Factors driving inflation higher and what the Federal Reserve can do to tame it
GVSU economist provides context and warns recession is likely.
The Federal Reserve hiked interest rates three-quarters of a percentage point Wednesday afternoon. It was the largest increase since 1994.
It’s one step to bringing inflation under control amidst a myriad of factors driving it higher.
WGVU's Patrick Center spoke with Paul Isely, Associate Dean in the Seidman College of Business at Grand Valley State University.
Paul Isely: The problem is the longer we go with prices going up, the more likely it is that those expectations of prices going up will reinforce the higher inflation rate. So if this had been transitory, if it had been true transitory where prices went up for 3 or 4 months and then started to drop. People's expectations wouldn't have changed. And so therefore the supply side improvement would have helped reduce this inflation that we're seeing now. What's happened, though, is people's expectations have changed and they also have more income. So now we have the supply problems out here. But the change in expectations is that fundamental piece that people keep forgetting about- that people's expectations of inflation actually help inflation maintain wherever it's at. So people are expecting higher inflation, right? And so the question I keep asking people is have you heard somebody used the phrase "I better buy that now because it's going to go up in price"? For 30 years we hadn't heard that phrase. In the early 80's it was used to sell cars. Well the price of car is going up next month, if you want to buy a better by now. We have that same thing happening now and that change in expectations, then, leads to people accelerating their purchases on the front side which then results in higher demand for goods which then result in more inflation. So this change the expectation is started to give inflation legs of its own, which means that we'll see elevated inflation from what we've seen over the last few decades. It will slow down from what it is now. But it will be elevated.
Patrick Center: Where does supply and demand come into all of this. Is there a supply issue? Where are we in that part of the equation?
PI: So depending on who does the study they'll say this is more supply or this is more demand. We know their supply side issues. We know that the shutdowns in China, the inability to transport goods, the fact that we have items running out at stores -random items at times. Those are supply side problem and then that was exacerbated by the supply side shock that we had from the Ukraine. So the Ukraine moved food inflation from what would have been likely around 5% for this year, which will now likely be about 10% for this year and that is a result of Ukraine's presence in the agricultural industry and Ukraine moved energy costs from what would have likely been relatively flat for the entire year to accelerating in ways that we all feel every time we walk or drive to the gas station. And we probably walk to it now. So, The Ukraine added to this and the supply side things added this. But we also put far more stimulus into the economy to help consumers as we reach the end of the pandemic, or the last part of the pandemic and all of that excess money has created a lot of extra wealth in individuals across United States. Not everybody. But when we add everybody together, we have trillions of dollars of extra wealth and extra savings that they can spend so they have more money. The bottom part is earning more money and we're having the supply side issues. So in the end, we probably have about 3 percentage points of the inflation that we're seeing right now is the demand side, and about 3% is about supply side, and then about 2% was The Ukraine. So we have all of those things sort of wrapped up together.
PC: So big picture, what is the Federal Reserve looking at because you broke it down into percentages. What changes over time? What's the calculus for raising interest rates?
PI: Well, they need to create a more stable monetary environment. So they want prices to be understandable and changing in an understandable way. So that's their first priority. And then they want to bring that inflation down to a lower level. But to do that, if you wanted to bring things back down to 3% level or 2% level, then you have to get rid of all of that excess demand and you have to get rid of part of those supply problems. Right? The Federal Reserve changing interest rates only affects the demand side. It only affects the demand side. Increasing interest rates makes it more expensive for people to buy houses and cars so buy fewer of them. It makes it more expensive for firms to buy machinery. So they buy less of it. It makes it harder to borrow money in order to do other things, so we buy less things. It slows down demand. So in order to slow down demand that far, it has to get rid of all the extra demand that we have now. Plus, we have slow down demand even more to get rid of that supply side problem. So what we're seeing right now is the Federal Reserve really stuck in a bad position because after the Ukraine happened, we now had even more of that supply side shock that they had to try and get rid of and the more there is of that, the more likely it is that the slowdown that they need to get rid of the price increases will also slow down the economy too far.
