Most surveys show inflation is one of the top issues in the country. For several months the inflation rate has been hovering just shy of double-digits on a year-over-year basis.
But what if the Federal Reserve is successful in reducing the inflation rate? Does this mean we’re fine? What if, for example, this time next year the year-over-year inflation rate has dropped to 2% — which, by the way — is the Federal Reserve’s target? Should we be dancing in the streets because we’re now back to where we were prior to the surge in inflation?
The answer is — no! If at the end of 2023, the year-over-year inflation rate is 2%, this means prices are still rising, just not as much. Reducing the inflation rate doesn’t mean all prices are falling. Sure, some prices would drop, particularly basic commodities like fuel and food. But most wouldn’t.
Still, if the pace of inflation is slowing, isn’t that good news? It is, but this doesn’t mean everything is fine. The major problem with inflation is not that prices are rising, but that our wages and salaries don’t increase at the same pace. Indeed, in the last two years, prices have risen faster than wages and salaries. This means most households have experienced a reduction in their standard of living.
It gets worse. History shows it’s taken a significant period of time for workers to recover their standard of living, even when the inflation rate moderates. The reason is a recession is usually the policy prescription used to reduce inflation. And during a typical recession, businesses reduce employment and sometimes cut wages for the workers they keep. Both actions cause further erosion in the standard of living.
The bottom line is it may take a while for workers’ incomes to recover from the combined trauma of rising inflation and a job-killing recession, even if the inflation rate is brought back to normal levels.
Consider these track records of recent inflation/recession combos. It took almost 20 years — yes, 20 years — for the purchasing power of weekly earnings of workers to recover from the combined impacts of the “great inflation” of the early 1980s and consequent recessions that ultimately cut the annual inflation rate from 13% to 3%.
It wasn’t as bad with later combinations of inflation and recession. Inflation jumped in the latter part of the 2000’s decade and prior to the housing recession in 2007-09. But it took only five years for the purchasing power of wages to get beyond the double pounding of inflation and recession.
Now we’re set up for another challenge. Many economists are predicting a recession in late 2022 or early 2023. Hence, even if there is some good news in coming months that the inflation rate is moderating, many households will experience a struggle to regain their previous living standards.
Unless, of course, like on many things, the pandemic has changed the rules. One big change has been the lingering labor shortage. Many businesses can’t find enough workers, and they want to keep ones they have.
This sets up a possible scenario where job cuts with an upcoming recession will be minor. The reason is firms have many unfilled positions to cut, and they don’t want to lose the workers they’ve tried hard to keep. Also, firms may be more forthcoming with pay raises in order to keep valued workers. The combination of more jobs and better pay may reduce the time needed to recover the peak purchasing power of worker earnings in early 2020, prior to the pandemic.
The conclusions are these. First, lowering inflation doesn’t mean lowering prices. It means lowering the rate of increase in prices. Most prices continue to rise.
Second, what matters for your standard of living is the purchasing power of your salary. The purchasing power of your salary can be eroded by both inflation and recession.
Third, this time may be different. Labor shortages may mean a mild uptick in unemployment if a recession occurs.
Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.