How inflation became America’s greatest economic problem

360 description topper for all 360s

Inflation 360: OVERVIEW

Inflation has hit its highest level since the early 1980s, with prices rising 8.3 percent in the last year.

The last time inflation, defined as the change in consumer prices over time, was this high was in 1982. It was actually coming down from a peak of almost 15 percent in 1980. The Federal Reserve had responded by choking off economic growth and activity with massive interest rate hikes, plunging the economy into a severe recession and reshaping the world economy for decades to come. The U.S. is hoping to avoid repeating that this time around.

New data is beginning to indicate that “core” inflation — the change in prices of goods and services excluding food and energy, whose volatile price swings tend to be linked to the commodities markets — has peaked.

Hear more from Matthew Zeitlin and Nikhil Kumar about this story:

Still, “inflation is much too high, and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down,” Federal Reserve Chair Jerome Powell said in a news conference last week. It was there that he announced the federal funds rate, the key rate the Fed controls, will rise to between ¾ and 1 percent, a half-percent hike from its previous rate.

We’re already seeing the effects of these hikes. Mortgage rates have risen from just over 3 percent to over 5 percent. The S&P 500 is down 17 percent since the beginning of the year.

The rate hikes may seem modest (the federal funds rate got as high as 19 percent in the early 1980s), but there are expectations that the Fed will get more aggressive in fighting inflation.

The Fed is trying to do something many think is nearly impossible — balancing efforts to cool down the economy without plunging it into a recession and increasing unemployment.

“Typically, you don’t see the declines in job openings in the magnitudes that the Fed is looking for outside a recession,” said Tim Duy, the chief economist of SGH Macro Advisors and an economics professor at the University of Oregon.

But as much as the Fed is wrangling the economy, it has its limits. A major factor in inflation has been issues with global supply chains; the current covid lockdowns in China and soaring oil prices thanks to sanctions against Russia following its invasion of Ukraine are things over which the Fed has no control.

“There are supply-side issues at play,” said Duy. “That is typically outside the realm of the Federal Reserve to deal with.”

Inflation 360: THESIS

Thesis

The Fed has long said it has the tools to deal with inflation and, at least according to the financial markets and some of the price data, they are starting to work. But inflation is affected by so much more than decisions that come from the Eccles Building in Washington, D.C. The Fed cannot control whether Chinese cities go into a prolonged lockdown, the inability of grain to leave Ukraine or sanctions against the Russian oil industry. And there’s more to the domestic economy than the price level. The Fed’s challenge is to try to walk the narrow path between using its tools effectively and plunging the fragile, post-covid U.S. economy into another recession, with untold consequences for the world as a whole.

Labor Lens

Wage growth is improving, but it’s not keeping up with inflation

By Matthew Zeitlin - Domestic Economics Reporter

Powell recently pointed to a high number of job openings per unemployed worker as a sign that the labor market was out of balance. “Wages are running high, the highest they’ve run in quite some time, and they are one good example of … how tight the labor market really is, the fact that wages are running at the highest level in many decades, that that’s because of an imbalance between supply and demand and the labor market,” Powell said in his press conference last week.

The high level of job openings are “evidence of an imbalance in the labor market that is causing the wage growth. Excess demand for workers is putting upward pressure on wage growth and doing so in a way that’s fundamentally inflationary,” Powell said.

“[Powell’s] hope that the underlying economy is so strong and openings outpace the number of new hires, his theory is that you can bring down job openings and not affect the pace of job hiring and that you can manage the soft-landing scenario,” Duy said.

A soft landing would be the Fed bringing inflation back toward its 2 percent target without plunging the economy into a downturn — although it may mean some decline in wage growth.

What isn’t happening yet, the Fed and many outside observers argue, is the dreaded “wage-price spiral” — when workers demand higher wages due to higher prices, businesses in due course mark up prices, and then workers demand higher wages to make up for their eroded real wages. It’s something both progressive and conservative economists seem to agree on.

“We haven’t really seen a whole lot of wage-push inflation yet. We haven’t seen employers saying, ‘Oh wow, I have to pay higher wages and therefore I have to increase prices.’ But I suspect that we will.” said Michael Strain, director of economic policy studies at the conservative American Enterprise Institute.

