This blog post accompanies the SDPB Monday Macro segment that airs on Monday, December 5, 2022. Click here to listen to the segment.
On Friday, the U.S. Bureau of Labor Statistics (BLS) reported employers added 263,000 jobs in November, while the unemployment rate remained at a very-low 3.7 percent and average hourly earnings grew strongly at 5.1 percent, all further evidence of a tight labor market in which employers are competing vigorously for the supply of employees. The story is not new; we have been reading some version of it since the economy recovered from the pandemic. Nevertheless, the story is misleading, if only unintentionally so, because the image the story portrays is one of households holding all the cards—demanding higher wages, remotely working, quietly quitting—and, so, precisely not working—and so on. The reality, at least for the average household, is quite different. This is because the story plays out against a backdrop of a macroeconomic phenomenon Schooled readers know all too well: high and variable inflation, a relatively large and persistent fall in the purchasing power of money. As I demonstrate in this post, despite the narrative of household preferences prevailing in the labor market, inflation has eroded the financial position of the average household. In Figure 1, I illustrate the inflation rate as the year-over-year percentage change in the consumer price index, a popular if imperfect measure of the average price level.
According to Figure 1, the inflation rate locally peaked in June 2022 at 9 percent, an astoundingly high figure that the U.S. economy last registered in late 1981, during the last years of the Great Inflation. Since June 2022, the inflation rate has fallen slightly. Last October, the rate registered 7.8 percent; an improvement perhaps, but hardly evidence of the low and stable inflation around 2 percent the Federal Reserve targets. Nevertheless, Schooled readers—particularly those who view the world through strictly macroeconomic lenses from fifty-thousand feet above the economy in the long run—may be forgiven for not thinking about how inflation affects households. After all, in theory, inflation is a fall in the purchasing power of money that is independent of what money buys: this is to say, in the long run, inflation represents a proportional rise in all prices—the price of lettuce, the price of gas, the price of an appendectomy, or the price of labor, for example. If every price in the economy rises by, say, 5 percent, then the proportional rise in a household’s flows of income, which depend on wages for example, match the proportional rise in a household’s flows of expenditures, which depend on prices of lettuce, gas, and appendectomies for example. We pay 5 percent more for goods and services, but we earn 5 percent more money.
So at the household level, inflation is a wash; except when it’s not.
As Schooled readers know well, inflation is always and everywhere a monetary phenomenon. Milton Friedman, who coined this expression, meant, of course, that the principal cause of a fall in the purchasing power of money is a rise in the quantity of money. Too much money chasing too few goods causes inflation. Put differently, then, in the long run, inflation is a nominal phenomenon, a relationship between the money supply and the price level, both nominal variables, which, by definition, we measure in terms of the monetary unit of account: dollars in the case of the U.S. economy. (In comparison, we measure real variables in terms of something else: 263,000 jobs created in November or 3.7 percent of the labor force unemployed in November, for example.) In Figure 2, I illustrate this nominal-to-nominal pattern as the relationship between trend annualized quarterly growth in the money supply (horizontal axis) and trend annualized quarterly inflation (vertical axis); the trend-to-trend relationship gives the scatterplot its curiously serpentine shape; the red line is a fitted line—the line that cuts through the scatterplot with the least amount of error, defined as the smallest sum of squared vertical distances of the dots from the red line.
Each dot in the scatterplot I illustrate in Figure 2 represents a quarter in the life of the U.S. economy from 1960 to 2019; thus, the x- and y-coordinate values associated with each dot represent trend annualized quarterly growth in the money supply (horizontal axis) and trend annualized quarterly inflation (vertical axis) during a particular quarter; incidentally, a reader cannot discern which quarter between 1960 and 2019 each dot represents simply from visually inspecting Figure 2. According to Figure 2, then, setting aside the long-run growth of the real economy, which is driven by innovation and so forth, a strong, nearly one-for-one positive long-run relationship exists between the growth of the money supply and the growth of the price level, both nominal variables. Put differently, then, in the long run, inflation is not a real phenomenon: the long-run relationship between the (necessarily nominal) inflation rate and, say, real GDP—think, the quantity of goods and services—is quite weak. In Figure 3, I illustrate this pattern as the relationship between trend annualized quarterly inflation (horizontal axis) and trend annualized quarterly growth in real GDP (vertical axis); again, the trend-to-trend relationship gives the scatterplot its curiously serpentine shape.
The x- and y-coordinate values associated with each dot in the scatterplot I illustrate in Figure 3 represent trend annualized quarterly inflation (horizontal axis) and trend annualized quarterly growth in real GDP (vertical axis) during a particular quarter. According to Figure 3, then, scarcely little if any relationship exists in the long run between inflation and the growth of real GDP; Figure 3 implies this because the red fitted line is essentially flat: on average, real GDP growth does not respond in the long run to inflation.
All fine and well, but households are hurting; and hurt is a real variable, by the way.
As a practical matter, in the short run, a fall in the purchasing power of money is not independent of what money buys. This is to say, in the short run, inflation does not represent a proportional rise in all prices—the price of lettuce may rise relative to the price of an appendectomy or the price of labor, for example. Lots of reasons explain why inflation affects relative prices—and, thus, the microeconomic decisions to allocate resources and distribute output—in this way. For example, lettuce suppliers may take the price of lettuce from a perfectly competitive market, where the price is flexible, determined minute by minute by market (including inflationary) forces associated with supply and demand; meanwhile, appendectomy suppliers may take the price of an appendectomy from an imperfectly competitive health insurer who renegotiates prices relatively infrequently; and imperfectly competitive employers may set the price of labor and, in doing so, renegotiate wages with, say, place-bound employees relatively infrequently. If some prices do not adjust completely and immediately to the average price level—that is, in the parlance of macroeconomics, if some prices are rigid or sticky—then inflation imposes relative-price adjustments, causing the nominal force of inflation to have real effects, including on household financial positions.
