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Wednesday, Aug 10, 2022
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OC LEADER BOARD

There is a lot of debate over where inflation has gone and when, or if, it will return. There are some old theories evolving (or devolving), such as Modern Monetary Theory, or MMT, that attempts to describe the current conundrum of our lost inflation.

Some supporters advocate why borrowing and/or printing money should not have any material future costs, or even more extreme, will never have to be paid back at all.

While this is a “nice” thought that we can borrow, buy stuff and then never have to pay back our lender, there might be a more reasonable explanation to the missing inflation. This explanation is a relatively basic premise of economics, one of the first topics covered in Economics 101: the supply curve.

The supply curve has another name, which is the marginal cost curve. Simply put, the lowest cost provider starts the curve on the bottom left (with a low price and a low quantity). Then, the next lowest cost provider comes on line; this adds more quantity, but at a slightly higher price. This continues and you have an upward sloping supply curve (see Figure 1). A simple real world example of this is Saudi Arabia pumping oil from an underground pool (lowest cost provider) versus the U.S. fracking diffuse sources of oil in layers of earth.

Now, after that refresher, there are some major assumption in the supply curve (and much of economics) that are, frankly, wrong in the real world.

A couple of these assumptions are “no friction costs” and “perfect information.” In simple terms, these assumptions are that I can get to these suppliers with equal ease, and that I know what each of them is charging. If you go back in time 10-plus years ago, these were pretty bad assumptions. Today, we have Amazon. Amazon makes these suppliers equally accessible and provides price discovery in mere seconds.

Prices, over the long term, rise. Low unemployment means workers can demand higher wages. Higher wages drive up demand of products. Increased demand drives higher prices. Higher prices are the definition of inflation.

So, why are we not experiencing inflation? Is inflation over? No, we are in a transition period. Amazon is helping add some of the previously unknown or local suppliers to the world mix. This has resulted in a slow steady shift of the supply curve to the right (see Figure 2). There will be a point, likely a few years out, where this shift stops as all available suppliers come on line. We are not experiencing inflation right now because the downward pressure of prices (due to suppliers coming on line) is offsetting much of the upward pressure from wages driving an increase in demand.

In short, thank you Amazon for keeping prices muted during the longest economic expansion in U.S. history. However, this is not a permanent fix to suppress inflation, and the inflation conundrum does not need a new economic theory to explain it.

What does this mean for the future of inflation?

After the “Amazon Effect” has completely worked its way through the economy (in a few years from now), prices will begin to rise.

Inflation will once again be a battle for the Federal Reserve and the “new normal” of the federal funds rate always staying south of 3% will no longer be a “new normal;” it will be old news. Interest rates will settle north of where they are today.

For California and Orange County, this may curb the rapid wealth gains we have enjoyed for the last decade.

Why? Because higher rates mean higher borrowing costs, which mean less housing affordability. This will put some downward pressure on home values.

To be clear, I am not predicting a housing crash again similar to 2007-08. However, I am predicting that the years of very easy money will come to an end. Because so much of Orange County’s economy is tied to housing, the next decade will not be as easy as the last decade.

Editor’s Note: Chris Lawrence has been a banking executive in Orange County for more than a decade. He is currently chief financial officer at Brea-based American First Credit Union, which had $767 million in assets as of June.

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