How inflation became America’s greatest economic problem
The last time inflation was this high, the Fed engineered a severe recession. Unfortunately, the problem is much more complex now. Can the off-ramp to spiking inflation go better this time?
What are 360s? Grid’s answer to stories that deserve a fuller view.
Inflation has hit its highest level since the early 1980s, with prices rising 8.3 percent in the last year.
The last time inflation, defined as the change in consumer prices over time, was this high was in 1982. It was actually coming down from a peak of almost 15 percent in 1980. The Federal Reserve had responded by choking off economic growth and activity with massive interest rate hikes, plunging the economy into a severe recession and reshaping the world economy for decades to come. The U.S. is hoping to avoid repeating that this time around.
“I know families all across America are hurting because of inflation,” President Joe Biden said in public remarks on Tuesday, calling fighting inflation America’s “top economic challenge right now.”
New data is beginning to indicate that “core” inflation — the change in prices of goods and services excluding food and energy, whose volatile price swings tend to be linked to the commodities markets — has peaked.
Still, “inflation is much too high, and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down,” Federal Reserve Chair Jerome Powell said in a news conference last week. It was there that he announced the federal funds rate, the key rate the Fed controls, will rise to between ¾ and 1 percent, a half-percent hike from its previous rate.
We’re already seeing the effects of these hikes. Mortgage rates have risen from just over 3 percent to over 5 percent. The S&P 500 is down 17 percent since the beginning of the year.
The rate hikes may seem modest (the federal funds rate got as high as 19 percent in the early 1980s), but there are expectations that the Fed will get more aggressive in fighting inflation.
The Fed is trying to do something many think is nearly impossible — balancing efforts to cool down the economy without plunging it into a recession and increasing unemployment.
“Typically, you don’t see the declines in job openings in the magnitudes that the Fed is looking for outside a recession,” said Tim Duy, the chief economist of SGH Macro Advisors and an economics professor at the University of Oregon.
But as much as the Fed is wrangling the economy, it has its limits. A major factor in inflation has been issues with global supply chains; the current covid lockdowns in China and soaring oil prices thanks to sanctions against Russia following its invasion of Ukraine are things over which the Fed has no control.
“There are supply-side issues at play,” said Duy. “That is typically outside the realm of the Federal Reserve to deal with.”
The Fed has long said it has the tools to deal with inflation and, at least according to the financial markets and some of the price data, they are starting to work. But inflation is affected by so much more than decisions that come from the Eccles Building in Washington, D.C. The Fed cannot control whether Chinese cities go into a prolonged lockdown, the inability of grain to leave Ukraine or sanctions against the Russian oil industry. And there’s more to the domestic economy than the price level. The Fed’s challenge is to try to walk the narrow path between using its tools effectively and plunging the fragile, post-covid U.S. economy into another recession, with untold consequences for the world as a whole.
Wage growth is improving, but it’s not keeping up with inflation
Inflation presents a conundrum for policymakers. The Federal Reserve and the Biden administration have touted the idea that the economy “running hot” can lead to lower unemployment and higher wages for workers, especially those with lower incomes or who typically have trouble finding and keeping work during normal economic times. While the past two years have hardly been typical economically, there is some evidence that the economy’s extremely high activity levels following the downturn in the spring of 2020 benefited those at the bottom — and that those gains could be imperiled, both from inflation itself and from slowing down the economy to fight it.
Powell recently pointed to a high number of job openings per unemployed worker as a sign that the labor market was out of balance. “Wages are running high, the highest they’ve run in quite some time, and they are one good example of … how tight the labor market really is, the fact that wages are running at the highest level in many decades, that that’s because of an imbalance between supply and demand and the labor market,” Powell said in his press conference last week.
The high level of job openings are “evidence of an imbalance in the labor market that is causing the wage growth. Excess demand for workers is putting upward pressure on wage growth and doing so in a way that’s fundamentally inflationary,” Powell said.
“[Powell’s] hope that the underlying economy is so strong and openings outpace the number of new hires, his theory is that you can bring down job openings and not affect the pace of job hiring and that you can manage the soft-landing scenario,” Duy said.
A soft landing would be the Fed bringing inflation back toward its 2 percent target without plunging the economy into a downturn — although it may mean some decline in wage growth.
