Thursday, June 23, 2022

A TALE OF TWO elastiCITIES

It was the best of times, the worst of times. ~ Charles Dickens  

Charles Dickens wrote A Tale of Two Cities in 1859 in the later part of his literary career. Dickens was already an admired, well-known author when wrote this book. I read A Tale of Two Cities long ago, together with many other high school-age Boomers. So long ago I hardly remember the book’s plot and characters. Nevertheless, the book still has relevance. 

Dickens’ judgements of Victorian society were represented in his tale. He sympathized with the revolution’s overthrow of France’s imperious aristocracy but disparaged the subsequent reign of terror. Fortunately today we have no broad reign of terror, except perhaps in the divergent eyes of radical leftists and rightists. Views of our aristocracy are similarly conflicted depending on which side of the political spectrum one inhabits.

No matter what your political beliefs are, our continuing excessive inflation has effectively emptied many people’s pockets. Inflation-adjusted weekly earnings for employees decreased 3.9% during the year ending in May. Investors have suffered more; the stock market is now in bear territory. The S&P 500 has dropped 13.3% during the past 12 months and 30.5% since Jan. 3. Pop goes the market.

 

A grizzly bear alarming intrepid investors.

Explaining who and/or what is responsible for our growing macroeconomic predicament is a challenge. President Biden’s attempts to blame Czar (er, Russian President) Vladimir Putin are valid, but not the whole story.

Anyone younger than 40 years old has never lived with inflation as high as it now is at 8.6%[1]. The average yearly inflation rate during the Millennial generation – the oldest of whom are now 41 years – was 4.1%. For Gen Zers –  the oldest are now 25 years – the average inflation rate was 2.4%. Although both these averages are greater than the Fed’s 2% target inflation rate that was officially set a decade ago, they are much lower than today’s inflation rate.

In 1981 we suffered from 10.3% inflation, principally due to the after-effects of the Iranian Revolution and resulting world Oil Shock, too-robust government spending and a swirling wage-price spiral. The Federal Funds Rate (FFR), our key baseline interest rate that the Federal Reserve sets, was 21% in 1981, which is more than 10x higher than the current FFR.

Starting in the early 1980s, this four-decade long period of historically low inflation has both been truly remarkable and uncommon. It has now ended.

Once again, dramatic energy price rises, initiated last month when the 27 European Union nations proclaimed they will be cutting much of their petroleum and natural gas from Russia, have enlarged macroeconomic inflationary pressures facing us consumers, shown in the table below. The giant increases in energy prices are notable. By themselves, gasoline prices have increased an astronomical 48.7%. The price of any kind of vehicle has also risen dramatically.

Consumer Price Index for All Urban Customers (CPI-U)

Annual Price Increase ending May 2022

All Items

8.6%

Food at Home

11.9%

Energy (incl. gasoline, electricity & natural gas)

34.6%

New Vehicles

12.6%

Used Cars & Trucks

16.2%

   The US government’s $5 trillion of covid-induced stimulus checks, business support and funding to state and local governments have increased consumer demand for many goods and services that have been stymied by supply-chain snafus.[2] When overall consumer demand increases relative to available supply, inflation results. Despite being clearly needed and useful, there’s little doubt such government funding has contributed to the economy’s inflationary pressures.

Elasticity is one analysis tool that microeconomists use to judge how much customer demand changes as a consequence of a good’s price changes. If a relatively small percentage increase in a good’s price causes consumers to buy disproportionately much less of that good, its price elasticity of demand (PED) is said to be elastic; numerically the elasticity is greater than 1.0. Conversely, if a good’s price increases by a relatively large percentage but consumers’ demand doesn’t change much, this good’s PED is said to be inelastic, and less than 1.0.

Factors that influence a good’s PED include whether it is a necessity or a luxury; whether it has close substitutes; what proportion of a person’s income is spent on this good; and how much time has passed since the price changed. If a good has no close substitutes, doesn’t account for a large proportion of people’s expenditures and the price change has been recent, then that good’s price elasticity is likely to be numerically low, termed inelastic. A good that has price inelastic demand is not that sensitive to price changes.

Let me tell a tale of two goods’ elasticities that have particular relevance for our existing situation: gasoline and food.

Gasoline’s PED is quite inelastic; calculated to be -0.26, which means if the price of gasoline increases 10%, consumers’ demand for gasoline will decline 2.6%, much less than the price increase. This calculation is unsurprising given that until very recently there have been no substitutes at all for gasoline if you drive a car. Gasoline remains an absolute necessity for the 97% of us car-owners who don’t drive EVs. As I mentioned above, gasoline prices have risen nearly 50% since May 2021, which means that car drivers’ demand for gasoline could drop by only 13%, given its PED. One of several conflicting factors that could lessen this drop includes that it’s now officially summer vacation time when folks who’ve been cooped up for months due to covid want to travel “on the road.”

