting. And that's why you have to look at all of this other data, not just what's happening with the consumer price index or PPI. You have to look at. the housing market, you have to look at everything that makes up a consumer, which is what it costs to live, all of the above. But I mean, I do think you're onto something. I know there's a lot of corporations that have the minimum 2% raise that is absolutely there and that is practice. But even on the other side, if you are writing contracts, even technology agreements, you would agree to a 2% minimum increase year over year if it's a long term, like 10 years or something like that. or inflation, whichever is higher, that is very natural in a lot of agreements. So why don't they do that for workers? That's a really great, great thought.

Jessie: Yeah, I'm going to keep that in mind. You know, you expect a two to 3% minimum wage increase for inflation, but like if inflation is at 7%, I wonder if we can negotiate with employers. Like I want whatever the inflation rate is as my...

Jess: Maybe.

Jessie: Like, yeah, I don't know if people can actually negotiate that, but that would be something to think about.

Jessie: I mean, I think you do anything you put your mind to. Nope. Have lots of, lots of practices on getting raises and things we could have an episode on, even though it's not really what we cover. Um, nonetheless, those are the three main ways though, that causes inflation is it's a change of supply and demand in products and services, cost push theory, demand pull theory, a change of supply and demand and money, which is more related to that demand pull theory, too much money, more people spent and built in. which is good. We want wage increases.

Jessie: Yeah. So then what's causing inflation today?

Jess: This is a fun one because it happened so quickly. And remember what caused inflation isn't swimming in the same lane, which means it's going to be resolved at different times. And some of these already have, so it started with the pandemic early 2020 lockdowns. And remember when we had the episode on what is a recession and how do you measure it? And we look and the NBER looks at it in 3D. So depth, diffusion and duration that was widely diffused and it disrupted global supply chains because we couldn't go elsewhere and we were a very global economy. We source things from China from everywhere, but that stopped. In addition to that, that was bottlenecks onto a lot of corporations. There were a ton of layoffs. Unemployment spiked up really, really quickly, but then it also shot back down very, very quickly, which we'll move on to. But in response. The government provided a lot of stimulus checks and they provided that in the form to consumers and they also did to businesses. So they created a lot of money to help prevent that economic shock that was foreseen, but that created a lot of money in the system and we recovered from that very, very quickly. We got COVID-19 vaccines super quickly and even though it felt like forever at the time, if you think about... just recovering from a pandemic in comparison to history, we bounced back really, really quickly. It was very, very interesting is during COVID, there was a demand for goods, like things. People went shopping, myself included. I got a gown for no reason. Like it was, I have this designer that I like and I don't wanna say their name right now because they're not responding to my. customer inquiries. Which worries me. They're normally like $1,200 and they had them on sale for like $150. Like obviously I'm gonna buy this. So

Jessie: yeah.

Jess: But there was a huge demand for goods because people were at home and they were bored. That's when trading became popular and whole another episode talk about that. And skincare. I really got into skincare at that time.

Jessie: Oh me too.

Jess: Yeah.

Jessie: we were looking at ourselves on zoom all the time and in the mean like we're looking at ourselves more than we ever do.

Jess: Exactly. But think about the supply chain issues were really disrupted at that time, but people wanted stuff because they were bored. So we got money from the government and we bought things and we caused goods inflation to go up really, really high. So part of that was because of the increased demand for things, but also because of the constraints on the global supply chain issues caused hyper. Good inflation.

Jessie: And there's also like a need for more specific things. People were more like at home on their zoom or meetings or whatever. So more of these little ring light things got bought. And I remember like, I remember buying a ring light for whatever. And I saw the price of it go up 1000% within two months. It was crazy.

Jess: Exactly. And the Fed at that time also put interest rates all the way down to zero. And they do that in response to stimulate the economy. It's like go buy things. Then Everyone wanted to move. There was a housing boom. I moved as well. I'm really part of the problem. It's me. Hi. I'm the problem. It's me. Oh my God. I'm going to keep that in. But I did because I knew it was a record low interest on my mortgage and that was amazing. But so did so many other people. They moved away from New York or really high-priced areas and that caused a supply chain issue. And we still have that actually within the housing industry. is there is

Jessie: Yeah, I was gonna say, I’m feeling a lot of after effects of all these things you're talking about.

Jess: We are. And yeah, and there's some reasons for that. On top of that, Russia invaded Ukraine and that led to some economic sanctions, trade restrictions, limiting oil and gas supply. We're adjusting, but Russia's a really large producer of that. That caused prices to rise, fuel and food that also had impact on value chains. So that caused a huge surge in inflation. Now we're over COVID, people got the travel bug, have revenge COVID tours. I'm literally having one this year. That's demand on top of Taylor Swift and Beyonce. Everyone wants to travel. Goods inflation actually has subsided. It's actually come down considerably. But then services inflation is going up is what we call it. And that's the hotel travel, food away from home, things like that. I really think it's gonna come back down because Taylor Swift is taking her tour overseas. So they're gonna have some problematics with some inflation, which their numbers actually said. Like it's good and bad, right? Like it's good for the economy.

Jessie: It's like stimulating the economy, but.

Jess: Yeah. I will never say a bad word about Taylor Swift. Such a genius with the football thing too. I literally think she was like, what is something I don't roll? Football. Okay, I'm going to do that. And she did.

Jessie: Good for her.

Jess: Hey, and you know what? Supply and demand. They had the most Jersey sales ever. So she causes inflation wherever she goes. She creates demand.

Jessie: Yeah, demand. Good and bad.

