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S1E02 Jimmy Wants a Raise

When I was around 12 years old my grandad (oupa) took me and some of my cousins to watch Teenage Mutant Ninja Turtles at one of the big movie theaters near Johannesburg.  We were very excited as this was the first – and turned out to be the only time – my oupa took us to the movies. I waited patiently in line with him while the rest went to buy popcorn and drinks. When we finally reached the front my oupa asked the young man behind the counter “How much are the tickets? We need six”, “Nine dollars per ticket sir” the guy behind the counter replied. “What! That is crazy,” my oupa exclaimed. “The last time I went to the movies it cost a quarter and I got popcorn and coke with it!” Without skipping a beat, the young man looked him straight in the eyes and responded “well sir, then you are really going to enjoy this movie… It is in colour.”  You can imagine the look on my oupa’s face.

Inflation often creeps up on us without us noticing – apart from maybe some rare occasions like this past year – it is only when we look back to how much things “back in the day” cost, that we realize how much prices have gone up.  Understanding inflation and its drivers are key to understanding what is happening not just today, but in the economy at any given point. It also tells us what the central banks are most likely to do from an interest rate standpoint.

In the last episode we looked at the principles of GDP (C + I + G + (X – M) ) and how it trends upwards, based on supply, in the long run, but fluctuates in the short run based on demand.

We will start this episode by looking at how the economy operates, starting at a normal state that accelerates to create an overheating economy. To do this we will take a more micro view and then zoom back out to a macro view.

Inflation, deflation, and stagflation

Just like GDP, I think we all have a good sense of what inflation is, but we might not have a good sense of how it is measured nor what happens in a non-inflationary (stagflation or deflation) environment.

Inflation is the rate of increase in prices over a given period of time and is measured by the changes in the price of the Consumer Price Index (CPI). The CPI aims to track how much the average household spends in Canada on goods and services. Of course, there is no real way to track how every person spends their money, which means that Statistics Canada (The Bureau of Labor Statistics in the U.S.) needs to use a proxy to get as close as possible to the true number.

How do they do that? Through an imperfect approach of filling a virtual shopping basket with about 700 goods and services that we typically buy every month.

This virtual shopping spree includes:

  • food—groceries and restaurant meals (tips not included)
  • shelter—rent and mortgage costs, insurance, repairs and maintenance, taxes, utilities
  • transportation—vehicles, gasoline, car insurance, repairs and maintenance, public transit costs
  • household expenses—phones, internet, child care, cleaning supplies
  • furniture and appliances
  • apparel—clothing, footwear, jewelry, dry cleaning
  • medical and personal care—prescriptions, dental care, eye care, haircuts, toiletries
  • sports, travel, education and leisure
  • alcohol, tobacco and recreational cannabis

Each of these items is given a weight in the basket based on how much it is believed we would typically spend on them. For example, food and shelter have a higher weight than say haircuts and dry-cleaning. I virtually spent $0 on the last two items during Covid while I can’t say the same on the alcohol side.

Inflation is more meaningful over a longer period of time which means that unlike GDP, which is compared against the previous quarter, CPI is compared mostly against the previous year.

The Bank of Canada, and most other central banks, aim to keep year of year inflation in a range of between %1 – 3% with a midpoint target of 2%. That is the main mandate of the central bank – keeping inflation at 2%. How would you like that simple job?

Please allow me to geek out for one minute as we take a closer look at something that seems simple on the surface but is not that simple at all. The headline inflation we typically see is the total or All-items CPI. However, there is also core CPI with three distinct measures.

They are:

CPI-trim – This measure helps filter out extreme price movements that might be caused by seasonal or other factors, so it discards the most volatile price changes.  

CPI-Median – This measure helps filter out extreme price movements by capturing the median/average price change.

CPI-Common – This measure tracks common price changes across the 55 components in the CPI basket.

If these scare you, that is okay – they will not be on the test nor are they overly helpful in our daily lives. I merely mention them to let you know that the central banks use different measures in an effort to get the clearest picture of the true rate of inflation with the hope of making the right policy decisions. 

