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Labor Or Energy Or ???

Inflation is a tax, pure and simple. Who pays the tax is determined by how much consumers (and businesses) spend and on what. The prices of what we buy do not all rise together, proportionately. Gasoline up 40%, used cars by 50%, houses by 20%, food items by varying amounts, but double digits, prescription drugs, the list goes on. President Biden blames inflation on a few large firms that don’t compete, thus being able to charge “above market” prices and make excess profits. There are 6 million employer firms in the U.S., but only 20,000 are “large” (over 500 employees) by Small Business Administration’s reckoning. In addition, there are millions of non-employer firms. Some non-employer firms are looking to grow, others content with being a one-person business, but they are always on the lookout for opportunities to “outperform” other firms and make money.

Main Street firms are raising selling prices. NFIB’s recent Small Business Economic Trends survey found that over two-thirds of owners (68%) reported raising selling prices in February, eclipsing the previous record reached in 1974. With 7 out of 10 employers raising prices, that’s 4 or 5 million firms raising prices at the same time, inflation will appear. These firms don’t know each other, and don’t collude to raise prices, they simply respond to their market conditions.

Energy costs have clearly risen dramatically, with gasoline and natural gas posting increases of 40% to 50% across the country. Historically, rising energy costs have been a problem for small businesses, especially in the early 2000s. In 2008, oil prices exceeded $145 a barrel (currently over $130) and all energy and energy-related goods prices soared. Owners responded by raising prices at a pace not seen since 1980.

Then the recession struck and price cutting became the practice of most firms, attempting to support sales and reduce inventories. Pricing behavior is certainly sensitive to changes in energy costs and small firms tend to spend a higher percentage of their sales than larger ones.

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(series updated every 4 years, 2022 is the next survey)

But a larger, and for many, the largest, business expense is labor. Labor compensation is less volatile over time, shaped by hiring policies and changes in labor law. But it too is driven by supply and demand conditions, just as is the price of energy. From 1973 through 2015, the percent of owners citing labor cost as their most important problem bounced around 5%. But starting in 2016 it began to trend up, most recently reaching 13% in December 2021, a 48-year record high level, rising in concert with the percent of owners citing labor quality as the single most important problem operating their business, which hit a record high 29% in November 2021.

The percent of owners reporting higher compensation for employees has also reached a 48-year record high recently. But so has the percent of owners raising average selling prices. The net impact of this depends on the unknown percentage increases of wages and prices at each firm, but it is clear that the incidence of price hikes moves with compensation, consistent with “wage push” models of inflation. Individual firms have trouble raising prices on their own, but when all or most firms experience the same cost pressures (like an increase in the minimum wage), then price increases become widespread and more frequent.

With both compensation and energy costs rising, firms have plenty of cost motivation to raise prices themselves. But supply chain interruptions have also created pressure for firms to raise prices because inventories are too low and consumer demand is strong, giving rise to opportunities to raise prices, a “demand pull”.

The policies the government will use to fight inflation are not supportive of strong growth. The Administration will not be sending out checks or engaging in other new spending programs, the politics won’t support it. The Federal Reserve will start raising interest rates. This will reduce credit demand and associated spending. It will also reduce the value of all assets, including stocks and homes. All this will reduce demand and give the economy time to resolve the supply problems. No fun, but necessary steps.

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