The Main Street Inflation Cycle

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Two major periods of inflation (late 1970s-early 1980s and 2020-2023) were both preceded by sharp increases in government spending and regulation supported by cheap financing facilitated by the Federal Reserve. Government spending increased by 15% (annual) in 1974-1975, and by double in 2020-2021 (Covid), compared to an average increase of 8% over the period 1973-2023). During those periods, small firms unusually raised prices faster and more frequently (Chart 1).

While every company, large or small, welcomes the opportunity to increase prices (and profits), that behavior is disciplined by competition and the impact of higher relative prices on customers’ willingness to buy. Large numbers of small firms do not raise their prices unless there are cost pressures (energy, input prices, minimum wages, regulations, etc.) that affect most or all firms. On the positive side, strong consumer spending offers opportunities to raise prices without fear of losing business to competitors or consumer resistance to higher prices. Shortages in the supply chain put strong upward pressure on the prices of goods and a tight labor market drove up the price of labour, for example wages.

The most recent price increase started when 1% of all small businesses increased prices by more than 10% in the second quarter of 2020 to 20% of all small businesses increased prices by more than 10% in the second quarter of 2022, and that rate is still high at 11% in the second quarter of 2023. The main driver of inflation in the early 1980s and more recently was the percentage of owners raising prices by more than 10%. The percentage of owners raising prices by more than 10% is down 10 percentage points, but remains 11 points above its Q2 2020 low. increases, to have peaked, which it did not do until well after the 10%+ category peaked in the last inflationary episode. When so many companies are raising selling prices at rates well above 2%, especially at double-digit rates, it is difficult to bring headline inflation down to 2%, the Fed’s goal. Price increases in the construction sector (59%) will take time to feed through into the CPI. Wholesale (54%) and retail (59%) are rising rapidly. High figures in the financial sector (52%) are usually reports of higher interest rates on financial products (loans).

Interest and inflation rates in 1980 were much higher than they are today, even though Main Street pricing behavior is very similar. In the 1980s, after the initial plunge in price increases, reports of higher prices stabilized at very high rates for a considerable period of time before capitulating to pressure from the Fed. If this pattern repeats, the Fed will have to continue to apply aggressive pressure to the economy to dampen inflation.