You can see the results of the different measures below. (You can click on the image to go to the interactive graph)

It might be interesting to note from the above that CPI-Common just passed the 3% mark in March while CPI-Trim is at 5.1% and the headline inflation is at 6.8%.

Which one does the bank of Canada use to make policy decisions?

Since 2001, the Bank of Canada has used the All-items CPI to make policy decisions, but shifted to the core inflation metrics in 2015  after a comprehensive evaluation of the measures of core inflation. This means that while the bank of Canada still publishes and often sites the total CPI, policy decisions are made based on the three core inflation measures outlined above. 

Click the image below to see the inflation numbers from around the world

So, what causes inflation and how do you combat it?

In the previous episode we learned that economic growth is largely determined by the supply side of the economy. So, let’s explore what happens to the economy in a normal state when there is a supply disruption.  

Let’s assume we own a widget factory. Our factory runs at 80% of capacity, our output is stable, and we have enough workers, and access to workers, to keep going at this comfortable pace. At this capacity, we can plan for maintenance shutdowns while keeping up with the stable demand. One day, our main supplier of lumber – who happens to be the largest supplier in the country – informs us that after an office party all their inventory burned down, and they will not be able to supply us with any new lumber for at least three months. I think you know what happens in a case like this. We immediately start calling all the other suppliers to secure enough inventory, but we are placed on hold. While listening to the elevator music we quickly realize that everybody else is also calling to secure inventory for their factories. The likely result? Just like higher Uber prices during rush hour because of higher demand and low supply, the price of lumber increases while we are on hold. We have orders to fulfill, so we have no choice but to pay the higher price. In an effort to stay in business, we call all our customers letting them know of the situation and we give them two options: (1) they can delay their order until the supply has been corrected or (2) pay more for their order to offset the additional input cost we now have. In most cases, they decide to pay more as they too have customers relying on them. And just like that, there is inflation because of a supply shock – it is easy to see the parallel with the supply shock brought on by Covid.

This chart shows the contribution of the current supply constraints to the inflation rate. The effect on inflation will become negative (moving inflation lower) as supply gets closer to its 2019 levels  

It is worth noting that over the past decades improvements in technology, globalization and efficient supply chains added downward pressure on inflation to such an extent that some prices decreased instead of increased over time (deflation). Think about that 55” TV that is selling at Costco for $800 today. In 1997 the same size TV, which wasn’t even HD and it was ugly, was selling for $22,924. There is good reason to believe that we will continue to see downward pressure on some goods but probably not to the same degree as in the past.  

We might come back to dealing with supply shocks, but for now, let’s look at demand shocks.

There are two kinds of demand shocks, and one often leads to the other.  We will use our same company and reset to a normal state with no supply shock. We have been operating at 80% capacity in a strong economy. Slowly but surely the demand for our product starts to increase. Since there is a lot of competition, we can’t just increase our prices, so we are forced to run at fuller capacity and pay our workers overtime. Since our workers are earning more, they are spending more, just like their counterparts in the growing economy, which creates more demand in the economy. Over time, this demand continues to grow and we have to hire more people and run longer shifts. At least we still have access to a labour pool.  That is until one day, Jimmy walks in and asks for a raise. “We can’t at this point Jimmy, we are stretched thin already.” “Well big boss in your fancy office, I can walk across the street and get an increase right away. In fact, most of us can leave now and have jobs by this afternoon paying us more.” Jimmy says confidently. What are we to do? We realize that the labour market is tight, and Jimmy is right. We have no choice but to give him and everyone else a raise. Now we have wage inflation. As wages increase, people spend more. This drives demand even more in all sorts of areas: maybe Jimmy buys that bike or pool the family always wanted – both those come with new maintenance costs.

While this has been happening, our share price along with the other companies in this growing economy has increased. Everybody feels wealthier because their Net Worth has increased. What do people do when they feel wealthier? They spend more of course. This is called the wealth effect. The wealthier we feel the more we spend.

