Inflation continues to soar, and in the newest report from the Bureau of Labor Statistics, inflation has now reached 9.1% as of June 2022—the highest point it’s been in nearly 40 years. It’s safe to say this is the top economic concern for Americans, and many of us are already in crisis mode.
To help you understand what’s happening right now and how inflation is affecting different corners of the economy, we sat down with John Horn, Professor of Practice in Economics at Washington University in St. Louis.
Professor Horn, thanks for agreeing to this interview. Let’s jump in with one of the biggest concerns right now: the Fed raising interest rates again. The last increase was on June 15, 2022 when the Fed authorized the biggest interest rate hike in 28 years.
Can you explain how delicate a balance it is for the Fed to raise rates in hopes of curbing inflation while not sending us into a recession?
It’s the biggest challenge the Fed has during an inflationary pressure. The primary way the Fed controls inflation is by raising interest rates on funds banks borrow from the Fed. When they do, it raises interest rates throughout the economy (because ultimately all interest rates are connected to each other). It makes borrowing money more expensive for consumers, businesses, and the government, and it also lowers net exports. All the components of aggregate demand in the economy decrease. This slows down overall economic activity.
If the Fed raises rates too much, then the economy will slow down so much that we enter a recession. But if the Fed doesn’t raise rates enough, then the economy will continue to overheat, and consumers and businesses (and borrowers and lenders) will all update beliefs to include higher inflation as part of the norm of the economy.
This gets baked into the interest rates going forward, but it doesn’t slow down the economy (or enough to counter the higher rates). So if the Fed wants to lower inflation, they’ll have to raise rates even further, which raises the risk of the overcorrection (and of recession). The “soft landing” talked about is that magical window where the Fed raises rates just enough to slow down the economy just enough that inflation tapers off back to the two percent target. It’s not an easy job to stay within that window.
So interest rate hikes are out of fears that inflation will become “entrenched”—can you explain this concern in simple terms?
Entrenched means the inflation expectations of borrowers and lenders, and workers and employers, remain at an elevated level. Lenders do not like inflation because it means the money borrowers repay in the future is worth less in terms of purchasing power. So if lenders expect inflation to stay around 8%, then lenders will only loan funds at a higher interest rate. Which means borrowers will need to pass on those higher costs to customers in the form of higher prices. Which justifies consumers asking for a higher wage. Which means firms charge a higher price. And the cycle continues.
In the late 1970s and early 1980s, everyone believed that inflation was going to stay high, which meant it got baked into interest rates and wage increases. Once those inflation expectations get entrenched, it becomes much harder for the Fed to generate a soft landing: they need to increase interest rates a lot more in order to convince those in the economy that inflation will come down, thereby resetting expectations.
While a 9.1% inflation rate feels awful, it’s reached a much higher level, approximately double that back in 1913. But is there a ceiling for how high inflation can or will go?
In theory, no. We’ve seen countries with hyperinflation of over one thousand percent. But in the U.S., it’s highly unlikely the Fed will let inflation go much higher without a drastic increase in interest rates. We know from the Volker rate hike in the early 1980s that it is an effective—though painful—way to lower inflation. Every indication from the Fed is that they have no desire to let inflation become entrenched in the economy, so inflation will likely not get much higher than it is today (though that doesn’t mean it will fall very rapidly—the Fed wants a soft landing, not a crash back down to two percent inflation).
We’re clearly going to be in this period for a while, even if the Fed can nail a soft landing. But are there any areas of the economy that we can expect to see major hits when it comes to costs as this period continues?
In terms of input costs, this will be driven by the supply constraints in particular sectors (like semiconductor chips used in the automotive sector, among others) and the demand for those inputs. Where we see these two forces continue to play out, we’d expect costs to experience upward pressure. Or at least, not much of a decrease in the costs; the input prices may stay high but not continue to increase.
Remember that inflation is the change of prices over time, so if inflation slows back to two percent, it doesn’t mean prices will go back to where they were in 2019—it just means prices won’t increase from their current level faster than two percent annually.
How can we determine whether a company is charging more due to inflation vs. price gouging?
One way of looking at this is to see what’s happening to the gross margins. If the cost of goods has been increasing (which they have because of the supply chain constraints), then firms will almost certainly try to raise prices to keep gross margins constant. If expenses (fixed costs) have not increased by the same percentage (e.g., salaries haven’t adjusted as quickly because they’re changed annually, amortization and depreciation aren’t affected by inflation as much), then the overall profit margin (and profit levels) will also increase. In that sense, it’s math.
But we can also think about the fact that most firms do not use cost-plus pricing, but rather use market-based pricing: what is the price I can charge in the market, not one that generates a fixed margin? The primary drivers of inflation are increased demand with supply constraints. Basic supply-and-demand framework analysis says that prices should increase.
This isn’t necessarily price gouging because it’s setting a price to try and balance demand and supply, not just to extract excess profits from customers. We also see that prices are not rising uniformly across sectors. Those where there are really tight supply constraints (like new and used cars, energy, housing) are the ones where inflation is rising the fastest. Tight supply with strong demand should lead to large increases in pricing, and since we don’t see the same price increases across industries, it’s hard to ascribe that to price gouging across the economy.
