Why Some Prices Rise First and Others Later

Why Some Prices Rise First and Others Later

Some comments on inflation point out how much of our recent inflation has come from oil prices, used cars, and a few other things. Although the arithmetic may be exact, it is misleading to analyze the contribution of particular prices to overall inflation. What we see in the first specific price rises is the interaction of supply and demand over different time horizons.

In the United States, since the start of the pandemic, fiscal policy and monetary policy have injected enormous stimulus into the economy. Demand for goods and services increased in general, but the specifics varied by product.

Some demands can increase rapidly. A person who owns a car can start driving it more and buying gas right away. But the person who can finally afford a new roof must work with a contractor or recruit some friends to help. A person who wants to take a long-delayed vacation may have to juggle the schedules of other family members. The bride and groom ready for a dream wedding may need to book a venue 18 months later.

One of the characteristics of a product that rises at the onset of inflation is that the stimulus rapidly increases demand. In the language of economists, the product has a high short-term income elasticity of demand. Used cars and computers also fit the description.

Some goods can be delivered in large quantities very quickly. Video streaming companies, for example, can speed up movie delivery almost instantly. Simple products can be produced quickly, locally. Other products, however, take a long time to manufacture. Used car prices have risen rapidly in 2021. How long does it take to make a three-year-old used car? This supply is not increasing rapidly.

If oil consumption has been depressed, production can quickly recover to previous levels. But ramping up production to new heights takes much longer. Geological studies are needed to identify probable oil deposits. Then exploration wells are drilled, some of which are likely to be dry holes. When oil is discovered, the next step is infill drilling of producing wells, with new wells connected, usually by pipelines, to refineries. The whole process can take ten years.

Now combine the two concepts of demand and supply. For oil, demand can increase rapidly as consumers drive more and businesses increase production, requiring oil-fired power. But the supply cannot increase quickly. Eventually, yes, oil production will increase to fill at regular prices. But in the short term, strong demand will cause prices to rise, not supply to rise.

In these examples, oil and used cars did not cause inflation. They were just the first signs of inflation. Over time, other goods and services are in greater demand. And in time, more supply of everything will be produced. Much of this new supply will result in higher costs. For example, as demand increases, oil rigs will cost more to rent. As automakers desperately seek to increase production, they will drive up the prices of labor and materials.

The ultimate cause of inflation is excess demand induced by monetary stimulus. The first price increases do not cause inflation, any more than the first crocuses bring spring.