There is a heated debate among politicians, political activists, and politically active people around the world about inflation. Price hikes are very high and a lot of camps are arguing that there’s one good solution to the problem—while other camps’ solutions are either bad, wrong, or evil. These debates get heated, intense, and impassioned. That’s no surprise; inflation was a major cause of World War 2, it’s what’s caused social unrest in countless societies in history, and it’s something that almost everyone can viscerally feel because they experience it every day in intimate ways as they try to provide for their families.
An impassioned debate might feel good, but it rarely gets much done. For us to solve the inflation question, we must first know what is causing it.
Let’s start with theory. In the abstract, what causes inflation? There are many possible answers, but they tend to fall into three major categories: changes to the money supply (the favored explanation from Milton Friedman), changes to pricing power within the market (the favored explanation from Adam Smith), and changes in technology (a pretty uncontroversial explanation).
Major inflation in the U.S. has not been observed since the 1970s, and so the recent bout has come as a shock and has forced a lot of economists to re-examine these factors and look for an explanation of what is happening. Their answers have been somewhat unsurprising. According to the Chicago Booth’s survey on the topic, a majority of economists disagreed with the assertion that inflation is the result of uncompetitive markets taking advantage of their market power to raise prices, and a majority added that antitrust interventions would succeed in reducing inflation over the next twelve months.
Surprisingly, very left-wing leaning economists seem to disagree with this idea. Daron Acemoglu, for instance, has acknowledged that the “US has a big business problem, with various pernicious effects. But it is not clear whether this has been a major factor in inflation” (it should be noted he voted “uncertain” on the question of uncompetitive markets). The consensus view, succinctly stated by Judith Chevalier of Yale University, seems to be that “Pass-through of both cost shocks & demand shocks clearly differ in industries with vs without market power.”
In other words, the picture is complex, but shocks in the system seem to be the primary cause of inflation.
What are those shocks? That’s an easy answer—COVID-19, the following easy comparables from low consumption in various sectors, the radical shifting in consumer behavior due to substitution effects, and the lingering issues of supply chain issues due to this shift, continuing pandemic protocols hitting productivity and efficiency, and lockdowns in China are all causing hard to define and hard to see chaos.
Does that mean the case is closed and there is no price gouging? Not exactly. As Kenneth Judd of Stanford responded to the question, “I am sure some of this [i.e. price gouging] is going on but I doubt that it is a major contribution.” Judd responded “disagree” with a somewhat high level of confidence to the question, so his acknowledgment that there is some price gouging is important because it demonstrates that the answer is not a simple yes or no. This should surprise no one; markets, like the human beings that make them up, are messy and complicated.
So what can we do to understand what’s really going on? That’s not just an academic question—stocks entered a bear market and are starting to recover, so betting on equities now largely depends on how you think inflation, the Fed, and corporate margins will move in the coming months. And this all dovetails on the question of corporate pricing power versus higher input costs due to supply chain disruptions and shocks to demand.
There is a rather easy way to start teasing this out—at least conceptually easy, but it involves a lot of grunt work. What one could do is look at the individual lines of expenses for publicly listed companies, see how their COGS, SG&A, and other expenses have trended over the pre-, mid- and post-pandemic periods to establish how much companies’ expenses have been hit, and then look at to what extent they’ve been increasing prices to account for this hit.
It would surprise no one to see that companies may be increasing prices to account for their higher costs while at the same time increasing them a little more to juice a bit more margin out of operations. If consumers are expecting inflation anyhow, what’s to stop a company that sees its expenses rise by a penny per dollar of revenue from rising prices by a penny and a half per dollar? Consumers won’t see how much of the price hikes are accounting for higher expenses—especially if the best economists in the world aren’t either!
There is a limit to how much companies can do that and, for that matter, whether they are doing it at all. But an analysis of income statements could get one closer to an answer, which in turn could have tremendous implications for future investing in equities and one’s expectations for economic growth as a whole.