What isn’t happening yet, the Fed and many outside observers argue, is the dreaded “wage-price spiral” — when workers demand higher wages due to higher prices, businesses in due course mark up prices, and then workers demand higher wages to make up for their eroded real wages. It’s something both progressive and conservative economists seem to agree on.
“We haven’t really seen a whole lot of wage-push inflation yet. We haven’t seen employers saying, ‘Oh wow, I have to pay higher wages and therefore I have to increase prices.’ But I suspect that we will.” said Michael Strain, director of economic policy studies at the conservative American Enterprise Institute.
“The inflation is not coming from the labor market. The price inflation is coming from sectors where you’re not seeing faster wage growth; it seems unrelated,” said Elise Gould, senior economist of the progressive Economic Policy Institute (EPI).
While the precise relationship between inflation and wages matters a lot for the Federal Reserve, it also matters even more for actual workers, who need to buy food, gas and other things with their wages. While the Bureau of Labor Statistics publishes a measure of real wages for full-time workers that shows terrifying swings — up 10 percent over the previous year between April and June 2020 and down over 4 percent at the end of last year — this probably doesn’t tell the whole story.
Gould and her colleagues at the Economic Policy Institute have analyzed labor market data to show that these aggregate real wage numbers are missing something very important. Those workers who lost their jobs in the early months of the pandemic were likely to be lower-paid workers — think servers, hotel staff, retail employees. This means that average wages shot up “mechanically”: Lawyers kept on getting paychecks, service workers went on unemployment. But as these workers returned to the workforce, average wages then went down, again, mechanically, in a way that had nothing to do with inflation, it’s just that a reopened economy meant more jobs at the lower end of the wage scale than before.
“More than 1 in 6 jobs in service occupations (18.7%) were lost in the first year of the pandemic; gains in the last year bring the job shortfall to 9.9% of pre-pandemic levels,” Gould and her colleague Jori Kandra wrote in a report for EPI.
When taking this into account, Gould found that the lowest quarter of wage earners had positive real wages in 2021. This year, however, with a more normalized workforce, it’s likely not the same, and “real wage growth is not, on average, beating inflation,” Gould said.
As economists on both the left and right would agree, the correct way to judge the economic situation and the Fed and legislature’s role in driving it is to look at how workers are doing over time. We just don’t have the full picture yet.
Strain argued, “There are totally plausible scenarios where we look back on this, that we traded a longer-term erosion in living standards and longer-term increase in unemployment rate for a temporary burst of activity that only lasted for a year or so” before inflation and a recession took back any gains workers experienced.
“Or,” Strain continued, “we may look at this and say we had a mild recession and the unemployment rate went to 4.5 percent and prices drifted back toward the 2 percent target. It may have taken a year and a half, but for the bottom half of workers, they had wage gains and unemployment is still low.”
Inflation and rising gas prices are bad for incumbents
But while the jury’s still out on how workers will fare in the long term, for the White House and Democratic congressional majorities, the problem is more immediate.
A wide raft of polling shows that Americans, despite continued strength in the labor market, are not happy with the economy and are especially worried about inflation. In March, the University of Michigan’s consumer sentiment index hit its lowest point since the aftermath of the Great Recession in 2011. Gallup’s measure of economic confidence is at a lower point than it was in April 2020. Around 40 percent of those surveyed by Gallup mentioned economic problems as “the most important problem facing this country today,” with almost a quarter mentioning the cost of living, inflation or gas prices.
In a CNN poll done at the end of April, Biden had a 41 percent approval rating and was 32 points below water on his handling of the economy, and 55 percent of respondents said that his policies had “worsened economic conditions in the country.”
There is some solid political science research on the link between Americans’ feelings about the economy and inflation. In studying how left- and right-wing parties do electorally in response to economic conditions, University of Buffalo political scientist Harvey Palmer has found that conservative parties, which traditionally have a more affluent voting base, tend to do worse when inflation is high, while left-wing parties, which tend to have more lower-income voters, do worse when unemployment is high.
But unexpected inflation, Palmer argued, tends to be bad for everyone. “It has an effect on views of the competence of the government,” Palmer said. “It’s something unusual, not typical of the recent past and suggests poor management.”
