Since the country has not experienced the ugly nastiness of long-term inflation in more than four decades, the majority of Americans either never experienced it or have forgotten about it. It is starting to appear as if a long-term inflation problem is brewing. It also appears as if both the Biden Administration and The Federal Reserve (Fed) will accept high inflation.
The Fed position is most perplexing. Historically, and in nearly every instance, the Fed stays in front of inflation. This time, they are admitting they will be behind. If inflation continues to be high, actions taken afterward must be very drastic, as was the case in 1981.
The Biden Administration has set “curing real or perceived social injustices” as the primary goal of economic policy. As such the huge amount of spending and taxes necessary to achieve those goals will be inflationary and could stagnate the economy. But the Biden Administration reasons that is simply the price to be paid.
High, long term inflation creates many nasty problems for nearly everyone. The most pressing problem is workers’ incomes. If an employee receives a 5% raise and the inflation rate is 7%, the employee correctly reasons there is a loss of purchasing power. Next year’s raise has to exceed the inflation rate. “I know the company is charging higher prices. They can afford it.”
That thinking leads to a classic wage-price spiral, which is difficult to reverse. In fact, the labor negotiations often get very ugly. Strikes will result from many of these negotiations.
Inflation hurts lower income earners and retirees or others who are on a fixed income. Although Social security payments are indexed to inflation, usually the cost-of-living increase is less than the inflation experienced by retirees.
Those retirees who have a pension or who have income from investments, typically assume a 3% or less inflation rate. Based on that they determine how much they need to draw each year from their retirement account for living expenses. Higher inflation means more money will have to be taken from a retirement account.
That means their retirement funds will last fewer years, resulting in many people outliving their money.
Low-income people also suffer. Typically, they have few options when they try to increase their income enough to offset the increase in prices. That leads to a lower standard of living.
Interest rates will rise significantly. As the Fed moves to combat inflation, they will slow the rate of growth of the money supply and raise interest rates. Higher interest rates will mean products that are interest rate sensitive, like houses and cars, will see a drop in demand. That could slow economic growth.
Then there is the issue of who benefits the most from inflation. It appears that the holders of capital are the only ones who do benefit. In other words, if someone owns a house, has stocks, or owns an income producing asset, the value of the asset will increase faster than the inflation rate. In other words, if inflation is 5%, houses typically increase in value by 7% or 8%.
Since most of the capital is held by the upper class, income inequality will worsen. This tends to result in a more divided population. The average citizen will be struggling while the wealthy seem to be gaining. This will create more social unrest.
The other problem with inflation is that it will not be the same in each market. The overall inflation rate may be say 5%, but inflation in some markets may be double that. This is a clear price distortion. That causes market inefficiencies making it difficult for firms to determine how much output to produce.
The last issue is that of consumer psychology. Normally consumers question an increase in price and often seek alternatives before agreeing to pay a higher price. Once high and persistent inflation is established, consumers change their thinking. If they see a price increase, they quickly buy the product because they believe the price will be higher tomorrow. “I better buy it now before the price goes up,” they often say.
Inflation is a nasty occurrence. It skews markets, reduces purchasing power, results in more income inequality, divides the population and there is a general feeling of helplessness in consumers.
The Fed should act now to reduce inflation, before the problem gets too serious and the remedy is very drastic.