It feels like everything has been constantly changing over the past two years. Like the houseguests who overstay their welcome, we just want it to go away.
But it might be good that we’ve all gotten accustomed to change, because more is coming in the months ahead in the form of higher prices and higher interest rates.
This week, we explain the drivers of – and reaction to – inflation and how they’re putting the U.S. economy in a precarious position, at least in the short term.
1. Higher prices and their hidden pain.
Last week, government data showed that the cost of consumer goods and services rose by 7% in December from a year earlier.
For those who haven’t been keeping track, that’s high. We haven’t seen inflation this elevated since 1982. Even after we strip away volatile food and energy prices, inflation still is up 5.5% from a year ago.
This is bad news for workers. Even though wages have risen during the pandemic, when you account for inflation, real wages are actually falling. That’s a rough spot for both workers and the employers desperately trying to add staff.
Households, too, are feeling the pain. Policymakers tend to discount the importance of higher food and energy costs, but Main Street spends a lot of its money on groceries and heat. That’s especially true for low-income families, where necessities like food, housing and energy eat up a much greater share of the budget.
So not only is inflation high: Low-income households are being hit the hardest.
Source: Bureau of Labor Statistics
2. Higher Spending? It might not be enough.
Last week I explained why we’re all economists. Even if watching the economy isn’t part of your day job, you can track its health by paying attention to consumer behavior.
Consumer spending is 70% of the economy. It’s held up well during the pandemic thanks in large part to unprecedented fiscal and monetary stimulus from Washington.
But consumers changed their spending habits during the pandemic. They’re buying more goods and fewer services than they used to, before the coronavirus invaded our lives. The increased demand for goods came just as the global supply chain was rattled by factory closures, a lack of materials, and labor shortages. The classic demand-supply imbalance contributed to higher prices.
Here’s the problem: In the presence of higher inflation, even robust consumer spending won’t go as far as it normally would to boost the economy. Over time, higher prices might lead people to spend less. That could slow growth.
Moreover, consumers as a whole have less of a financial cushion now than they did a year or two ago. The household savings rate, which was in double-digit territory for the past two years, has dropped to 7%. That’s even lower than the 8% savings rate prior to the pandemic.
And household debt as a share of income, though still low, is edging back toward pre-pandemic levels.
Less savings, more debt. Going forward, Main Street families and businesses will be less willing – and less able – to increase their spending.
3. Higher rates aren’t all bad.
The Federal Reserve has a powerful tool to manage inflation. It’s called the federal funds rate and it represents the interest big banks charge each other to borrow money overnight. The rate also affects short-term borrowing costs for Wall Street and Main Street businesses.
The Fed cut short-term rates to rock-bottom levels at the onset of the pandemic and has kept them there ever since. Low interest rates stimulate the economy by encouraging people and businesses to spend money and invest, thus boosting demand. But if stimulus is left in place for too long, it has the side effect of encouraging inflation.
To mitigate the risk of inflation, the Fed is likely to raise rates in coming months and keep raising them until they’re back closer to pre-pandemic levels.
Higher rates can contain inflation, but the process of increasing rates is not without peril. A recession can result if the Fed raises rates too aggressively. That’s why the central bank is likely to move slowly.
In the 10-year economic expansion that preceded the pandemic, Main Street had become used to super-low inflation and historically low interest rates.
While the cost of borrowing is going up, it’s coming off of ultra-low levels. Even as interest rates edge higher, they’re likely to remain historically low even years from now.
The greater concern is what’s happening right now. Higher inflation has hit just as pandemic relief, including cheap borrowing, is expiring.
We’ve reached a fragile point in the economic recovery.
The good news is that the economy writ large remains on strong footing. And positive change is under way. Supply chain logjams will lessen, consumer demand will stabilize and inflation will moderate.
That would be a winning combination for Main Street.
How is inflation affecting your business? Email us at [email protected].