Swing voters, Palmer said, “will be very sensitive to unexpected inflation, they’ll view it as a sign that the Biden administration isn’t doing a good job managing the economy.” And the inflation currently being experienced is not just high but is also unexpected. In March of last year, the Federal Reserve expected so-called core inflation in 2022 to run at 2 percent. When asked to do the same projections at its meeting early this month, the 2022 inflation projection was 4.1 percent, itself a substantial jump from the 2.7 percent projection at the end of last year — but still short of the 5.2 percent it’s currently running at.
One factor that’s left out of that “core” calculation is gas. This core measure is thought to more accurately reflect the rate of inflation that the Fed has meaningful influence over because food and energy prices are linked closely to the prices of commodities, which can shoot up and down for reasons that have nothing directly to do with monetary policy, like a Russian invasion of Ukraine cutting off one of the world’s major wheat exporters from world markets and leading to an American boycott of Russian oil exports.
Gas prices have risen dramatically since the pandemic, going up from $1.77 a gallon in April 2020 to $2.39 when Biden took office and then rising dramatically following the Russian invasion of Ukraine from $3.50 to $4.18 today. It is conventional wisdom that high gas prices are not good for presidential approval. The progressive polling firm Data for Progress analyzed Biden’s approval rating decline and rises in gas prices late last year and found a tight relationship.
“Voters want cheap energy and food. If Democrats are unable to lower costs here, this will create added political problems for the party. Midterms are always a challenging environment for the party in power. Inflation only adds to this,” said Ethan Winter, a lead analyst for Data for Progress.
But something has happened since that original analysis. Gas prices have gotten substantially more expensive, and Biden’s approval, while quite low still, has not gotten much worse. According to FiveThirtyEight′s tracker of Biden’s approval rating, before the Russian invasion of Ukraine, it was 42.3 percent; today, it’s … 42.3 percent. Considering the worsening of the gas price situation since then, it may seem like the connection between gas prices and approval are not as tight as we thought.
Well, yes and no, said Jonathan Krosnick, a political science professor at Stanford University and one of the authors of the definitive research on the connection between gas prices and presidential approval.
“Controlling for all kinds of other stuff, as gasoline prices go up, historically, presidential approval goes down. There’s every reason to imagine based on that literature, given recent weeks and months, the increase in gas prices would cause Biden’s approval to go down,” Krosnick said.
“Why did it not go down? These are special circumstances; this is a condition under which everyone knows why gas prices went up. It’s because of a war with Russia,” Krosnick said.
Krosnick’s explanation: “Americans are sometimes sophisticated,” giving presidents credit or not depending on their evaluation of whether or not they’re responsible for economic conditions.
But, of course, Biden’s approval ratings are still low. “There’re all sorts of stuff going on — the stock market crashed [Thursday] … other aspects of the economy that are not looking good, that we would expect would translate into dissatisfaction with Biden. There is a sense in which covid is not over, all of that is contributing to his approval rating. The surprising thing given our work is that you would have thought any increase in gas prices would turn into decreases in presidential approval,” he said.
But, the question remains, if inflation moderates, will Biden — and Democrats in Congress — get the credit? That remains to be seen.
Russia and Ukraine are critical cogs in the global food and energy supply chains
In economic terms, this year was always going to be a tightrope walk for the world: Inflation had already started climbing at the end of last year as covid-19-induced closures fell away and global trade and industry started coming back to life.
And then came Russia’s war in Ukraine. The two countries are critical cogs in the global food and energy supply chains; together, they account for roughly a quarter of the world’s exports of key staples such as wheat, barley, sunflower oil and corn. Russia is also a big player in the energy market: It is the world’s third-largest oil supplier and the second-largest provider of gas.
Which is why ever since the Kremlin invaded Ukraine, global commodity prices — the prices of oil, gas and food — have climbed at a record pace. The war has disrupted supply routes — in particular shipping in the Black Sea, as Ukraine closed its ports and fighting in the area intensified. Air freight costs rose, both as a result of rising fuel prices and the need for cargo jets to navigate away from the region, lengthening flight times. And Western sanctions have hit critical parts of the financial infrastructure Moscow relies upon to do business with the rest of the world, hitting growth and driving up inflation inside Russia — and as a result, affecting other areas such as global energy prices, which have climbed amid concern on the global markets about supplies from the region.
