There is a lot of focus on inflation
There is no doubt in my mind that inflation is a huge problem for all of us today. There are constant talks about how the Federal Reserve Bank needs to make changes to reign in the high inflation. They use numbers (like currently it is about 4.2%) to represent the level it is at and what they are trying to reach. You might think that they would try to cut it to zero, but that is impossible. The best that they can do is try to keep it at a reduced level, which I believe their target is 2%.
Why not Zero?
Trying to understand all the ins and outs of inflation is beyond my very little brain; however, I will give and explanation as I see it. I’ll do this by trying to describe the actions of one small piece of the overwhelming picture. This is very simplistic but covers the basics. I’d like to say that I will start at the beginning but there really isn’t one, since it is all a big circle, so I will just start where I start, and you will see that we come back to the same point.
Let’s start on a farm. The farm produces food. It might be vegetables, or beef or other fruits or meats. It doesn’t matter. For now, we just need to know that it produces food. Essentially, they start with something small (newborn animals or seeds) and gives them the ability to grow into bigger animals or plants. Let’s just talk about plants for the time being.
So a farmer gets a bunch of seeds, and he puts them into the dirt on the land that he owns or leases. For some time after that he cares for them by keeping ground around them clear of other growth, making sure they get the right amount of water and nutrients so they can grow and product the vegetables. At some point after that, they gather up the vegetables that have been produced, and send them off to be processed.
Processors get the vegetables and prepare them for sale. The vegetables go to some kind of warehouse facility or where they are sorted and packaged. Some may go to a sauce making plant (to make ketchup or soups, etc.) and some just go to grocery stores directly. Either path that they take, they end up on the shelves of a grocery and eventually someone buys them and eats them. Done.
So far the whole process is very linier. It starts here (at the farm) and ends there (in our stomachs). This is only the mechanics of the process and obviously I left a lot of steps out, but you get the idea. But now we have to look at the economics of the process.
First the Farmer buys the seeds. If it all works out well, each seed will generate plants that give him several vegetables as the plant grows. However, for that to happen, the farmer pays to get the ground ready, then they pay to plant the seeds, then they pay to provide nutrients, and they pay to keep the weeds down.
They have to pay for the tractors and other equipment. They pay the fuel that the equipment needs. They also have to pay for the workers who drive the tractors and plant the seeds, and care for the plants. One farmer can’t do it alone. Plus, they have to feed and house their family as well. The first part of every farmers year is all expenses, not income. For that reason, many get a loan from a bank at the beginning of the year to pay the expenses, and pay it back with interest (we’ll come back to that later) when the money starts to come in.
This means that every single vegetable that is harvested has a cost associated with it. For instance, if the expenses are 1 million dollars, and the farmer grows and sells 1 million vegetables, then the cost per vegetable is 1 dollar. If the farmer can sell the vegetables for $1.10 each they will do pretty well for the year. However, a lot can go wrong on a farm that produces a bad crop. A lot can go right that can produce a bigger crop. Each year is sort of a gamble. If a bad crop occurs, and they only get 500,000 vegetables, then the cost goes up to $2.00 each. To make the same profit, they charge $2.20 each. If there is a wonderful year and they get 2 million vegetables, then the cost is 50 cents each which if they make equal profit means they charge 55 cents each. Most likely though they’ll charge 60 cents and double their profit. That’s saying that harvesting 2 million veggies costs the same as harvesting 1 million. Which we know it doesn’t.
But lets just continue along our supply chain and see how things progress. The veggies are priced at $1.10 each from the farmer (this isn’t realistic and is for explanation only). They go to a processor, and they have expenses to pay. They have equipment, rent, electricity and utilities plus of course, the big expense is workers, plus profit. So, by the time it leaves their doors, the vegetables now cost $2.00 each. They go to a warehouse for distribution, and the warehouse has expenses including rent, utilities, people, supplies (for packaging and such) and profit. On their way to the grocery stores the vegetables now cost $2.75 each.
At the grocery store, they get put on the shelf at $4.00 each because the grocery has to pay for rent, utilities, and people plus probably some advertising and other things that are required to run their businesses, plus profit.
Of course, these are not real numbers, but I am using them to show the relationship of the economy and pricing. We have also not discussed a very important piece and that is shipping. Each time the vegetables move from farm to processor to warehouse to grocery store, there is a shipping company that is part of the expenses of each area. They are paying drivers, gasoline, road taxes, trucks and maintenance of trucks and lots of other things. But shipping is usually a part of the expenses of the other companies in the process. It still figures into the overall pricing formula.
Now if everything stays the same (exactly the same) then essentially inflation is at zero. Let’s say that everyone is happy and the food flows through the supply chain without incident. How lovely that would be.
But then something happens
There are so many things that can happen, it boggles the mind! We talked about the chances of a bad crop at the farmer. But let’s just consider something completely out of the supply chain. Let’s say that the workers on the farm ask for a raise to live a little easier. The farmer agrees, but the money has to come from somewhere. So instead of selling the vegetables at $1.10 each, they sell for $1.50. If nothing else happens, the processor has to raise the price of the vegetables going out the door to $2.50 and then the Warehouse has to raise the price to $3.25, and the grocery store now sells the for $5.00.
But now that vegetables are more expensive, the workers in the processor and the warehouse and the grocery store all need to get a raise to afford to buy them. But there are other people involved as well. The drivers at the shipping company need a raise, and so do the workers who make packaging supplies, and the people who work at the utility company supplying oil and gas, making gas prices go up, and the people who work at the fertilizer plant that provide supplies to the farmer.
Supplies at the farmer are more expensive than they used to be, so they have to raise the prices even more to pay for more expensive fertilizer and gas for their tractors. This is why I said it’s a circle. The farmer now has to pay more and everyone else has to pay more which causes the farmer to have to pay even more the next time around.
Round and Round it goes
This is just a very simplified version of the circle, but you can kind of get the gist that little changes that occur in one area can affect other areas, and each little change can get magnified through the various steps that each segment that each process goes through. When something big happens, like a war and the Strait of Hormuz is closed causing gas prices to go way up, there are consequences as we all saw recently. Fortunately, that is settling out some now and oil prices are coming down, but it will take time for it all to trickle down to us. One person told me that prices go up like a rocket but come back down like a feather. But it will come down. That’s the good thing.
But in essence if nobody ever got a raise, and no natural disasters ever happened, and nobody got greedy (not likely) then we could probably see an inflation rate that approached zero. But I don’t know anyone who doesn’t look forward to a little more money every year or so. Prices will continue to rise, and we’ll all see inflation for the rest of our lives.
The government is trying to keep the amount of increases down, which is why they have a “target” of 2%. I don’t think we’ll hit that anytime soon either, but the closer we get the better!