Back at the factory, we are forced to increase prices to offset our increased labour and another cost like energy that has increased with the growing demand in the economy.  The increase in prices, of course, is inflationary. As our output peaks and demand continues to grow, we are forced to raise our prices even more. Partly because we can, partly because we want to sell less so we can operate at a more sustainable pace. And partly because Jimmy and his friends keep coming back to the office asking for a raise. This increase in prices continues to drive and accelerate prices/inflation upward.

At his point, we need outside help to slow down the demand. This is where the central banks step in and use the best tool in their toolbox to fight demand – interest rates.  

Interest Rates – the kryptonite to inflation

Since the 80s, interest rates have been the main tool used to slow down or speed up economies.  If you want to aggressively grow an economy – keep rates low. If you want to slow down the economy – increase the rates. It is basically that simple. The tricky thing with interest rates is that nobody really knows the magnitude of the effect or how long it would take for an increase/decrease in interest rates to affect the economy. The other thing that is tricky is that it is a very blunt tool – it affects everything. If for instance, your housing market is running hot while the rest of your economy is not, increasing interest rates will certainly cool down the housing market but will throw cold water on the rest of the economy too. I think we experienced a bit of that in Alberta when interest rates started rising in 2017 through 2019 to slow down other parts and sectors of the country.  These increases poured cold water on Alberta’s economic recovery from the 2015 local economic crash.

See Alberta’s GDP below from 2014 to 2019 (click on the image to see the interactive graph).

  

Why do interest rates work so well in slowing demand?

For one, we are a credit-driven society; which means that as interest rates go up, we have to spend more of our disposable income (which could have gone to buying more goods and services) on interest payments. It also means that buyers might have to adjust their purchase decisions – like buying a less expensive home than they would have been able to if interest rates were low. Secondly, less new money gets created in the economy as the demand for lending goes down. While this last statement is super interesting, I don’t think we will have time to dive into that at this point but feel free to ask me about it. Also, remember, it is not just consumers that use debt but corporations and governments as well. The more they have to spend on interest payments the less money there is to go to other areas. Projects that might have made sense to do at a 3% interest rate might no longer make sense to do at 5%, so business investment slows down too. (More on this last part in a future episode when we look at the math behind share prices). You can probably now see the impact on C + I + G clearly by now and why interest rates are such a blunt tool.

Below is teh C + I +G + Net Exports breakdown and forecast into 2023. (Click to go to the source)

Let’s go back to our widget factory, where we are running over capacity to keep up with demand, while Jimmy has been getting raises and working  a lot of overtime. After a series of interest rate increases, we noticed the demand for our widgets coming down. We are not sure if it is temporary or a new trend, so we continue to produce at current levels. As interest rates continue to increase, we notice our product inventory starting to build up while our orders are slowing down. It is time to slow down production. It is a bit of a relief as we can now catch up on some of the maintenance we have been deferring, but it also means less overtime for Jimmy and his friends. At first, Jimmy is happy that he gets to spend more time with his family again but after a couple of months the bills start adding up. He realizes that he is not making the same amount of money anymore. His expenses/lifestyle are still the same as what it was when he was working all that overtime. Along with all his friends, he needs to start cutting back on his spending. As everyone starts to spend less, the demand for our product decreases even further. We are now forced to offer discounts to move our inventory out of the door. The lower revenue leads to more job cuts which leads to less demand again as fewer people yet have money to spend. And so, the seeds for a recession are planted.

The chart below shows the all-items CPI against the bank of Canada interest rates. Expect the blue-line (interest rates) to continue to increase over the coming months and the blackline (inflation) to start moving lower.

We are so close to being done with this section but I think this is a perfect place for a break. The next episode will be a lot shorter as we look at some of the concepts I did not mention here – i.e., deflation, stagflation and real GDP and real interest rate – as it builds from the same concepts we already saw in this episode. After that, we can jump into bonds and how they correlate with interest rates and other fun topics

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