The overall effect, in the words of one senior World Bank official, has been “the largest commodity shock we’ve experienced since the 1970s.”
How big a shock? World Bank economists project that global energy prices could rise more than 50 percent this year. Prices for other commodities — from agricultural goods to metals — could spike almost 20 percent.
That’s the projected average over the year. But costs have already started to spiral. For cereals such as wheat and other grains, the United Nations estimated that prices on the international markets were up around 17 percent in March compared with February, when Russia launched its invasion. Food prices overall, it said, were up around 13 percent.
The impact is already being felt in shops and markets around the world, particularly in countries that rely heavily on imports of basic staples from Ukraine and Russia. In Egypt, for example, CNN reported that just three weeks after the Russian invasion, prices for bread at certain bakeries had risen by 25 percent. Together, Ukraine and Russia account for more than two-thirds of Egypt’s wheat imports. In mid-March, Egyptian authorities directed the army to step in and distribute staples at subsidized prices to those in need.
Further from the war zone, in the U.K., the supermarket chain Tesco said in late April that it would introduce limits on how many bottles of cooking oil each customer could purchase — another knock-on effect of the conflict. Two-thirds of the world’s sunflower oil exports originate in Russia and Ukraine; the interruption of those exports has been a big driver of a 23 percent hike in global vegetable oil prices in March. In Turkey, the jump in cooking oil costs has been such that restaurants have had to raise menu prices. Supermarkets in Istanbul were also reported to be imposing buying limits, amid concerns about hoarding by panicked customers.
These hikes — coupled with other factors such as the continued impact of pandemic-related supply chain disruptions — are already driving up inflation in several economies around the world, including the U.S. and Europe. Recent figures showed that the impact of surging energy prices had pushed inflation across the Eurozone — the countries that use the euro as their currency — to 7.5 percent in April, the highest on record.
The impact is global, in the sense that many of the commodities affected — oil or wheat, for example — are traded internationally. That means price rises on the international markets affect even those countries that are not directly dependent on supplies from Russia and Ukraine. That in turn feeds into inflation even in faraway places such as the U.S.
In less well-off countries, the International Monetary Fund estimated that the hit will be more severe. The IMF expects the war in Ukraine to drive up inflation in developing economies to 8.7 percent this year. That means higher costs for some of the world’s poorest people, at a time when economic growth is slowing in many of those countries as well. As the IMF’s top official, Managing Director Kristalina Georgieva, put it last month: “What has Russia’s invasion of Ukraine cost? A crisis on top of a crisis, with devastating human costs and a massive setback for the global economy.”
Climate change makes inflation worse, and inflation makes climate change worse
Drought, fire, flood and other climate-fueled disasters can cause quick and enduring hits to supply chains, with obvious knock-on inflationary effects. What’s a bit less obvious is the relationship’s somewhat bidirectional nature — while an inflationary state may cause consumers to reduce their use of fuel or food and thus lower emissions, the state-level policy responses to high inflation may act to stall out climate action.
In the former case, spikes in food prices in particular have been pegged to climate-related impacts. For example, the severe heat wave in the Pacific Northwest last summer severely damaged the area’s wheat crop, contributing to the highest prices seen in years. That heat wave, researchers found, was a one-in-a-thousand-year event, and it would have been “virtually impossible” without climate change.
More generally, one study looked at temperature shocks between 1961 and 2014 and found that they do inflict “inflationary pressures” on economies — pressures that last several years beyond the initial shock.
Suzi Kerr, chief economist for the nonprofit Environmental Defense Fund, told Grid that the price shocks caused by climate-related disasters aren’t technically “inflation” because of their temporary nature, but they can look like it or trigger it. “Although we will adapt by managing climate shocks better to a certain extent, a less stable and predictable climate will almost certainly also have a long-term effect on the level of certain costs,” she said.
With climate change helping drive inflation, a tougher question is then what inflation sends back at climate change. One of the authors of the temperature shocks study, Osman Ouattara, an associate professor of development economics at the University of Manchester in the U.K., told Grid that the immediate impact of an inflationary state would likely be at least a temporary reduction in emissions. “If inflation means higher prices, then we expect people to control their expenditure,” he said — spend less on food, on fuel, on heating or cooling. But he acknowledged that states facing inflation may see climate action knocked down the list of priorities.