Gasoline demand’s very low price elasticity also means that President Biden’s request to temporarily eliminate the 18.3¢/gal. federal gas tax won’t have much if any effect. His proposed 3-month gas tax holiday will likely have about as much impact on the US gasoline market as his release of millions of gallons of oil from the Strategic Oil Reserve did several months ago; which is to say minimal. But these actions demonstrate Joe’s at least trying to reduce inflation; perhaps more than his previous, bizarre statement that his bipartisan infrastructure program will diminish inflation. Don’t hold your breath, infrastructure expenditures’ effects move at the tortoise-like speed of concrete.

A gas tax holiday is a strictly performative, smoke and mirrors action that would effect no significant inflationary relief. In addition, it will cut the already-stretched Highway Trust Fund of needed infrastructure money. I expect the impact of a transitory removal of the federal gas will mostly be visual, showing a small price reduction on the giant price signs at gas stations across the nation.[3]

This is especially true if you live in California, as I do. On July 1st, our state’s gas tax, which has a built-in yearly CPI adjustment, will increase to a monumental 53.9¢/gal., the highest in the US. My closest gas station is currently selling regular at $6.39/gal. If only it were a mere $5/gal. like the media constantly reminds everyone.

It’s fortunate that Congress will unlikely go along with the president’s proposed tax holiday, for political not substantive reasons. But if enacted, I and the other 39 million Golden Staters would see only a 2.8% reduction in our gas price that could result in a miniscule 0.8% increase in the demand for gasoline given its inelastic PED. Even this slender price break has been understandably and vociferously opposed by environmentalists and most economists as the wrong way to “get to green,” despite its ephemeral value for the inflation-fighting president. In sum, due to gasoline’s price inelastic demand Joe should not press Congress to add another federal holiday.

Let’s now examine a second good’s price elasticity of demand. Food is in an elite class of items because it is absolutely required by all living creatures to sustain life, like air and water for those of us who live on more or less solid ground. As a necessity, food’s PED is quite inelastic, meaning the amount of food we consume is not much influenced by price changes. And as you’ve already noticed, food prices have risen. The price of food we buy for home consumption at grocery stores has increased 12% during the past year.

There are many different kinds of food, as anyone who walks the isles of a grocery knows. The average grocery store apparently carries an astonishing 40,00 individual items, which means there’s not just a single price elasticity for food. Price elasticities are calculated for specific food types.

Fortunately, thoughtful microeconomists have been busy for decades estimating the price elasticity of demand for many food types. One meta-assessment of food type elasticities reviewed 160 individual studies. Soft drinks, the most-often purchased item in groceries, have an inelastic PED of -0.79. The food item with the greatest price inelasticity (the numerically lowest numeric value) is eggs at -0.27. The PED of milk, the second most purchased food item, is a bit less inelastic than eggs at -0.59; meaning a 10% milk price increase could reduce milk purchases by 5.9%. Our grocery store offers a stultifying choice between 37 different types of “milk:” everything from 7 versions of good ol’ animal milk (in 4 different fat concentrations: whole, 2%, 1% or 0%) and 2 different sources (cows and goats) to 30 versions of plant-based milks (almond, coconut, oat and soy).

This tale of two inelastic elasticities - food and gasoline - has illustrated the president’s weak and limited policy options to reduce inflationary pressures. However, these elasticities have far less direct consequence for the Federal Reserve’s efforts to cut inflation. That’s because Fed anti-inflation policy focuses more narrowly on increasing the price of money (hiking loans’ interest rates) to reduce aggregate demand.

Last week the Fed finally increased the Federal Funds Rate by a whopping three-quarters of a percentage point to 1.75%, the biggest hike since 1994. This increase will raise the cost of consumer and business loans that the Fed hopes will eventually reduce demand for big-ticket items like appliances, cars, homes and business expansions. The Fed’s action, along with its sale of some of the $8.5 trillion corporate bonds it has amassed, will reduce or tighten the US money supply. The risks associated with the Fed’s delayed, aggressive tightening our money supply include eventually pushing the nation into a recession, with higher unemployment and reduced GDP growth.

The Fed chairperson Jerome Powell and his 20,000 employees remain cautiously optimistic that its efforts will reduce inflation to its 2% target without causing a hard-landing recessionary downturn. The Fed’s record in this arena is problematic.

Since 1955 during 7 previous inflationary cycles when the Fed has increased the FFR as fast as it’s now doing, a recession has followed in 6 of them. Six out of 7 means the Fed’s Recessionary Batting Average (RBA) is regrettably an economic Hall of Fame high of .857. Looking even farther in the past, the Fed has managed to reduce inflation without wounding growth only 3 times since 1945.

Will 2022-23 demonstrate a rare, successful economic soft landing for the Fed’s anti-inflation efforts that reduce its all-too high RBA? We can help by embracing the Fed’s efforts by somehow believing in an edited version of Dickens famous book’s incipit, “it is an age of wisdom and a season of light.” The benefits of such an embrace can go far beyond softly taming inflation.

 



[1] As measured by the Consumer Price Index for all urban consumers (CPI-U).

[2] Snafu is an acronym that stands for situation normal, all fucked up. It was born in the beginning of WWII by Marines as a satirical expression of what they all too often faced on a day to day basis.

[3] Interestingly, these ubiquitous signs are not required by federal or state regulation. Nope, it’s drivers like you and me who in effect require those signs, born from decades of tradition that gas station operators accede to. 



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