Facing Inflation Part 1: UK Economists Tackle the Tough Questions

Facing Inflation Part 1: UK Economists Tackle the Tough Questions

By Lindsey Piercy Thursday

LEXINGTON, Ky. (June 23, 2022) — From gas prices to groceries, it seems like everything is going up lately. And it’s weighing on you — the consumer.

Naturally, many have questions about the impact of inflation. How will it affect your finances and future?

In a Q&A series, we asked University of Kentucky experts — from the Gatton College of Business and Economics and the College of Agriculture, Food and Environment — to tackle those tough questions.

In part one, Michael Clark, Ph.D., director of the Center for Business and Economic Research, and Ana María Herrera, Ph.D., associate chair of the Department of Economics, share their insight on inflation, prices at the pump and the possibility of a recession.

UKNow: What is the driving force(s) behind the current rate of inflation?

Clark and Herrera: Inflation refers to how fast general price levels are rising throughout the economy. Price levels tend to increase over time. From 2010 to 2019, prices increased at a rate below 2% as measured by the U.S. Bureau of Labor Statistics’ Consumer Price Index. During this time, price increases were fairly stable. However, prices began rising at a much faster pace about 14 months ago. In April of 2021, prices were up 4.2% compared to April 2020. As of May 2022, prices were up by 8.6% from the year before.

Prices increase when supply cannot keep up with demand. Several factors are likely contributing to the price increases we’re experiencing, and economists are still trying to understand the role each factor plays.

The COVID-19 pandemic certainly played a significant role. When the pandemic began, businesses closed to help slow the spread of COVID. Workers exited the labor force due to lack of childcare, health concerns and other reasons. These events changed consumer spending patterns and disrupted supply chains. The results were shortages for many consumer goods, particularly those that required computer chips to operate and higher prices.

The fiscal stimulus provided by the federal government to help families weather the pandemic and prop up the economy likely contributed to high demand and price increases as well. A recent analysis by economists from the Federal Reserve Bank of San Francisco suggests that fiscal stimulus in the United States contributed to about 3 percentage points of inflation toward the end of 2021. However, any stimulus effect should be declining as households spend down the savings accumulated during the pandemic.

The Russian invasion of Ukraine has also contributed to inflation. Oil prices were already rising before the invasion due to a slow response of oil production to the increase in demand stemming from the recovery after COVID. Once the invasion occurred, many countries including the United States responded by banning imports of Russian oil. While this may have a major economic impact on the Russian economy, it also reduced the supply of oil to these countries and pushed oil and gasoline prices up. Since oil and gasoline are major inputs into manufacturing and transporting goods across the economy, these price increases pushed prices for broader consumer goods up even further. The conflict is also directly affecting food and natural gas prices.

UKNow: What trend(s) in the U.S. are economists most concerned about? Rising rent? Or gas prices? Unemployment? Something else?

Clark and Herrera: Currently, the employment situation is very good. Consumer demand for goods and services remains strong, and businesses are trying to hire workers to help meet this demand. As a result, employers are competing aggressively for workers. This has contributed to higher wages and low unemployment rates. According to the Kentucky Center for Statistics, Kentucky’s unemployment rate was 3.9% in April, its lowest level since the U.S. Bureau of Labor Statics began reporting state rates. While total employment and labor force participation haven’t quite returned to pre-pandemic levels, they are improving.

Inflation is probably the biggest concern right now and rising rent and gas prices are part of that concern. Most understand that families are hurt when prices rise faster than their incomes. However, inflation also affects businesses. Uncertainty over input prices makes it hard for businesses to negotiate contracts, set wages for workers and price their goods.

UKNow: When looking at the numbers as they relate to inflation, how does Kentucky compare to the national average?

Clark and Herrera: Unfortunately, we do not have measures of price increases that are specific to Kentucky. However, Kentucky has likely experienced many of the same inflationary pressures as the rest of the country. The prices for most of the goods we purchase are determined in regional, national and global markets. So, while our prices might differ somewhat, they generally tend to move with national prices.

UKNow: With summer travel plans, many are concerned about the prices at the pump. What is causing soaring fuel costs? And can we expect them to come down any time soon?

Clark and Herrera: The higher gasoline prices that we’ve seen likely reflect three main factors. The conflict in Ukraine pushed oil prices up significantly. However, demand for gas is also up. This is due partially to seasonal patterns. We’re entering the summer, and families are starting to travel more. I also think demand for travel may be particularly strong this summer. With most COVID-related restrictions having been lifted, people seem to be ready to take vacations and enjoy some of the activities they postponed for the past two years.

There’s a lot of uncertainty on oil and gasoline prices. Travel will fall again when schools reopen in the fall, but this might have a small impact on prices. It’s unclear how long the Ukraine conflict will last. When it does end, it is unclear whether countries that banned Russian oil will resume imports. While demand for Russian oil is down, we have not yet seen a significant reduction in oil production from Russia. Once import bans are fully implemented, Russian production should decline and restarting production will be costly.

Higher oil prices can provide incentives for oil companies to produce more oil from existing wells and increase the number of oil rigs to replace oil from Russia. However, it can take time of the new rigs to begin producing oil. 

UKNow: All of us want to know, how high will prices go? Could inflation get worse before it gets better?

Clark and Herrera: It’s possible that inflation peaked in May. Supply chains issues are slowly improving, and the labor force is returning to pre-pandemic levels. These changes should help improve supply and slow price increases. We’re also starting to see some evidence that the Federal Reserve’s efforts to slow the economy by increasing interest rates is having an effect.

Core inflation, which excludes food and energy prices, has declined somewhat over the past couple of months. Gasoline and energy prices, however, have pushed overall inflation upward. Energy prices may be the primary inflation driver now.

We do expect the inflation rate will improve during the next 12 months. That doesn’t mean prices will decline, but that they might not increase as fast. Unfortunately, there is still a lot of economic uncertainty.

UKNow: For consumers, this is an immediate issue. But why does it take weeks/months/even years for the economy to correct itself?

Clark and Herrera: Part of the issue is that COVID created such a significant disruption in the global supply chain and labor markets. Even now as the pandemic appears to be receding, COVID continues to pressure global supply chains. For example, China is still imposing lockdowns in portions of Shanghai. It also takes significant investment and time to bring new capacity online to meet growing demand.

UKNow: There’s a split on whether we are heading for a recession. What factors will be most determinative in steering us clear from going there?

Clark and Herrera: The recession concern reflects uncertainty over the Federal Reserve’s ability to slow the economy down enough to reduce inflation without choking off demand. The Federal Reserve’s goal is to raise interest rates by just the right amount. Higher interest rates will encourage households to save more and spend less. This reduces demand and slows inflation. However, the Fed might find it has to raise rate aggressively given the high level of inflation. If the Fed acts too aggressively, the higher rates could reduce demand so much that we fall into a recession. No one can say definitively that we will have a recession, but the probability of recession appears to be high and increasing.

UKNow: What — if anything — can consumers do to help alleviate the impact of inflation?

Clark and Herrera: Inflation is particularly challenging for households because it forces them to make hard choices. Consumers typically adjust their spending when prices increase. This might involve finding lower-cost substitutes. For example, families might prepare more food at home rather than eating at a restaurant. Workers who have the option to work remotely might do so more often to save gas. Lower-income families are more vulnerable to higher prices because they might have fewer options to make these adjustments. Remote work is not an option for many workers in lower-paying service jobs. The effects of inflation will be more significant for these families.