MainStreet Macro: The New World of Inflation

The Federal Reserve met last week and raised short term interest rates by three-quarters of a percentage point.  That’s the biggest rate hike since 1994.  At that time year-over-year CPI inflation was just shy of 3 percent gas prices were around a $1 a gallon and house price growth was up 2.5 percent from the previous year. 

The stakes are higher now with gas soaring to $5 a gallon, home price growth at double digits and inflation coming in hot at 8.6 percent.

In his press conference, announcing the rate hike, Chair Powell allowed himself to venture from the hard truths of present-day inflation challenges, to contemplate whether the economy has entered a new world of inflation.

You see historically big global supply shocks would slide through the economy quickly, and bumps to prices would fade fast. 

The global economy has been hit with several gigantic supply shocks over the last two years – a pandemic, a reopening, the war in the Ukraine and most recently, a lockdown in China. 

Yet the global economy is not reacting the same way it’s done historically.  These shocks are sticking around and pushing up prices a lot longer than before and inflation has become a global phenomenon.

Leading Chair Powell and the rest of us to ask the question – Have we entered a new world of Inflation?

Here are three signs that inflation is behaving differently now than in the past.

1. Consumer Expectations.

A recent survey showed that consumer confidence on the economy has dropped to the lowest level on record.  The biggest driver of the downbeat sentiment – you guessed it – inflation. Another survey showed that consumer expectations for inflations over the next year has tied its highest level on record.

As we discussed before the expectations of consumers and business have a big impact on inflation. Expectations are where psychology collides with economics.  If Main Street thinks prices are going up in the future, consumers and businesses change their behavior in the present in a way that drives up future inflation – the very essence of a self-fulfilling prophesy.

2. Borrowing costs

Another sign of a shift in inflation now versus in the past is tighter financial conditions, which is just a fancy way to say it cost a lot more for Wall Street and Main Street to borrow money. 

Look at home loans – the 30-year mortgage rate is now at 6 percent, a place it hasn’t been since the height of the financial crisis in 2008.

This is notable because real short -term interest rates adjusted for inflation (the one’s Fed policy directly impacts) are still very low, negative in fact.  Despite short term rates being near rock bottom levels, the rates that consumers and small businesses face are now increasing at a fast pace. 

This is a signal of the end of cheap money that both Wall Street and Main Street had become use too.

3. The jobs market

During the last expansion the economy was able to do something spectacular – achieve record low unemployment without driving up inflation.

If you look at Fed projections for unemployment over the next couple of years, it clear that Fed officials think this feat is going to be harder to achieve achieved in the next couple years.  The Fed expects unemployment to rise from the historically low 3.6 percent rate it is now to a more inflation piercing 4.1 percent.

This idea that low unemployment is not sustainable without overheating the economy is not new.  There’s a name for the tradeoff between unemployment and inflation – the Phillips Curve – that is embedded in ever macro textbook.

This relationship seemed to breakdown in the 10 years leading into the pandemic.  It now looks like this relationship has reconstituted itself with the unwelcomed return of a tradeoff in monetary policy decisions between higher prices on the one hand and job losses on the other.

My Take:

For past 40 years, automation, globalization, aging demographics and low productivity were signatures of advanced economies that kept inflation low.  Even when there were big shocks to supply, disruptions were quickly absorbed by these disinflationary trends.

Disinflationary trends seem to have lost some of their power post pandemic and it’s likely that in this new world, inflation will look and act different than it did in the past with supply shocks becoming more persistent in accelerating price growth.

That means the economy is going to have a harder time supporting the super low interest rates that Main Street and Wall Street had become accustomed to without overheating.

But before we get too dystopian about the future – remember as long price growth is contained and stable, even if interest rates are higher than the super low levels of the past decade, the economy can still do well. It just has to exercise different muscles (higher productivity, being one of them) than it’s had to for a very long time to stay strong.