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Inflation | Learning by Proxy

Price discovery in any market takes place when demand meets supply.

Over the last couple of years, it has been very difficult for demand to meet supply simply because of the number of disruptions that have taken place in the supply chain. This has further been exacerbated by the fact that people have been hoarding things because of the uncertainty surrounding availability, access, etc. 

When demand exceeds supply prices go up. This rise in price is called inflation.

Capitalism seeks growth. Growth can only arrive when demand rises. When the growth in demand is not met by commensurate growth in supply, inflation is the result. 

The government use fiscal and monetary policies to control inflation. If demand is more than supply; either make it difficult for consumers to borrow (increase interest rates) or make it easier for producers to expand supply (stimulus, subsidies, etc). 

Since the Second World War, a cornerstone thesis of policymakers across the globe has been to keep inflation low.

Why?

Deflation, which is the opposite of inflation often results in revenues shrinking even if demand exists. Lesser revenue would lead to layoffs and therefore further decrease in demand. So nobody wins. 

If inflation is high, goods and services become more and more expensive over time. People will spend only on things that are absolutely essential and even that, sparingly. Consumption drops. The other way in which this scenario plays out – employers are forced to increase the salary of employees. That lowers margins. 

Let me illustrate this with some data from the US.

Source: Official Data

This is US Dollar Inflation since 1635. Throughout history, It was normal to have deflationary years. Prices went up and then markets collapsed and prices went down. That is all fine, till you reach 1948. After the Second World War, there was a focus on reigning in Inflation. Leaving out the fiasco caused by the Oil Embargo in the 1970s, inflation has been quite sedate. 

Source: Official Data

At the same time, what we also notice is that buying power has collapsed since the Second World War. The absence of deflationary years ensured that prices kept going up. This resulted in more money being required to buy the same goods. For most of American history, $1000 dollars from 1800 could have bought $1000 dollars worth. In other words, the buying power of $1000 remained strong.

In the last 50 years, you would need 10s of thousands of dollars to buy what $1000 dollars could have bought in 1800.

Source: Official Data

Another way of showing the collapse of buying power.

In this context let us look at the rising inflation that is being witnessed in 2022. 

For more than 2 decades now, the US has had an inflation rate of 1% to 3.5%. If you buy an item for $10, a year later it is likely going to cost you $10.1 – $10.35. Nobody would even notice this. Worse, at a one per cent inflation over a prolonged period of time, while prices might move from $10 to $12/$13, it happens so gradually that nobody would realise the changes taking place. The sudden doubling of inflation makes the changes in pricing obvious. 

For companies that need to compensate their workers, when inflation is at 1% giving them a 3% hike and letting them know that they are going to comfortably beat inflation is easy. The more blue-collar your work, the truer this is.

As inflation hits 7%, claiming to be providing a hike 3 times the inflation becomes far more difficult. A worker who is paid $30,000 per year is offered a 3% increment or $900 more the next year. The minimum wage stagnated at the same level for decades. 

This is the advantage of a low inflation environment. The top managers and executives in the company are able to give themselves 20%  to 50% in salary hikes without causing too much hurt (they are fewer in number) to the shareholders while giving little to nothing to the people who make the wheels go around.

The chasm between what the country’s corporate leaders and their workers earn is widening to Grand Canyon-like proportions, according to new research that shows CEO compensation surged 940% between 1978 to 2018 while the average worker saw a meagre 12% pay hike over the same 40-year period.

Source: CBS News 

Simply divide 940% by 40, you get a respectable 23.5%. Through multiple recessions, stock market collapses, etc. CEOs have managed to pay themselves more! In that same period, the average worker saw their salary increase 12% or 0.3% per annum.

Then comes a term popularised by Alfred Rapport in 1986 – Shareholder Value. The thesis is that the sole purpose of the company was to maximise shareholder value. Not stakeholders but only shareholders. And managers who maximise shareholder value (read CEO) are rewarded with money. Often this maximisation happened at the expense of all own the other stakeholders. The environment suffered; employees (esp Blue Collar) were paid incredibly poorly, and sweatshops were invented.

Source: Times Now

Source: Livemint

Source: BBC

Source: Investopedia

The issue at hand is not inflation. It is the possibility that corporations would have to dish out unprecedented salary hikes to retain employees. The pressure on Biden is not from the consumer, it is from corporate leaders.

The unfortunate truth is, we will see the other side of this inflationary peak much sooner unless COVID has a say in it. COVID has battered the world and its economies and still, Apple managed to sell more iPhones in 2020 and 2021 than ever before. This is because of the liquidity that the stimulus has introduced into the market.

That tap will be closed. Demand will fall.

Inflation will climb down in less than 2 quarters. The leaders will project this as incredible economic shepherding. It will be hailed a victory. The corporates will continue to dish out measly single-digit salary hikes.

The rich can continue to get richer and the poor can continue to get poorer.

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