Everything is more expensive. Prices overall
are about 13% higher than they were in April
2021, with the cost of groceries rising by
nearly 20% over that time and the cost of gas
up 22%.
It's even expensive to stay home.
For example, the cost of electricity has surged
21%.
Reducing inflation is the number one long term
objective of central banking right now.
And that's true in the US as well as globally.
Sometimes inflation is like a shock because it
destroys the consumer's real income.
We look back in the early days of inflation, the
Fed was using this term "transitory" to describe
inflation because they thought a lot of the
things that were causing prices to go up in the
near term were related to the pandemic.
They thought eventually that stuff would just
dissipate. Well, it really hasn't.
The Federal Reserve is using the most powerful
tool it has to slow down the inflation creep,
interest rate hikes.
It is a very effective way.
The problem is it's as much an art as a science.
Different parts of the economy respond
differently to changes in interest rates.
One of the things that people don't understand
is that inflation really might be benefiting them
in ways they don't fully acknowledge.
There are winners and losers. There are
certainly people in the economy for whom this is
the major challenge and there are people in the
economy for whom this is a big opportunity.
So why does inflation stick around?
Is anyone benefiting from it?
And how do we get rid of it?
Inflation is simply the rate of increase in
prices in the economy.
Inflation can occur for a number of reasons.
One is supply and demand issues, meaning there's
too much money to go around or not enough
things to go around.
Another catalyst: the cost of doing business
increases, which leads to companies raising
their prices. All of those things happened at
scale in the past three years.
Prices skyrocketed in a very volatile
environment. But now that we're past the worst
of the pandemic induced stressors, prices are
still struggling to stabilize.
It's difficult for businesses to figure out
how to set exactly the right price.
When do the prices of things change?
Some goods change prices frequently.
If you go to the gas station, it's different
every time. If you think of other things that we
pay for like college tuition or rents or even
something simple like the cost of a movie
ticket, those things have lower frequency
resets.
Also it's difficult for consumers to do their
shopping. If you put something in your
shopping basket and you come back the next
morning and it's a different price, you
might feel not good about that and not like
the firm that's doing that to you.
And because of these reasons, the firms often
leave their prices stable for a period of
time. Inflation also has a funny component that's
expectations driven, meaning if we expect
prices to go up in the future, that's probably
going to happen.
If we think, for example, that inflation is going
to stay higher for longer, I will be
inclined to price that in because I only get to
reset my prices once or twice a year.
So I'm building in an expectation that
inflation may stay higher for longer.
Actually doing that may mean inflation stays
higher for longer.
But if I expect for prices to be stable, if
I'm convinced the Federal Reserve is going
to do their job and get rid of inflation and
stabilize prices, well, I should stabilize my
prices as well. So part of the battle that we're
fighting when we fight inflation is the battle
of expectations.
When inflation expectations are high, it
tends to influence behavior.
It will make people think, well, I'm paying
more for goods, so I need more money.
And then in turn, business owners will say,
my employers are going to come to me for raises,
so therefore I need to raise prices so you can
see where this goes. It just creates kind of this
vicious cycle.
Economists would call it a "wage-price spiral"
whereas prices go higher, wages will go
higher and then prices will continue to go
higher. And those things just start to chase each
other. And it perpetuates this kind of
vicious cycle of inflation that we've
seen.
A very strong labor market or an overheated
labor market can be one factor in pushing
inflation higher.
There's a tension here.
Workers have been steadily losing out for
decades while firms are gaining more and more
profit share. But the other problem is that the
primary driver of inflation right now is
not stuck supply chains.
It's really the wage piece.
A worker shortage contributed to pushing
wages and prices higher.
Workers have seen big pay increases since early
2021, which led to record job openings, high
turnover and the unemployment rate at
historic lows.
But there are signs that wage growth is cooling,
with layoffs skyrocketing in 2023
across different industries.
People care about inflation because of the
low unemployment. The ability to change jobs
for higher pay is a result of low
unemployment. And so we may increase their base
salaries to say please stay.
The only way to correct for overpaying on base
salary is reductions in force: layoffs.
It's a challenge for businesses because it's
mostly coming from wages and they have to find
ways to be profitable despite the rising cost
of labor. But that's not a challenge for the
workers that are getting those higher wages.
So there are some people who are benefiting
because they're getting paid more and they're
getting paid more relative to the profits
of business that have been high for a long
time. Typically in inflationary periods,
wages don't keep up, and it's the price of goods
that are going up more than the cost of labor.