The final argument against price gouging is that if firms are market-based pricing, then we’d need a good argument for why they were not able to price gouge before 2020. If firms have the ability to charge whatever they want and engage in price gouging, then you’d have expected this before the crisis hit.
We’ve had a perfect storm of increasing demand, constrained supply, government stimulus and a tight labor market. Any of the four factors would lead to inflation on their own; combined, they have created the large increases we’ve experienced.
Speaking of the labor market, back in May, Microsoft announced that it would be raising compensation to deal with labor force tightening and increasing inflation. Can we expect to see other companies follow suit?
This is the wage-price spiral at play (price increases lead to workers asking for wage increases, which lead to price increases to cover the higher wages, etc.). We’ve seen other firms raise wages (or offer large signing bonuses) to attract workers, and this will almost certainly continue as long as the labor market stays tight (i.e., low unemployment rate) and inflation stays high. One of the reasons the soft landing is so hard is that workers will keep asking for wage increases as long as inflation is high, which drives prices higher.
The Fed needs to slow down the economy enough so that there is sufficient slack in the labor market such that firms can find other workers to replace those asking for higher wages. Slowing down the economy too much creates large unemployment, which would then mitigate the need to raise wages to attract new workers (or keep workers from leaving for other opportunities), but that would also be a really painful outcome for those workers who lost their jobs.
For workers at companies that aren’t planning COL raises that reflect the current rate of inflation, any tips for talking to your employer?
It depends on what your alternative options are, and what other options your firm has in case you left. If you have other companies you could shift to, and there aren’t many employees who could replace you, then you’d have more bargaining power with regards to seeking a wage increase. However, you should be careful about being too aggressive; once the economy slows down, if you’re the highest-priced worker, you’ll be the most tempting one to lay off.
It’s best to approach the request with a strong story for why you’ve added value to the firm, why you will continue to add value, and why the wage increase is justified by those arguments. It’s not that different from the advice for asking for a raise at any point in time: make a strong business case based on the value you create for your employer.
Labor force participation rates are still significantly lower than they were prior to the start of the pandemic; do you see any relationship between low labor force participation and inflation?
The low labor force participation rates are a big driver of the tight labor market: it’s hard for employers to find enough workers. In order to attract the labor they need, firms have to raise wages to get them. It also means that finding replacement workers is hard if they don’t accommodate demands for higher wages by current employees, who might decide to leave if they don’t get a raise. If the supply of labor doesn’t increase to meet the strong demand from companies, then we’d expect wages to stay high. If we enter a recession, then demand for labor will fall off, which would lower (or stabilize) the equilibrium wages in the economy.
I’ve heard some concerns about automating labor as a way to deal with low work force participation and inflation. How would workplace automation impact inflation short term and long term?
In the short run, it depends on the demand and supply of the automation itself. If there are supply chain problems with obtaining the automation equipment, yet demand for it stays high, then this will lead to price increases for this capital equipment. If producers pass these costs on to customers, then we would expect consumer price inflation to increase, too.
In the long term, automation would mitigate the potential for wage/price spirals. However, we’d still expect the same cost pressures as those in the short run: if supply of automation equipment can’t keep up with demand, then costs would increase and likely be passed on to customers.
There’s obviously a lot that can happen between now and when rates eventually go back down. With President Biden continuing to move on student loan forgiveness, do you think it will hurt or help inflation?
It depends on what borrowers are currently doing with the payments they are not making to the government because of the moratorium in place. The current proposal on student loan relief would limit interest capitalization, make public service loan forgiveness easier to receive, and forgive loans for those defrauded by for-profit colleges. These would be similar to other government payments in the sense that it would increase the disposable income of the borrowers who receive the benefits.
However, since there has been a moratorium on student loan payments for the last couple of years, it’s not clear that the new proposals would drastically increase spending from this cohort, since they are already receiving the benefit—though temporarily.
If these borrowers are saving some of the payments they are not submitting currently (because they think they will have to pay them in the future), then making these moratoriums permanent would likely increase their spending. But if they are already spending the funds for other purposes (there is some evidence this is the case, especially since it was the motivation for the moratorium in the first place), then there would not be a large increase in new spending. If demand does not increase significantly, it shouldn’t put new pressure on inflation.
Professor Horn, this has been great. I really appreciate your time and knowledge. Let’s wrap things up with best and worst case scenarios in the next six months. What can we expect?
Best case, the Fed achieves a fast soft landing by raising rates just enough to offset the overheating in the economy and returning inflation to the two percent target range.
Worst case, additional shocks hit the U.S. and global economy which create further supply chain shocks without dimming demand, thereby increasing inflation further. These could be oil supply constraints, additional wars/conflicts, another Covid-19 variant that leads to further government stimulus and a tighter labor market.
I hate to be a forecaster, but my best guess is that the Fed will continue to raise rates with the aim of hitting that soft landing target. They may not achieve the best case in the next six months, but that will be the objective. If the Fed misses that target, my guess is they would over-correct (i.e., recession) rather than under-correct (i.e., entrenched inflation).
Professor John Horn has been at Washington University in St. Louis since 2013, where he specializes in corporate strategy, international business, microeconomics, monetary policy, and more. Prior to that, he was Senior Expert in the Strategy Practice of McKinsey & Company in Washington, D.C. There, he worked with clients on competitive strategy, corporate and business unit strategy, and war gaming workshops.
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