Inflation propagates unevenly
January 2nd, 2022
Inflation hits some parts of the economy harder and faster than others. It's obvious once you say it, and yet the way pundits and academics talk about inflation glosses over this reality. As a result, most people who haven't had direct experience with high inflation have a flawed view of how it affects daily life.
Popular use of the term "inflation" makes it sound like the inflation rate is a single indisputable number that you can plug into a formula to make decisions. A pen pal recently made the following (paraphrased) comment in an email to me:
Inflation isn't actually a problem, since all it's doing is changing the measuring stick. Businesses can just price it into what they charge, workers can just price it into their wage negotiations, and banks can just price it into the interest rates on their loans.
Nominal prices go up, but on a relative basis, real prices are essentially the same.
Unfortunately it's not that simple. That model doesn't factor in information asymmetry, time delays, or structural differences between economic actors. It can take years for an inflation shock to propagate through the economy and reach a stable equilibrium, and it only does so after wreaking havoc on people's expectations about money and commerce.
This unevenness creates surprising downstream effects that are difficult to price in. In turn, systemic uncertainty reduces people's willingness to make long-term investments. (For example, high-inflation Argentina has almost no mortgage industry.) This drawback in investment isn't predicted by the model that my friend had in mind, because the model doesn't take into account the uncertainty that inflation causes or its psychological impacts.
So let's go beyond the abstract term "inflation" and look at what it actually means in the real world. Inflation describes the overall effect of many individual people responding to the opportunities and challenges they see day-to-day. It's a very reactive process—prices adjust upwards throughout the economy as a response to the adjustment of other prices around them.
Each of these adjustments happens at a different interval, depending on how quickly the information flows and how much power the person has to react. When a baker notices that flour is more expensive than last month, he'll increase the prices on the menu to cover those costs. When a independent consultant notices that her landlord raised her rent this year, she'll start to charge her clients more to be able to pay her expenses.
As a result, prices adjust at different rates across an economy. Inflation is a much more staggered, uneven process than our models and metrics take into account. For example, cheese in Argentina has gotten much more expensive in the past few years. One Argentine I know said that he can't believe that a kilogram of cheese costs the same as a kilogram of beef, and as a result he and his family have stopped buying cheese to grate on their pasta.
Current prices in the US illustrate the effect as well. The NYT writes that "prices have soared for physical products but have risen only modestly for services. The cost of gasoline is up 58% in the last year, while health insurance prices have fallen almost 4%. Meat prices are up 13%, dairy 1.6%. Boys’ apparel is up 8.4%, while girls’ apparel is down 0.4%."
As a result, the inflation rate each person experiences is very personalized. It's hard to agree on what "the inflation rate" is, because it depends on what you need to buy. If you drive a lot, fuel inflation will impact you more. If you're vegetarian, meat inflation isn't going to hit your pocket book.
Foreign exchange (FX) fluctuations also create weird distortions in the economy. When your currency depreciates, imports suddenly become more expensive, while domestic products aren't affected much at first. There's a whole spectrum between these extremes that is affected in uneven ways. For example, Argentina manufactures some cars locally, but those cars need electronic control units that are not manufactured in Argentina. As a result, when a devaluation occurs, Argentine car prices grow more quickly than the price of beef but not as quickly as pure imports like laptops.
This uneven effect impacts income too, not just consumption. I've heard multiple Americans say that "inflation is good for workers because it erodes debts", but they forget that wages are generally the last thing to adjust. Employers are motivated to change prices more rapidly than wages, and salaries are usually negotiated on a quarterly or yearly basis. This means that households lose purchasing power when inflation occurs. This is especially difficult those who are living paycheck to paycheck.
Wage adjustments are not just slow but also uneven across the economy. For example:
- A waiter might do okay when their tips are a percentage of prices, because as long as the restaurant's owner updates prices consistently (which they're very motivated to do), the tip-based wages will adjust accordingly. Their base pay will not adjust so quickly though, because the restaurant owner is unlikely to updated wages as fast as menu prices.
- A retiree with a pension is in a really tough spot, because pensions are rarely (if ever?) indexed to inflation, so over time their income gets eroded to zero.
- Architects are in a tough spot too. They usually charge large lump fees, so if they give you a quote at the beginning of the year and then inflation hits, the real value of the quote they gave you went way down by the time you actually pay for their services.
As a general rule, inflation disproportionately harms people who can't easily adjust their income upwards. Fixed contracts and fixed incomes are especially vulnerable. Wages also don't automatically adjust—you generally need to advocate for yourself to get a raise—so if you lack negotiating skills in a high-inflation economy, you're at a significant disadvantage.
One concrete example: I know a general contractor who was working on several houses in Argentina in 1989, a year when the peso saw 5,000% inflation. That year, he made the unpleasant discovery that his clients paid late much more often than usual. They always had excuses: "Ah sorry, I forgot to pay before I went on vacation. I'll pay you when I'm back!" When you're seeing 40% inflation per month, delaying payment by a week is effectively a 10% discount. Awfully convenient to be out of town the week you're supposed to pay! Ever since learning this lesson the hard way, the contractor has always denominated his prices in USD.
When you look at abstract models, it's easy to miss the realities on the ground. The theoretical concept that you can "just price in inflation, what's the big deal!" does not hold up to the reality of how inflation actually propagates through the economy.
The term "inflation" is useful shorthand, but it's important to remember that it's just that: a shorthand.
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