Inflation is a hot topic now, with comments from Federal Reserve Chair Jerome Powell looking like veiled hints as to when (no longer if) the Fed will get serious about hitting the monetary brakes to slow the economy. Until recently, inflation was described as transitory, or just passing through. But at some point, as the days flutter by, the story has to change. Transitory? Temporary? Or had we better get used to it?
Now, Fed commentators and others are suggesting price levels will rise into 2022. There can be no doubt that we have inflation and that the Fed can clobber the economy to purge it, but some basic questions remain to be addressed: What’s so bad about it? Can’t we just learn to live with it? What needs to change?
Yes, inflation is real. The all-item consumer price index (CPI) was up more than 5 percent on a year-over-year basis for July, August, and September, and now shows a 6.2 percent increase for October—the largest jump since 1990. The Fed considers 2 percent inflation to be its bright-line monetary policy goal. Obviously, there is a large gap between that and what we are seeing on the ground.
Estimates by independent scholars using high-frequency credit and debit card data, in an effort to capture actual purchasing patterns, suggest the increases for 2021 are understated by as much as 0.7 percentage points. With CPI data applied, the millions receiving Social Security payments can look forward to a corresponding 5.9 percent increase to their checks in 2022, the largest in decades.
Price levels measured by the producer price index, which partly foretell what is on the way, are up even more; these show an 8.6 percent year-over-year increase for September and for October, the largest since the series started in 2010.
It’s not just a U.S. phenomenon, though U.S. inflation outpaces inflation in the eurozone and G-20 countries. This means that the dollar should remain relatively weak against those currencies. Other things equal, it makes our exports stronger and imports weaker.
And while a few key items—energy, rent, and used cars—are frequently called out, an analysis of the price movements in the July personal consumption expenditures index (PCEI), which is the Fed’s preferred inflation measuring rod, shows 84 percent of included items rising. The September PCEI was up 4.4 percent on a year-over-year basis, having risen from 4 percent in June, registering the largest monthly increase since October 1990.
The Bigger Problem
Individuals whose salaries, wages, Social Security payments, and even mortgage interest or rental rates are automatically adjusted for inflation have much less to worry about than their neighbors on fixed salaries, who must cope with ballooning grocery bills or pay twice as much at the pump. On these grounds, inflation may be devastating for some and almost meaningless for others. These gaps widen as inflation gets worse.
Another worry is that inflation can be a burden for people living in states with sharply graduated income taxes, who find themselves hit with a heavier tax bill if their income tracks with inflation and rises a bit. Seven U.S. states have no broad-based income tax, three have a flat rate, and the rest rise with income.
Although this is all quite serious and should be avoided, there is yet another serious matter: The rate of inflation gets captured in interest rates that borrowers must pay, especially for longer-term debt. Lenders hope to be paid back with at least as much purchasing power. If they believe inflation will tick away at 4 percent, interest rates tend to rise with this baked-in expectation.
In any case, higher interest rates mean higher interest costs on all forms of public and private debt. As a result, mortgage rates will rise, all forms of construction will suffer, and businesses will postpone making large investments in plants and equipment.
Now consider the public debt—especially the federal debt that ballooned from large deficits in recent years. (In 2020, federal revenues were $3.4 trillion and spending was $6.6 trillion.) The interest cost of the national debt in 2008 was $253 billion and remained at about that level through 2015. Even though the debt doubled in those years, sharply falling interest rates and low inflation worked to contain costs.
But that was yesterday. With today’s higher inflation and rising interest rates (perhaps with more to come), the Congressional Budget Office (CBO) estimates the interest cost of public debt to be $413 billion in 2021. Obviously, any dollar spent on interest cannot be spent on government benefits and services to taxpayers.
Looking ahead, the CBO expects much of the same. For 2026, the interest rate on the 10-year Treasury projects to 2.6 percent versus the current 1.5 percent, with the interest cost of the debt rising to $524 billion. For 2030, it’s 2.8 percent and $829 billion, respectively.
Now, we are talking about real money. Just to put $829 billion into perspective, in 2020, the United States spent $714 billion on defense, $769 billion on Medicare, and $914 billion on all nondefense discretionary spending. Back-of-the-envelope calculations strongly suggest that some spending categories will have to give.
Finally, we come to the heart of the issue. The United States is experiencing an inflationary surge caused fundamentally by the injection into the economy of trillions of dollars—stimulus and other spending—without an accompanying production of goods and services that might be purchased with the new dollars. It’s rising demand plus troubled supply.
These forces will be with us until the stimulus dollars work their way through the economy and the federal government stops printing more money. It’s painful to large categories of people and beneficial to only a few. Those seeking to borrow or who don’t have their wages adjusted must cut back, manage resources, and find ways to conserve cash.
As the process continues, our government—the source of inflation in the first place—will face hard choices when paying for past and future deficits and rising debt. And that, as they say, is when the rubber will hit the road.
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