In the past few months, several folks asked if recent inflation is the worst it has ever been. To those sweet summer children, I say what should be obvious, inflation has been much worse.
That is why economists at the Federal Reserve are burning the midnight oil trying to figure out how much monetary tightening will be needed to prevent it from worsening. A far better question is how does inflation affect the economy, and also, who benefits and who bears the cost?
It’s important to note that inflation has toppled governments, throwing power to ruthless despots from Hitler to Mugabe. And yet, those were events unlike ours in every conceivable way. I have a 1 million Reichmark bank note and a 1 million Zimbabwean dollar note to prove it. Neither of these were worth their face value in toilet paper when printed.
The inflation we suffer is of the more ordinary kind. Year over year, the price level has risen at just over 8% for the last quarter. As I mentioned before, most of that increase is a result of the many steps that the Trump and Biden administrations, Congress, and Federal Reserve took to sustain the economy through the COVID-19 pandemic. Some of it is due to real economic shocks, such as oil price increases because of Russian attacks on Ukraine.
The Federal Reserve is charged with sustaining price stability in the U.S. This inflationary period showed them to be less effective than they wished, but I am not sure anyone else would’ve done better.
The Russian attack is outside their control, and the official economic data in 2021 was unreliable due to massive job swings after the pandemic.
To put it in context, we have a lot more data on earthquakes and hurricanes than we do on inflation, and those phenomena are two things we humans are bad at forecasting. It seems unlikely we can predict inflation spikes any better with today’s understanding of the problem.
We measure inflation by looking directly at prices. The Bureau of Labor Statistics collects data on prices in many different ways. There are price indices on producer prices for hundreds of different products. These tell us the potential for increases in consumer prices in the coming months. For consumer price changes, the BLS constructs a hypothetical “basket of goods” the typical family might buy in a month. There are 400 or so items in that basket. They then collect price data, and make an honest effort to control for changes in the quality of goods.
Most folks tend to focus on gasoline prices because they are so visible, and most consumers don’t change their buying patterns very much if the price increases. Economists worry about gas prices because transportation costs are part of the cost of making everything.
Inflation affects families differently based on how they save, what they buy, and how they earn their income. The actual effects are pretty surprising and counterintuitive.
Over the long run, inflation penalizes those who save and benefits those who borrow. In particular, anyone borrowing or lending on a long-term fixed-price loan is affected. For example, if you took out a 3.25% 30-year, fixed-rate mortgage last year, your interest rate is currently -5.25 percent. If you granted that loan, you are losing money. Again, inflation hurts those who save and helps those who borrow. This mostly benefits less-wealthy households.
Inflation also affects families differently due to the ways they earn their incomes. Retirees who live off income from savings are obviously struggling from the secondary effect of a stock market decline. This is offset partially by much more generous cost-of-living adjustment (COLA) increases from Social Security. These are based on a basket of goods that are more sensitive to inflation than the average retiree experiences. Likewise, federal employees and military service members typically have COLA adjustments that are roughly in line with inflation.
State and local government employees almost never see inflation adjustments at this level. Thus state, municipal, and school employees have experienced real pay cuts of 4% to 6% this year, and higher next year. This will be particularly acute in states with biennium budgets. For example, Indiana’s teachers will end next year with an inflation-adjusted salary that is perhaps 10% below that of last summer. It may be worse.
Private sector workers in industries with price flexibility will typically fare better than inflation. Firms will have some ability to raise wages in these sectors; whether they do so depends upon how valuable individual employees are to the business.
Inflation affects families and businesses differently. For some, especially borrowers, it is a short-term panacea, but for most others, it means lower living standards and incomes. Short-term inflation rarely has left lasting damage on an economy, and there are plenty of reasons to think inflation will lessen in the coming months. Long-term inflation slows growth as businesses invest less in the domestic economy. Over time that risks stagflation, which is the combination of inflation and stagnant growth. That would be bad news for everyone.