“The inflation is not coming from the labor market. The price inflation is coming from sectors where you’re not seeing faster wage growth; it seems unrelated,” said Elise Gould, senior economist of the progressive Economic Policy Institute (EPI).

While the precise relationship between inflation and wages matters a lot for the Federal Reserve, it also matters even more for actual workers, who need to buy food, gas and other things with their wages. While the Bureau of Labor Statistics publishes a measure of real wages for full-time workers that shows terrifying swings — up 10 percent over the previous year between April and June 2020 and down over 4 percent at the end of last year — this probably doesn’t tell the whole story.

Gould and her colleagues at the Economic Policy Institute have analyzed labor market data to show that these aggregate real wage numbers are missing something very important. Those workers who lost their jobs in the early months of the pandemic were likely to be lower-paid workers — think servers, hotel staff, retail employees. This means that average wages shot up “mechanically”: Lawyers kept on getting paychecks, service workers went on unemployment. But as these workers returned to the workforce, average wages then went down, again, mechanically, in a way that had nothing to do with inflation, it’s just that a reopened economy meant more jobs at the lower end of the wage scale than before.

When taking this into account, Gould found that the lowest quarter of wage earners had positive real wages in 2021. This year, however, with a more normalized workforce, it’s likely not the same, and “real wage growth is not, on average, beating inflation,” Gould said.

As economists on both the left and right would agree, the correct way to judge the economic situation and the Fed and legislature’s role in driving it is to look at how workers are doing over time. We just don’t have the full picture yet.

Strain argued, “There are totally plausible scenarios where we look back on this, that we traded a longer-term erosion in living standards and longer-term increase in unemployment rate for a temporary burst of activity that only lasted for a year or so” before inflation and a recession took back any gains workers experienced.

“Or,” Strain continued, “we may look at this and say we had a mild recession and the unemployment rate went to 4.5 percent and prices drifted back toward the 2 percent target. It may have taken a year and a half, but for the bottom half of workers, they had wage gains and unemployment is still low.”

Politics Lens

Inflation and rising gas prices are bad for incumbents

By Matthew Zeitlin - Domestic Economics Reporter

But while the jury’s still out on how workers will fare in the long term, for the White House and Democratic congressional majorities, the problem is more immediate.

There is some solid political science research on the link between Americans’ feelings about the economy and inflation. In studying how left- and right-wing parties do electorally in response to economic conditions, University of Buffalo political scientist Harvey Palmer has found that conservative parties, which traditionally have a more affluent voting base, tend to do worse when inflation is high, while left-wing parties, which tend to have more lower-income voters, do worse when unemployment is high.

But unexpected inflation, Palmer argued, tends to be bad for everyone. “It has an effect on views of the competence of the government,” Palmer said. “It’s something unusual, not typical of the recent past and suggests poor management.”

Swing voters, Palmer said, “will be very sensitive to unexpected inflation, they’ll view it as a sign that the Biden administration isn’t doing a good job managing the economy.” And the inflation currently being experienced is not just high but is also unexpected. In March of last year, the Federal Reserve expected so-called core inflation in 2022 to run at 2 percent. When asked to do the same projections at its meeting early this month, the 2022 inflation projection was 4.1 percent, itself a substantial jump from the 2.7 percent projection at the end of last year — but still short of the 5.2 percent it’s currently running at.

One factor that’s left out of that “core” calculation is gas. This core measure is thought to more accurately reflect the rate of inflation that the Fed has meaningful influence over because food and energy prices are linked closely to the prices of commodities, which can shoot up and down for reasons that have nothing directly to do with monetary policy, like a Russian invasion of Ukraine cutting off one of the world’s major wheat exporters from world markets and leading to an American boycott of Russian oil exports.

“Voters want cheap energy and food. If Democrats are unable to lower costs here, this will create added political problems for the party. Midterms are always a challenging environment for the party in power. Inflation only adds to this,” said Ethan Winter, a lead analyst for Data for Progress.

Well, yes and no, said Jonathan Krosnick, a political science professor at Stanford University and one of the authors of the definitive research on the connection between gas prices and presidential approval.

