If inflation subsides does that mean everything is ok?
Published November 23, 2022
Most surveys show inflation is one of the top issues in the country. The latest reading for September shows the inflation rate is still over 8% when measured on a year-over-year basis. This means the average retail price of what we bought in September 2022 was more than 8% higher than the average retail price of those same products and services in September 2021.
But what if the Federal Reserve is successful in reducing the inflation rate? Does this mean we’re fine? What if, for example, that this time next year the year-over-year inflation rate has dropped to 2% - which, by the way – is the Federal Reserve’s target? Should we be dancing in the streets because we’re now back to where we were prior to the surge in inflation?
The answer is – no! If in September 2023 the year-over-year inflation rate is 2%, this still means average retail prices would have risen 2% between September 2022 and September 2023. The 8% inflation rate between September 2021 and September 2022 would not have been wiped out.
Sure, some prices will go down, particularly basic commodities like fuel and food. But for most products and services, success against inflation means prices rising more slowly, not prices falling. So, when you hear that inflation is falling, what’s really meant is that the rise in inflation is falling. Inflation is still occurring; it’s just not as bad.
But if the pace of inflation is slowing, isn’t that good news? It is, but this doesn’t mean everything is fine. The major problem with inflation is not that prices are rising, but that our wages and salaries don’t increase at the same pace.
The most recent inflation data for September show a year-over-year inflation rate of 8.2%. During the same time period, the average hourly wage rate for workers increased only 5%. This means workers effectively had a pay cut of 3.2%. Or in other words, workers saw their standard of living drop 3.2%. There was also a reduction in inflation-adjusted wage rates for the September 2020 to September 2021 year.
It gets worse. History shows it’s taken a significant period of time for workers to recover their standard of living, even while the inflation rate is moderating. The reason is that a recession is usually the policy prescription used to reduce inflation. And during a typical recession, businesses reduce employment and sometimes cut wages for the workers they keep. Both results cause further erosion in the standard of living.
The bottom line is it may take a while for workers’ incomes to recover from the combined trauma of rising inflation and a job-killing recession, even if the inflation rate is brought back to normal levels.
Consider these track records of recent inflation/recession combos. It took almost twenty years – yes twenty years – for the purchasing power of workers’weekly earnings to recover from the combined impacts of the “great inflation” of the early 1980s and consequent recessions that ultimately cut the annual inflation rate from 13% to 3%.
It wasn’t as bad with later combinations of inflation and recession. Inflation jumped in the latter part of the 2000’s decade and prior to the housing recession in 2007-09. But it took only five years for the purchasing power of wages to get beyond the double pounding of inflation and recession.
Now we’re set up for another challenge. Inflation has been eroding worker incomes for two years, and many economists are predicting a recession later this year or in early 2023. Hence, even if there is some good news in coming months that the inflation rate is moderating, many households will experience a struggle to regain their previous living standards.
Unless, of course, that like many things, the pandemic has changed the rules. One big change has been the lingering labor shortage. Many businesses can’t find enough workers, and they want to keep ones they have.
This sets up a possible scenario where job cuts with an upcoming recession will be minor. The reason is firms have many unfilled positions to cut, and they don’t want to lose the workers they’ve tried hard to keep. Also, firms may be more forthcoming with pay raises in order to keep valued workers. The combination of more jobs and better pay may reduce the time needed to recover the peak purchasing power wages in early 2020, prior to the pandemic.
The conclusions are these. First, lowering inflation doesn’t mean lowering prices. It means lowering the rate of increase in prices. The prices we had before the take-off in inflation won’t return for most products and services.
Second, ]The purchasing power of your salary can be eroded by both inflation and recession. Unfortunately, we may be entering a time period when we have both.
Third – and some good news – this time may be different. Rather than suffering big drops in living standards and years before a full recovery is made, today’s pandemic-made economy may short-circuit the pain, thereby resulting in fewer job losses and a quicker rebound in living standards.
My late mother always said, “plan for the worst but hope for the best.” So, plan for a challenging couple of years ahead, but hope they don’t occur. Is this a good outlook? You decide.
Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.