Improving Quality of Life

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With the Current Level of Inflation, are there Signals that a Pernicious Visitor from the ‘70s and early ‘80s is Back?

The current economic context

The Consumer Price Index (CPI)* is rising by more than 9.1 % in the United States and even more globally. Higher prices affect the cost of living, the cost of doing business, access to financing, government and corporate bond yields, and all other aspects of the economy. How will this new economic reality play out and how concerned should we be? 

It' s been two years of record-breaking market disruption for so many companies in the world's most advanced economies. Businesses were hit by a sudden and sharp collapse in demand for their products.

But the economic recovery, supported by exceptionally strong consumption and healthy corporate and household finances, has reignited global demand. That demand is now exploding as businesses struggle to source the products and workers needed to meet it.

The pandemic has created major distortions in the economy: rising inflation, soaring oil prices, and global instability led forecasters to significantly lower their estimates of economic growth for this year, raising the likelihood of an outright contraction. The U.S. GDP growth is expected to fall to 2.6% this year and to 1.5% in 2023 (Federal Reserve).

Such predictions may seem confusing when the economy, by many measures, is booming. For example, the unemployment rate fell from 4 percent last December to 3.6 percent in May.

Given this contrast, gauging the health of the economy in the months ahead will be a complex exercise that will require analysis beyond the usual indicators.

Main drivers of the present inflationary surge

The current inflation rate, as measured by the PCE (Personal Consumption Expenditures) Price Index*, is 6.3 % in advanced economies (Federal Reserve, May 2022). It is running at its fastest pace since the ‘70s and early ‘80s.

Identifiable factors contributing to the current inflationary episode include the unusual confluence of a surge in demand for goods and services coupled with a shortage of supply – due to the pandemic – along with the compounding effect of war-related hikes in energy prices. 

Unlike macroeconomic factors that affect the prices of goods and services in general, idiosyncratic shocks typically impact certain categories of goods and services, as evidenced by the sharp increase in the prices of new and used cars, furniture, and travel-related services.

Supply chain disruptions, partly due to factory closures for lockdowns, led to a shortage of computer chips, which caused a steep rise in vehicle prices. 

As the restrictions were lifted and the economy reopened, households shifted their spending from goods to services. The demand for meals, hotel rooms, airline tickets – and the labor required to provide them – outstripped supply, leading to higher wages and thus further price increases.

The imbalances driving inflation are pandemic-related and therefore transitory. They will dissipate, largely on their own and as businesses find alternative solutions to many of their supply chain problems. Thus, the current trend is not predictive of the future.

* The PCE Price Index reflects the average price paid by U.S. consumers for a typical sample of household commodities. Changes to the PCE Price Index captures inflation or (deflation) across a broad range of consumer expenditures and reflects shifts in consumer behavior. For example, if beef prices rise, consumers will buy less beef and more chicken. The CPI reflects inflation but fails to indicate its impact on the individual consumer basket.  

What is a recession? - are we in a recession?

A recession is a significant decline in economic activity that lasts for months or even years.

Experts declare a recession when a nation’s economy experiences a negative gross domestic product (GDP), rising unemployment, declining retail sales, and a contraction in income and manufacturing activity for an extended period of time.

Since World War II, the United States has experienced 12 recessions, each with a double feature: a contraction in economic activity and a rise in unemployment. 

The current economic situation points to a highly unusual finding: while economic output is down, the labor market is strong, unlike previous recessions. Historically, any recession has resulted in job losses and unemployment. At present, however, companies are having difficulty attracting and retaining workers. The demand for workers is such that jobs remain unfilled despite rising wages.

If the U.S. is about to or is entering a recession, it is unlike any other recession on record. “I would be surprised if there were a recession without much job loss,” said Gregory Mankiw, a professor of economics at Harvard University. In fact, a “slight downturn” could be needed to bring inflation under control, he added.

These are not normal times – a healthy slowing of growth is desirable

More job creation, faster wage growth and rising consumer spending are all signs, in normal times, of a booming economy.

But these are not normal times. With twice as many job openings as available workers and businesses struggling to meet record demand, many economists and policymakers argue that the economy needs not more, but less - less hiring, less wage growth and above all less inflation, which is running at its fastest pace in 4 decades.

The economy is growing so fast that Federal Reserve Chairman Jerome Powell has qualified the labor market as “unsustainably hot” and the Fed is raising interest rates to cool it – to cool the labor market while avoiding a downturn.

A slowdown in job creation "will not be a cause for concern" but rather "a sign that we are successfully moving into the next phase of the recovery,” said Mike Konczal, an economist at the Roosevelt Institute.

The Fed's goal in setting monetary policy is to gradually correct the imbalance between demand and supply to achieve price stability while maximizing sustainable economic output and employment. This amounts to curbing demand by raising short-term interest rates to limit interest-sensitive spending, such as on cars, homes, and commercial projects, and bringing it back down to levels we can sustainably produce. 

"There is a lot of evidence that the Fed's efforts to cool the economy are already paying off," said Konczal, who is optimistic that the U.S. may "[return] to a normal economy" instead of the wild boom it experienced last year. Indeed, consumers are cutting back on spending, as evidenced by the slowdown in the housing market, which will lead to a slowdown in hiring.

The global economy is better positioned than in the ‘70s to deal with economic threats

Some observers have attempted to draw parallels between the current inflationary episode and the 1970s, when soaring oil prices persisted and were followed by rising interest rates that resulted in a combination of high inflation, slow economic growth, and sustained high unemployment ("stagflation").

In some respects, economic threats reminiscent of the 1970s, such as concerns about a return to stagflation, are perceptible and dominate the headlines.

Meanwhile, the World Bank argues that the world economy and governments are in a much better position today than they were 40 years ago to weather difficult times. This is because the current situation differs greatly from that of the 1970s in many ways: first, the labor market is booming; second, the inflation rate isn't in double digits as it was in the 1970s; third, the strength of the dollar contrasts sharply with its severe weakness in the 1970s; fourth, the percentage increase in commodity prices is lower; and fifth, the balance sheets of major financial institutions are generally strong. Most importantly, unlike in the 1970s, central banks in advanced and many developing economies have a credible record of managing inflation, which helps to keep self-defeating inflationary expectations in check.

Few tips from experts on weathering the current inflation

It is essential to breakdown our spending patterns and determine our personal inflation rate: I calculated mine, and my personal inflation rate is 5.6%. It includes groceries, electricity (Kw/hr.), which is up 69%, and gas (Kw/hr.), which has doubled. Reducing electricity and gas consumption must be a priority for me.

By changing our buying habits, we can limit the weight of inflation on our budget. I think it should be possible to reduce the impact of inflation on our basic consumption by up to 40%.

Some things to consider:

Watch out for shrinkflation: the price stays the same, but the quantities of goods supplied are reduced. Check the unit prices!

Time your expected purchases: You intend to buy a new car. Wait longer if you can. If you lease a car, buy it: the price is contractually fixed at the beginning of the contract, before inflation, and you dispose of the car immediately. A smart move that saves you a 34% price increase.

- If you're about to retire, defer your Social Security payments. For every year you defer, the amount you receive increases by 8%.

Insulate your home better: these measures pay for themselves, sometimes in a very short time (3 years).

- Finally, seek a higher return on happiness: apply the Pareto rule (see 80/20 Pareto rule) and spend only on what gives you the most pleasure.

 

 

 

 

 

 

 

 

 

 

 

 

 

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