But this is an unusual episode where it seems
like right now the main driver of inflation is
actually labor costs.
And what that means actually is that workers
are gaining.
There's a balancing act when it comes to tackling
inflation because we generally don't want to
stop prices from rising completely.
The Fed considers an inflation rate of about
2% to be signs of a growing economy.
If you have no inflation, that implies
that things are just generally flat.
And if you look at times through history when
we've had extremely low inflation rates, it has
coincided with very slow growth.
The goal is to make price changes so minimal on
average over time that the average household and
the average firm doesn't think about it when
they're making their spending and investments
and hiring decisions.
The primary tool is monetary policy.
And here we're talking about the Federal Reserve
raising short term interest rates to slow
down economic activity and slow down demand.
When the Federal Reserve raises rates that
quickly, it changes the impetus to borrow if
you're a US consumer and it changes the impetus to
lend if you're a bank.
It sort of slows nominal demand and with the
slowing of nominal demand, if we think about
a steady state of supply, with that steady
state of supply, with lower demand, brings in
the generalized price level.
The Fed's goal is to slow down the increase in
prices, not to make prices go down below
where they were originally, which
economists call "deflation."
Deflation is pretty harmful because if prices
are going down, then a lot of consumers will
say, 'Well, why do I want to buy something
today that will be cheaper tomorrow?' And so
it's usually associated with very low demand and
a recessionary state.
But interest rate hikes can also lead to some
pain for consumers.
Sometimes slowing inflation down, reducing
demand means the labor market weakens, and that
could mean consumption slows, activity falls,
and you do get a recession. It's not a
pleasant trade off for policymakers to run that
risk of saying, well, we need to slow the economy
down to bring inflation down.
Yes, it means we're risking a recession.
But the long run history – here I'm
talking across decades – suggests the best outcome
for the US economy or any other economy in
general is when inflation is low and
stable and we're not talking about it.
So at times that does mean you have to risk a
recession, but evidence suggests that's the right
thing to do if it means that inflation will be
low and stable over time.
There's also a consumer behavior component to
slowing down inflation.
There is that quote: "Nothing like high prices
cures high prices." And it's in some ways
reflective of the fact that the consumer solves
a lot of the problem, even without the help of
the Federal Reserve or anything else on their
own by restricting demand to come in line
with supply.
Eventually prices will hit a point where
consumers will just say, okay, enough, I'm not
going to buy this good anymore. And that will
result in some other things: Either consumers
just won't buy anything.
They'll just say, we're not going to buy cars
anymore because car prices are too high.
What consumers will sometimes do then is that
they'll substitute.
Instead of buying those higher priced goods,
they'll buy lower priced goods and that in turn
will help kind of pull prices down.
Obviously, if your goods aren't selling, what are
you going to do? You're going to cut prices.
It's been a little over a year since the Fed first
started hiking interest rates in March 2022.
There are signs that economic growth is
slowing, which is what the Fed thinks the
economy needs. But the current rise in prices is
still above the Fed's goal of 2%.
The Fed uses the Personal Consumption
Expenditures Price Index, or PCE, as its
inflation indicator.
The year over year changes in PCE peaked in
April 2021 at 30%.
That number was down to around 6% year over year
change in March 2023.
We're looking at more normalized levels of
inflation for the first time really in history
without a recession.
Consumers still have a lot of money.
They're still able to buy things.
And I think anybody who has tried to get a
restaurant reservation lately can see that
anybody who's tried to book a vacation can see
that people are still out there spending money.
And that, of course, is in itself inflationary.
There are also global factors at play.
The US actually imports some inflation from the
rest of the world and that's because we import
some of our goods and services that we consume.
If you get a good that was produced in Mexico
and the price of goods in Mexico is rising, well
then probably that import from Mexico is
more expensive here as well.
And that shows up as higher goods prices in
the United States.
I think the big question now is will it remain
sticky and have we seen something that's
necessarily going to change the outcome over
the next decade versus our prior decade?
And I'd say the jury's still out on that.
Markets are kind of saying we can get down to
2% even by the end of 2023, early 2024.
We think it'll happen by the end of 2024.
The Fed thinks sometime in 2025.
I think that's feasible.
Yes, we will be risking a recession in the
process, but if we get one, it would likely be
shallower than the average recession.
Obviously not desirable, but might be the right
trade off for for the long run.
The goal is for you and I to never really need to
have a conversation about inflation.
So how will we know when we're winning and when
policy is working?
It's when conversations like this will shift back
to other things.