“Shocks to energy supplies and markets can legitimately require management of short-term energy price impacts or the need to ensure that households have adequate heat, but also can be used as yet another excuse not to take action,” Kerr said.
Climate activists in the U.S. have lamented the Biden administration’s response to high gas prices, which involved a massive extended release of oil from the Strategic Petroleum Reserve as well as efforts to increase domestic production of oil and gas. It is likely that, even aside from the immediate carbon emissions associated with those moves, encouraging increased production today could have long-lasting impacts on the climate.
For example, Chevron announced plans to increase its production in the Permian Basin by 15 percent this year, “as economic and geopolitical events underscore the importance of meeting society’s expectations” for energy. But that increase will continue beyond just the current crisis: The company expects to reach 1 million barrels produced per day by 2025.
Of course, speeding up a transition to cleaner energy by subsidizing or otherwise pushing for solar and wind power and electric vehicles won’t come without cost either. In a recent speech, European Central Bank Executive Board Member Isabel Schnabel noted that because of the mineral needs of electric vehicles and other green technologies, a rapid transition will also likely contribute to inflation. If such a transition succeeds, though, the world would likely be at far less risk for inflationary shocks both from climate change itself and the policy response to it.
Covid lockdowns in China disrupt the supply chain, but they also decrease global demand
How is the U.S.’s largest trading partner, China, affecting inflation? The picture is mixed.
Strict covid lockdowns from Tianjin to Shanghai have rattled China’s economy over the past few months, and China’s factories haven’t been spared. Tesla, Volkswagen, Foxconn and other corporate giants have had to shut down their production for stretches due to the policy. As a result, China’s manufacturing activity in April dropped to the lowest level since the beginning of the pandemic. As long as China embraces its zero covid strategy and vaccination rates lag, there may be a lot more disruption ahead.
The lockdowns have also thrown a wrench into transportation networks. The port of Shanghai and other ports are backed up due to the ongoing lockdown. The IMF warned in April, “Recent lockdowns in key manufacturing and trading hubs such as Shenzhen and Shanghai will likely compound supply disruptions elsewhere in the region and beyond.” Reuters recently reported that companies are facing 74 days of extra shipping time to move products from China to the U.S. “That adds to the inflationary pressure,” said Gary Hufbauer, a nonresident senior fellow at the Peterson Institute for International Economics. “It would be nice if it would go in the other direction.”
However, experts Grid spoke to also pointed to countervailing forces in China. “Despite the global panic about inflation, the immediate impact of covid lockdowns within China has been disinflationary due to weaker demand,” said Shehzad Qazi, managing director of China Beige Book, a data analytics firm. Oil demand in China, for instance, dropped sharply in April, as people stopped traveling and bought fewer goods due to the lockdowns. Inflation in China itself remains relatively low as a result, at 1.5 percent in March.
There is another way China has factored into the inflation debate in the U.S.: as a potential part of the solution. The Biden administration has been debating dropping some of the Trump administration’s China tariffs, which some economists say would help shave a bit off inflation. “It is something that President Biden could do on his own,” said Hufbauer. However, he added that political appetite for dropping tariffs remains low because Democrats fear being painted as weak on China.
Inflation is both a cause and effect of greater economic trends. In some ways, the fact that the U.S. is experiencing higher inflation than many of its peer high-income countries is a straightforward reflection of the strength of its expansive response to the pandemic. Incomes, especially at the lower end, have held up remarkably well in the past two years despite a pandemic that wreaked untold havoc on people’s lives, routines and economic activity.
And because of the restrictions on everyday life and business’s fitful attempts to reopen, many responded by increasing their purchases of goods, snarling supply chains and driving up inflation.
Similarly, the rise in energy prices are partially driven by economic activity being high enough to strain supplies — as well the United States and its allies explicit decision to hamper Russia’s production and sales of oil. That inflation is the outcome of these policies and trends is a sign of economic strength, not weakness.
The challenge now is for the Fed to manage the negative outcomes of this strength without completely negating the bounty it has given us. Nothing less than the prosperity of the country — and the world — hangs in the balance.
Thanks to Lillian Barkley for copy editing this article.