Dan Sutter: The pain of inflation
Inflation is a top concern of voters. Yet economists generally argue that the costs of inflation are exaggerated. Can we reconcile these views? To begin, inflation as measured by the Consumer Price Index (CPI) has fallen significantly since hitting 9.1 percent in June 2022. Inflation was 7 percent for all of 2022 but only 2.9 percent in July. Remember also that inflation is the rate of change in prices. A decline in inflation means that prices are increasing slower. To return prices to 2021 levels would require negative inflation, or deflation. Economists normally think about a “pure” inflation, or equal percentage increases in all prices, including wages and salaries. Five percent inflation then is a five percent increase in the prices of all goods, services, and labor. The increase in wages should offset the higher prices (ignoring tax impacts). An increase in the prices of only some goods is a change in relative prices. A ten percent price increase for food, energy, and transportation might increase the CPI by five percent. This is not, strictly speaking, inflation and since wages do not rise, people will be worse off. I think economists should focus on how inflation impacts families. Understanding decisions as viewed by the subjects of our analysis is a core element of economic research. The CPI measures the cost of purchasing an average market basket of goods which no household probably buys. The effective inflation rate for households depends on the things they buy. Today some face more than 2.9 percent inflation. Raises do not come automatically with price increases except with a COLA or Cost of Living Adjustment. COLAs adjust wages or salaries as the CPI rises. Social Security benefits get COLA adjustments, but only about one in ten private sector employees have COLAs. Consequently, most workers are not guaranteed an offsetting raise. Inflation therefore generates uncertainty, which is stressful. Also, many Americans’ “raises” came from changing jobs, which entails its own costs and stresses. An offsetting raise, if received, comes after prices rise. Monthly budgets were still stressed during 2022 even for those receiving a seven percent raise at year’s end. Wages generally lag prices in the inflation race. Many Americans do not save annually and have little accumulated savings. Higher prices for essential items create hard decisions. Most economists can afford an extra $100 a month for groceries without a raise. We fail to recognize the burden higher prices impose on many families. A change in calculating the CPI may heighten the divergence between measured and felt inflation. Substitution bias contributed to the CPI overstating the inflation rate. The CPI market basket does not change monthly as prices rise and fall, but consumers will respond. To illustrate, suppose Coke and Pepsi initially sell for $4 a bottle. The price of Pepsi rises to $6 while Coke stays at $4, a 25 percent increase in the average soda price. The impact on consumers is less than the 25 percent increase resulting from both prices rising to $5. Many will substitute Coke for Pepsi here. Beginning in 1999 the Bureau of Labor Statistics began adjusting the CPI for substitution bias, which makes sense. But consumers miss out on some satisfaction even if substitution keeps budgets from busting. A final consideration involves the COVID and lockdown supply chain disruptions. Shortages create significant economic pain, in several ways. To see how, during the baby formula shortage, desperate parents drove from store to store. The time and gas spent searching increase the effective price of formula when finally purchased. Items not consumed reduce consumer satisfaction. And shortages produce uncertainty. The prices necessary to keep some items in stock provide a way to value the impact of shortages. Measured inflation if prices had risen like this would have significantly exceeded seven percent. To be precise, this pain is due to the shortages and not inflation. But people likely associate it with recent inflation. A simultaneous equal percentage increase in all prices and wages might not be very painful. But that’s not how inflation works. Recognizing the felt pain illuminates Americans’ concern with inflation. Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.
Daniel Sutter: The battle against inflation
Inflation fears rose briefly during 2018, as the increase in the Consumer Price Index (CPI) approached 3 percent. In 1980, three percent annual inflation would have set off celebrations. Our success in reducing inflation provides a lesson about policy making by elected officials. To avoid confusion we should be clear about the meaning of inflation. Americans often mean the cost of living when they say inflation. Economists, by contrast, specifically mean an increase in the overall price level. A pure 5 percent inflation would be exactly a 5 percent increase in every price. Salaries and wages are prices and would be included. Inflation should not reduce the ability of households to buy goods and services, as income and expenses both increase equally. Economists call an increase in the price of gasoline or housing a change in relative prices, not inflation, even though either raises living costs. Housing costs more in New York or San Francisco than in Alabama. That the cost of living in Manhattan is more than double that in Montgomery matters for weighing job offers. Differences in living costs, however, are also not inflation. The CPI does not include wages and rises even for relative price increases, yet still measures inflation pretty well. The annual change in the CPI exceeded 10 percent in 1974 and 1979-1981, hitting 13.5 percent in 1980. By 1983, inflation was below 5 percent and has only topped this level once since. The U.S. has not been the only nation to bring inflation under control. U.S. inflation fell from 8.5 to 1.7 percent over 1974-83 and 2008-17. Yet over these decades, inflation fell from 11.3 to 1.1 percent in France and from 16.7 to 1.1 percent in Italy and Spain. Even Latin America has experienced progress; inflation fell from 33 to 4 percent in Mexico and from 112 to 6 percent in Brazil. International success argues against a uniquely American explanation for our decline in inflation. For instance, I might wish to credit Ronald Reagan for defeating inflation. While President Ronald Reagan undoubtedly deserves some credit, a “great person” story would require great leaders in many nations, which seems less likely. During the 1970s, many blamed inflation on rising world oil prices. A decline in oil supply would raise oil prices and hike the CPI, but would be a relative price change, not inflation as defined by economists. And significant oil price increase last decade did not produce double digit inflation. One economist who never wavered about the cause of inflation during the 1970s was Milton Friedman, who insisted that “inflation is everywhere and always a monetary phenomenon.” Governments and their central banks, like our Federal Reserve, inflate the money supply, driving up prices. Behind the focus on oil, the Federal Reserve did indeed fuel the 1970s inflation with money supply growth. With Paul Volcker as Federal Reserve Chair and Ronald Reagan in the White House, the brakes were put on the money creation and inflation fell accordingly. The economics profession now largely accepts that Professor Friedman was right on inflation. Why then did so many nations cause themselves the pain of inflation? And what has changed? Monetary economists have identified central bank independence as a key. A central bank is like a bank for the nation’s banking system, and generally controls the money supply. Politicians find easy money and credit irresistible, particularly when running for reelection. If politicians have too much control, they will inevitably inflate the money supply. The Federal Reserve has always had some political independence. When the Fed Chair and Governors want monetary stability, as Mr. Volcker and his successor Alan Greenspan did, they can often prevail over the President and Congress. Other nations increased their central banks’ independence, based on economists’ advice. The European Central Bank was modeled on Germany’s independent Bundesbank. People are imperfect and face problems of self-control. Our elected officials are human, and the potential to shift blame in politics exacerbates self-control problems. The world’s success battling inflation shows that elections alone do not always ensure wise economic policy. Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University and host of Econversations on TrojanVision. The opinions expressed in this column are the author’s and do not necessarily reflect the views of Troy University.