PC: and that leads to...
PI: The R word.
PC: That's where I was going, it leads to the R word.
PI: Yeah. The it leads to a potential recession. I think about this. You know, I have a tweener kid at home. And so we watch a lot of Marvel movies. If you remember, I believe that at the end of Infinity War, with Doctor Strange is sitting there and he's shaking and looking through millions of future possible things that could happen and then he’s asked how many out of those million ways do we win? And he puts up one finger and says one. What happened is because of all these extras shocks, the pathways for the Federal Reserve to slow us down and avoid a recession has gotten smaller and smaller and smaller. And now we need luck to avoid that recession, that we would be getting some time end of this year or next year.
PC: If you are Jerome Powell and as you take a look at this landscape, are there areas that you could address while also not raising interest rates too high? Is there a balancing act that you would prescribe if you were Jerome Powell?
PI: He's really got no good choices at this point. I mean, literally there are no good choices. We overheated the economy and we ended up with supply shocks. When you combine those 2 things together, the options that the Federal Reserve has is not wide enough to do a targeted slow down. They have to slow things down. But the trick is, is when they do something when they increase interest rates, they won't know the effect of that increase for 3 to 6 months. So if they increase them in May like they did and now they saw higher inflation in June, which they did. It's too early for them to know whether the change that they made in May actually did anything. But now you have the markets freaking out, that it didn't do anything. So just like everything else in American society, people are impatient. They want the Federal Reserve to be able to click it and turn things off. But what we know is the tools that they have will change things slowly over the next 6 months to 12 months. And so if we crank too hard, then we end up with a recession. If we don't crank hard enough, then we end up with a lot of extra inflation. But, it's not like I get to adjust immediately. I make my adjustments and then I got to wait 6 months to see whether I did enough or not. That’s an awful place to be and so I wouldn't want to be on the Federal Reserve right now. Because I promise you that there's almost nothing that they can do that's going to make people happy at this point.
PC: So what is the probability of a recession? Deep? Shallow? What's your forecast looking at things?
PI: So right now, it's a really weird world because we've been through all of this. But people have much better balance sheets than they had 2 or 3 years ago. So that tells me that if we slow things down, if we find a way to slow things down, then that balance sheet will keep us from falling too far. So it really is looking like we'll probably dip down into a shallow recession as opposed to the deep one's like we saw in 2007, then again in 2020. It's going to be more like things that we saw in 2001 and 1992, that it was like these newer ones. So unfortunately for a lot of young adults, they only know really deep recessions. And so when we use the word recession, there's a huge amount of fear. We should be worried. We should be worried about slowing down, but that slowdown is not going to be as deep and pervasive as what we've recently seen a recession. At least that's what in all likelihood the final say will be.
PC: You mention the cash that's out there and people have better balance sheets. If you are in the bottom half and we talk about income disparity, that balance sheet is not as good as somebody who is at the top. How much cushion do folks at the bottom have?
PI: Well, what we've seen is over the course of the pandemic, the amount of net worth of people in the bottom 50% nearly doubled. So there's a lot of extra wealth sitting there. The trick is that it's also where the big inflation pieces are, so the amount of fuel and food and housing, which are the things that have been growing the fastest in price, as opposed to things like electronics and things like that. Those are the things that affect people on the bottom income the most. But we've also seen much faster wage growth for people who are in the bottom group than people in the top groups. So we've seen essentially for semi-skilled workers that the minimum wage has gone to 16 to $17 an hour in West Michigan. Up from probably 12 to 13 before the pandemic. That's a big jump in hourly wage and it's faster than inflation so far. So there's a lot of thought that this is really going to affect that middle part the most, the groups that are more skilled and so their wages are going up as fast. But they also don't have that large chunk of wealth that people further up the income stream have. It's really that middle group that were most worried about.
PC: Paul Isely, Associate Dean in the Seidman College of Business at Grand Valley State University. Thank you so much.