Jess: It's complicated. It's not simple. And in the case of our current inflationary environment, it is not one thing. It is true that we have a labor shortage. You think about the boomer generation, they're called the boomers because there's a lot of them. Less of us.

Jessie: Millennials definitely are not having as many babies because it's expensive to have children in this economy. Are you abundantly clear on what caused inflation today? A lot of things.

Jess: Okay.

Jessie: Let me ask you this though, going back to COVID, was that the right move? Cause when you bring it down to 0%, then you create like too much demand, right? Too many people are buying too many things. And then now we're like, we're still feeling those after-effects, like 0% like not a good move.

Jess: No, it wasn't. They acknowledged that. So they thought that inflation was transitory, like is going to go away when COVID went away because of supply chain issues. But what they didn't account for was the buffer in savings that consumers built. Because. stay at home jobs, like we adapted, which is kind of amazing if you think about how corporations really adapted very, very quickly. And that goes on to my overall theory of the changing market and how corporate America is shifting, which we can talk about in a stock market update.

Jessie: So now that we know what inflation is and what causes inflation and how it's measured, how do we bring inflation back down?

Jess: This is Papa Powell's job. Or also known the Fed, the FOMC, Federal Open Committee. Jessie: Yeah. They tackle this.

Jess: I think it's doing a-

Jessie: Come on, Papa Powell, bring some costs down.

Jess: Yes. So the Fed has a dual mandate. It's maximum employment and price stability. So they're supposed to achieve price stability, which means slow sustainable growth, that 2% target, and have maximum employment. But normally the fed's actions are what tips the economy into a recession. So they have to exercise with care, but they can only tackle the demand side of the equation. They can't tackle the supply side. They just cannot do that. They cannot go fix that there are bottleneck issues because of the supply constraints to the Russia-Ukraine war. They cannot do that.

Jessie: Okay. So they can tackle demand by...

Jess: They raise the interest rates.

Jessie: Making prices go up, right. So that's why they keep raising these interest rates.

Jess: That's right.

Jessie: So that we spend less, but we're not spending less. Last episode, the one before that, we were saying like the consumers weren't spending less, but we were also saying like, well, we might've been using our credit cards more, dipping into savings and like that runs out at some point. Like you can't do that forever.

Jess: Exactly. And Fed policy acts with a lag. That's what's so important to know. They have actually have a lot of tools beyond raising interest rates, but the one that we talk about the most is raising interest rates. So perhaps we'll talk about that. When they raise interest rates, that is passed on to the consumer. So if it's higher for banks, then it is going to be higher for you. But that also has positive and negative effects. Yields go up. So your high yield savings account had, it could get more money. What is important to know is how it affects the stock market. So when you're raising interest rates, it's going to make it harder to borrow. We've talked about that. It's going to be higher interest rate to get that mortgage. you're gonna have a higher rate on your credit card, you're going to have a higher rate, therefore you're not going to spend as much. But that takes time before you actually feel that. And that's what we mean by the lag effects or that delayed effects that happen with Fed policy. Rents is something I know that you and I have talked about quite a bit. They're expecting and really looking for that to come down now, just now. And they've been raising interest rates for over a year now, but that's because think about rents. Your leases are really long as those long-term leases are coming to the end of their life cycle. They should be or hopefully are. This is what will be looked for in the data is coming down in price. Those are lag effects. Have you reached your limit yet? Are those interest payments eating away your savings? So terrible the thought of it. There are meetings throughout the year where they will tell us Fed policy if they are going to raise or lower interest rates or even keep them the same. That is just an announcement. It happens right at 2 PM on a certain Wednesday, not every month, but most months at 2:30 PM Eastern time. Then we get the fed policy speech and that gives us an indication of where they feel, where the data is going, why they made that decision. And then there's some Q and A, and that to me is so much more important. And the market moves more even with that speech because the Fed is telling us where they're going. why they did what they did and a look into the data and you have to realize that it's a human making these decisions. So not only do you have to look at the data and formulate your own personal opinion, it's not your opinion that matters, it's the people who are making the policy. His view, and I do agree with this, is too high of inflation hurts lower income individuals much more. Five percent increase in prices for people who are living paycheck to paycheck is detrimental. And that's why he says he is committed to bringing down inflation to that 2% target. And there's been progress. Like it was 9%. Now we're about three and that last 1% is like that end of the marathon. I've never done one before. So I would imagine that like the last bit's a little bit hard, but you know what I mean?

Jessie: push through it I guess?

Jess: Like, yeah, that's where we are right now. I think that last 1%. is going to be really, really difficult, but there's been progress. There's lots of progress. The leases though, I do have some data on that. They were like recently 20% higher than they were in the pandemic, but in 2021 they were 49% higher. So that's still a reduction. It's still super high, but it's not as high. So it's coming down, but it takes some time.

Jessie: So rent is slowly coming down. I do think we've seen... grocery prices or some things start to slowly come down too.

Jess: And this is why you invest in the stock market. If you have cash sitting there, it loses its purchasing power over time because 2% inflation year over year is actually good for the economy. So you invest in the stock market to outpace inflation, which historically it has. We've looked at that data. It's important to account for how a stock makes money. where their operating expenses are. So you can understand these impacts on inflation and how it translates over into their profit margins and earnings and also why it's important to look at good management because you purchase too many products and there isn't as much demand, you're gonna have to put it on sale.

Jessie: It's all coming together now. Now I'm like, it's starting to all click. Yes, okay.

Jess: It's my favorite. It's my favorite moment.

Jessie: Yeah. Well, I think that's enough talk about inflation for today. Let us know if you have any follow-up questions or thoughts about this topic on our social channels or on our website forum.

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