“Controlling for all kinds of other stuff, as gasoline prices go up, historically, presidential approval goes down. There’s every reason to imagine based on that literature, given recent weeks and months, the increase in gas prices would cause Biden’s approval to go down,” Krosnick said.

“Why did it not go down? These are special circumstances; this is a condition under which everyone knows why gas prices went up. It’s because of a war with Russia,” Krosnick said.

Krosnick’s explanation: “Americans are sometimes sophisticated,” giving presidents credit or not depending on their evaluation of whether or not they’re responsible for economic conditions.

But, of course, Biden’s approval ratings are still low. “There’re all sorts of stuff going on — the stock market crashed [Thursday] … other aspects of the economy that are not looking good, that we would expect would translate into dissatisfaction with Biden. There is a sense in which covid is not over, all of that is contributing to his approval rating. The surprising thing given our work is that you would have thought any increase in gas prices would turn into decreases in presidential approval,” he said.

But, the question remains, if inflation moderates, will Biden — and Democrats in Congress — get the credit? That remains to be seen.

War Lens

Russia and Ukraine are critical cogs in the global food and energy supply chains

By Nikhil Kumar - Deputy Global Editor

Which is why ever since the Kremlin invaded Ukraine, global commodity prices — the prices of oil, gas and food — have climbed at a record pace. The war has disrupted supply routes — in particular shipping in the Black Sea, as Ukraine closed its ports and fighting in the area intensified. Air freight costs rose, both as a result of rising fuel prices and the need for cargo jets to navigate away from the region, lengthening flight times. And Western sanctions have hit critical parts of the financial infrastructure Moscow relies upon to do business with the rest of the world, hitting growth and driving up inflation inside Russia — and as a result, affecting other areas such as global energy prices, which have climbed amid concern on the global markets about supplies from the region.

These hikes — coupled with other factors such as the continued impact of pandemic-related supply chain disruptions — are already driving up inflation in several economies around the world, including the U.S. and Europe. Recent figures showed that the impact of surging energy prices had pushed inflation across the Eurozone — the countries that use the euro as their currency — to 7.5 percent in April, the highest on record.

The impact is global, in the sense that many of the commodities affected — oil or wheat, for example — are traded internationally. That means price rises on the international markets affect even those countries that are not directly dependent on supplies from Russia and Ukraine. That in turn feeds into inflation even in faraway places such as the U.S.

Climate Lens

Climate change makes inflation worse, and inflation makes climate change worse

By Dave Levitan - Climate Reporter

Drought, fire, flood and other climate-fueled disasters can cause quick and enduring hits to supply chains, with obvious knock-on inflationary effects. What’s a bit less obvious is the relationship’s somewhat bidirectional nature — while an inflationary state may cause consumers to reduce their use of fuel or food and thus lower emissions, the state-level policy responses to high inflation may act to stall out climate action.

“Shocks to energy supplies and markets can legitimately require management of short-term energy price impacts or the need to ensure that households have adequate heat, but also can be used as yet another excuse not to take action,” Kerr said.

China Lens

Covid lockdowns in China disrupt the supply chain, but they also decrease global demand

By Lili Pike - China Reporter

How is the U.S.’s largest trading partner, China, affecting inflation? The picture is mixed.

Inflation 360: CONCLUSION

Inflation is both a cause and effect of greater economic trends. In some ways, the fact that the U.S. is experiencing higher inflation than many of its peer high-income countries is a straightforward reflection of the strength of its expansive response to the pandemic. Incomes, especially at the lower end, have held up remarkably well in the past two years despite a pandemic that wreaked untold havoc on people’s lives, routines and economic activity.

And because of the restrictions on everyday life and business’s fitful attempts to reopen, many responded by increasing their purchases of goods, snarling supply chains and driving up inflation.

Similarly, the rise in energy prices are partially driven by economic activity being high enough to strain supplies — as well the United States and its allies explicit decision to hamper Russia’s production and sales of oil. That inflation is the outcome of these policies and trends is a sign of economic strength, not weakness.

The challenge now is for the Fed to manage the negative outcomes of this strength without completely negating the bounty it has given us. Nothing less than the prosperity of the country — and the world — hangs in the balance.