It’s time to write about inflation again, even though I devoted three columns to it in 2021. In April, I argued that inflation was a distant threat to the still slow economic recovery.
As the months passed, new data confirmed that the economy was in worse shape than it appeared then, but also that inflation worsened faster than expected.
The second column, in August, explained some of the major challenges that economists face in analyzing inflation. It was a column that pushed the need for humility in our understanding of the timing and severity of inflation. The third column, in October, noted the rising price level that was clearly evident to buyers.
To be clear, from April to October, there were many reasons to expect higher prices for goods and services. Federal stimulus payments have pumped money into households and businesses, and the pandemic has forced savings to a record high. Last spring, household savings were two trillion dollars higher than a year earlier, pointing to a wave of spending.
Over the summer, families and businesses spent like crazy on everything from vacations to recreational vehicles and new homes. This caused what many have called “supply chain” disruptions. In fact, US industrial production reached record inflation-adjusted levels, while imports broke all previous records. Supply chains were moving more product than ever before, and they simply couldn’t keep up with the demand from all those pent-up economies.
When people want to buy more of something than you can supply, the prudent businessman raises the price. Likewise, when many companies want to hire you, the cautious worker demands a higher salary. This is how we first see inflation which now appears in the monthly inflation data.
To be clear, the monthly inflation data is not as bad as a year-over-year comparison would suggest. Remember, we’ve had deflation in 2020, so the two-year average price increase is a bit more subdued than the scary headlines. However, this sober, factual analysis doesn’t count for much in the grocery store queue.
In the middle of winter 2022, a large part of household savings is spent, which reduces the urgent demand for goods that we had last summer. This is now showing in the data, with goods inflation slowing slightly, while services inflation has increased. This signals that price inflation also affects wages because labor costs dominate services.
A short-term price shock is generally not something that has long-term negative effects on the economy. A one-time price increase that would also remain permanent. Both of these issues occur from time to time with different products. The deep worry about inflation is that it will last, so the price increase each month will get worse on its own. Last week, I saw the first sign of this prospect.
INside Indiana Business reported that Viewrail, a manufacturing company in Goshen, was offering cost-of-living adjustments to its employees through 2022. They called it an inflation protection plan that would ensure their workers would be protected from a loss of their purchasing power. While this is good for both the employees and the company, it signals that inflation expectations are creeping into the contracts. Or, at the very least, that this employer is worried about losing employees.
To be fair, Viewrail claimed it was out of concern for the employees, and I don’t dispute the motives of these employers. I’m just pointing out that if they’re worried about inflation and wages, surely a lot of other employers are too. If companies raise prices or wages because of last month’s inflation, the problem is self-perpetuating and slowing inflation becomes very difficult. Undoubtedly, the Federal Reserve is now seeing similar warnings across much of the country.
The next scheduled meeting of the Federal Reserve’s Open Market Committee is in March. With recent data suggesting stronger underlying economic conditions accompanied by higher inflation, it seems certain that they will raise rates. Two months ago, casual conversations among economists were that there could be a 25 basis point (25 percentage point) hike in March. Now, most of those I speak with are anticipating a 50 basis point increase, and at least one member of the rate-setting committee has been reported to be in favor of a full percentage increase.
An interesting aspect of inflation is how it affects Americans differently and how that influences political decisions about how to stop it.
In the short term, price inflation tends to affect low-income families more than high-income families. Indeed, low-income households consume goods that are more sensitive to inflation. The effect is not large and the onset of wage inflation effectively erases income differences in its effect. However, in the long term, inflation is much more damaging to high-income households because higher-income families hold more savings.
Inflation affects both goods and services, as well as the price of borrowing. However, a large part of household savings is held in accounts with fixed interest rates. As George Bailey explained in ‘It’s a Wonderful Life,’ the money held in his savings and his loan was not in the bank vault, but in mortgages and small business loans. from the city. This remains true today. Likewise, most savers have money in long-term fixed rate accounts such as municipal bonds.
Inflation quickly degrades the value of paying off fixed rate mortgages and bonds. If severe enough, it can lead to bank insolvency. Indeed, the Savings and Loans Crisis of 1987 was not about greed (a commodity in seemingly constant supply), but was the inflation hangover of the 1970s and 1980s. stopping inflation a major concern of the Federal Reserve.
Inflation benefits borrowers of fixed price assets. Thus, holders of student loans and fixed-rate mortgages benefit from inflation as the real cost of that borrowing declines, while their salaries rise. Of course, this makes long-term borrowing by someone else more expensive, so no one should be happy about that.
We are at the start of an inflationary period, and it seems likely that higher interest rates and other Fed policies will eventually bring inflation down to the target rate of 2.0-2.5%. The magnitude of the rate hike and the speed at which it will take effect can be estimated from the history of interest rates, but the likelihood of history repeating itself remains an open question.