Consider, for example, the news last Friday that average hourly earnings grew strongly at 5.1 percent. This economic statistic represents a nominal variable—the current dollar value of average hourly earnings; what these earnings buy in real terms—think, goods and services—now versus a year ago is unknowable from knowing only the statistic, 5.1 percent. For example, maybe average hourly earnings buy the same amount of goods and services now versus a year ago, an outcome that would prevail if, say, the average price level and average hourly earnings both rose by 5.1 percent over the year; in this example, wages are flexible prices that adjust one-for-one with the average price level. Or, maybe average hourly earnings buy 5.1 percent fewer goods and services now versus a year ago, an outcome that would prevail if, say, the average price level rose by 5.1 percent over the year, while average hourly earnings did not change; in this example, wages are sticky prices that do not adjust (in the short run) with the average price level. In Figure 4, I illustrate nominal (blue line) and real (red line) average hourly earnings; the last data point for nominal earnings represents the 5.1 percent measure reported last Friday.
To calculate real average hourly earnings, I divided nominal earnings by the consumer price index. According to Figure 4, although households earn on average 5.1 percent more now versus a year ago, the real purchasing power of these earnings has fallen over the year. This fall is evident in Figure 4, where the last data point for real earnings registers negative 2.6 percent: average hourly earnings purchase 2.6 percent fewer goods and services than those earning purchased a year ago. Thus, despite the story of a tight labor market in which employers are competing vigorously for a limited supply of employees, households are not experiencing a rise in purchasing power in return for their labor services. Meanwhile, households continue to consume goods and services. In Figure 5, I illustrate real personal consumption expenditures, which are necessarily adjusted for inflation.
Setting aside the erratic behavior of real consumption expenditures during the pandemic, behavior that resulted from shutting down and then reopening the economy, according to Figure 5, households are consuming at roughly the same rate of year-over-year growth that they were before the pandemic. This is to say, the blue line in Figure 5 before and after the erratic behavior during the pandemic is positioned at a vertical axis reading of about 2 percent year-over-year growth. So how is this possible? How could real average hourly earnings fall while real consumption expenditures grow at their usual rate? The answer is revealed, in part, by the personal saving rate—personal saving as a share of personal income—that I illustrate in Figure 6.
Incidentally, the personal saving rate is a real variable, because it measures nominal personal saving as a share of nominal personal income; informally speaking, the monetary units of account, in this case the dollars in the numerator and the denominator of the personal saving rate, cancel out, leaving a (real) proportion—2.3 percent in October 2022, for example. According to Figure 6, the personal saving rate, which also behaved erratically during the pandemic, has since fallen far below its pre-pandemic level. Thus, one interpretation of Figures 4, 5, and 6 combined is that households are essentially dissaving to pay the portion of their real consumption expenditures not covered by their real average hourly earnings. Thus, according to this interpretation, on average, households are not doing particularly well. This is to say, the burden of price instability—and, specifically, high and variable inflation—is compromising the budgetary position of the average household in the short run, which is to say, here and now.
Of course, average hourly earnings (Figure 4), real personal consumption expenditures (Figure 5), and the personal saving rate (Figure 6) are flow variables, each measured over an interval of time; in the case of these three variables, the interval happens to be a month. Inflation is perhaps most consequential to nominal stock variables, which, by definition, we measure at a moment in time. Consider, for example, total household net worth, which I illustrate in Figure 7, where the vertical axis measures the dollar value of total assets owned by all households at a moment in time minus the dollar value of total liabilities owed by all households at a moment in time; the difference in these accounts is the dollar value of total net worth owned by all households at a moment in time—the blue line.
According to Figure 7, nominal household net worth (blue line) has fallen from $142 trillion in the fourth quarter of 2021 to $136 trillion in the second quarter of 2022, the last quarter for which these data are available. Much of this decline is due to the fall in equity prices over that same time, when the S&P 500 index fell by 15 percent, for example. In any case, inflation has eroded household net worth as well. Since around March 2021, when the inflation rate began to rise, real household net worth (red line)—nominal net worth divided by the consumer price index—has fallen below nominal net worth by proportionately more than usual; the vertical distance, measured on a log scale, between the blue and red lines in Figure 7 has increased since March 2021: unusually high inflation has had an unusually erosive effect on the purchasing power of household net worth.
In summary, although the labor market remains tight and employers continue to compete vigorously for the supply of workers, driving up average hourly earnings in nominal terms at least, the financial position of the average household has weakened since early 2021, when the inflation rate began to rise aggressively. This effect on household wellbeing is one of many pernicious outcomes macroeconomists associate with high and variable inflation. The first best way to deal with this problem is to avoid high and variable inflation in the first place; unfortunately, that option is no longer available to monetary policymakers. The second best way to deal with this problem is to reduce and stabilize the inflation rate—something around two percent would be good. Thus, the policy path for the central bank is unambiguous: continue to tighten monetary policy. Of course, such a path would very likely slow economic growth, weaken the labor market, and potentially compromise the financial position of the average household.
In monetary policy, the cure for pain is often painful. We don’t call it the dismal science for nothing.
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