October's CPI (consumer price index) inflation report was a doozie. Year-over-year, inflation rose at a 6.2% rate through October, the fastest rise in 30 years.

When the inflation debate was kicking off early this year, one of the primary arguments against persistent inflation was that the COVID shutdown period in the first half of 2020 was distorting the comparisons — i.e., that inflation only looked high today because it had been so low a year earlier. October's report blows any vestiges of that idea away, as not only was the annual increase massive, the increase from the prior month (September) was a whopping +0.9%. Obviously September 2021 wasn't a particularly depressed starting point to measure against. Worse yet, the inflation wasn't confined to specific areas of the economy — prices rose in nearly every category in October.

So much has been said about inflation — the transitory narrative, the supply chain disruptions, the energy component, Fed money printing, prospects for how this resolves — that I think many people are confused about what's really going on. At the risk of oversimplifying a complicated subject, I think the current inflation dynamic boils down to one pretty simple thing.

We've got way too much demand for the current level of supply.

Simple right? Supply and demand. The following chart, from the wonky Bridgewater report It’s Mostly a Demand Shock, Not a Supply Shock, and It’s Everywhere, makes the case pretty clearly.

The red line shows the supply of goods being pretty steady in the pre-COVID years. Then you can clearly see the drop in supply during the crisis. But contrary to the current narrative, you can also see that the supply of goods has already bounced back to surpass its pre-Covid levels this year.

So the problem isn't supply — the red line. That's back above the pre-COVID trend. The problem is the blue line, which is demand. The massive gap between current supply and current demand isn't because of shutdowns and backlogs at ports, as we're being told. It's because demand has simply exploded higher since the depths of the COVID crisis. When demand runs way higher than supply for a prolonged period of time, higher prices are the typical mechanism of closing that gap (at least in the short term).

As the Bridgewater report states, "There are not enough raw materials, energy, productive capacity, inventories, housing, or workers." So it's not as if these other factors aren't playing  a role. They are. But at the end of the day, that booming demand is the primary culprit.

How did we get here?

The government pumping money directly into citizens' hands throughout 2020 and early-2021 was clearly the game changer and the primary difference between the aftermath of the 2008-09 recession and what we've seen over the past 18 months. Both periods saw central banks stimulating like crazy. But unlike 2009, when there was no broad-based inflation as the Fed embarked on its Quantitative Easing policies, this time around the inflationary dynamic has been profound. The difference has been the government putting money directly in consumers' hands. Not surprisingly, they've been spending it.

The current administration claims that passing even more spending is going to cure the inflation problem. Hopefully, the chart above makes it clear why the opposite is, in fact, the case. Stimulating demand further via more "free money" is the worst thing we could do when supply can't even meet current demand.

Yes, getting the ports open and the supply chain issues resolved will help, although there's the counterbalancing force of nearly every business in the country needing to rebuild their inventories. In time, these dynamics will work their way out (the core of the "transitory" idea). But there's no quick fix there.

What does "Transitory" even mean?

When Fed Chairman Powell started telling America that inflation was transitory back in the early part of 2021, this is not what he meant. It's pretty clear the Fed has been surprised by the strength and duration of this inflationary pulse. That kind of surprise can happen when you run unprecedented fiscal and monetary experiments in real time.

But importantly, there's also a disconnect between what the Fed means when they say "transitory," and what normal people think when they hear that.

To the Fed, transitory inflation is a spike in the inflation rate that peaks and declines relatively quickly. We can debate "quickly" in this context, but that's the idea.

What many normal people hear is something different. They hear "transitory inflation" and think "prices will go up but then come back down."

Those are two totally different ideas. Here's a quick example to illustrate.

Over the past 12 months, we know that CPI inflation has increased 6.2%. Let's pretend that a year from now we're looking at an October 2022 CPI increase of +3.6%.

From the Fed's point of view, that would (marginally) fit within the "transitory" framework. Inflation spiked up to 6.2% and then gradually receded back to 3.6%. A bit higher than their 2% target, but then again, that was the idea of the shift in 2020 to "average inflation targeting" which would allow inflation to run a bit higher than 2% after years of it lagging that mark.

From the perspective of the man on the street, however, a year of 6.2% inflation followed by a second year of 3.6% inflation is radically different from "prices will go up and then come back down." What those two years of inflation are, in fact, is a 10% price hike on the things they buy in the span of two years. Or perhaps to frame it a little differently, in the case of a retired couple with a small nest egg — it's the theft of 10% of their lifetime savings (via the 10% reduction in their purchasing power). In two years time.

Kind of gets the blood boiling when we look at it that way, doesn't it? Raises all kinds of uncomfortable questions, like "So what is the appropriate degree of theft inflation?"

Conclusion

That's probably a good place to leave this post, before I get all wild-eyed and start talking about sound money, gold, bitcoin, and Nixon's closing of the gold window 50 years ago...

In closing though, keep in mind that in order for these headline inflation numbers to keep rising, they have to not only hold the price increases of the past year, they have to then exceed them by whatever the new CPI percentage is. That's a good news/bad news scenario.

On the positive side, that's why I'd be surprised to see these CPI figures go significantly higher. I don't expect to see these inflation numbers fall rapidly either, but I doubt we've just hit 6% on the way to 10%. (I reserve the right to amend this statement if the rest of the $3.5T Congressional spending package passes! But I don't think it will.)

On the negative side, you've just learned why a decline in CPI from 6.2% to 4.2% (or whatever) in the months ahead is hardly a "win." Smaller numbers are better than bigger numbers, but they all stack cumulatively.

There's lots more to say about this in terms of how this likely resolves and what the implications are for 2022 as a result. We'll tackle those subjects as we head toward the new year.