Inflation inflicting pain, as wages fail to keep pace with price hikes

April 4, 2011

Inflation is back, with higher prices for food and fuel hammering American consumers, and this time it really hurts.

It’s not just that prices are rising — it’s that wages aren’t.

Previous bouts of inflation have usually meant a wage-price spiral, as pay and prices chase each other ever upward. But now paychecks are falling further and further behind. In the past three months, consumer prices have been rising at a 5.7 percent annual rate while average weekly wages have barely budged, increasing at an annual rate of only 1.3 percent.

And the particular prices that are rising are for products that people encounter most frequently in their daily lives and have the least flexibility to avoid. For the most part, it’s not computers and cars that are getting more expensive, it’s gasoline, which is up 19 percent in the past year, ground beef, up 10 percent, and butter, up 23 percent.

Inflation is typically the symptom of an economy overheating. Workers can’t keep up with the demand for the vast array of things they make. Abundant dollars pursue scarce goods and services, forcing prices and wages up. The solution is simple enough: Central banks, such as the Federal Reserve, increase interest rates, applying brakes to the economy.

But the current price spike is in some ways more pernicious than the last great U.S. inflation — the steep increases of the 1970s — and harder for policymakers to address. Today, raising interest rates might make a weak economy even weaker, stifling what meager growth there has been in wages. Moreover, higher interest would make the nation’s massive budget deficits even more expensive to finance, taking an additional toll on the economy.

Few would argue that the U.S. economy, with its 8.9 percent unemployment rate, is overheating at the moment. Rather, the global economy — in particular developing nations such as China and India — is growing so rapidly that it’s straining the available supplies of all types of raw materials.

Although unique factors have contributed to the latest price shocks, such as turmoil in the oil-rich Middle East and a weak Russian grain harvest this year, there’s a common, more fundamental cause. As people in poor nations become wealthier, they develop middle-class tastes. They wish to eat more beef instead of just rice, for example, and drive cars rather than bicycles. Those rising living standards in developing nations have left suppliers struggling to grow enough feed grain, mine enough iron and pump enough oil to keep prices near the lower levels of recent decades.

The resulting rise in prices likely reflects a long-term trend, separate from the routine ups and downs that are traditional for oil and other commodities. That, in turn, means that prices could be rising faster than Americans’ incomes for some time to come.

Evidence of this long-term dynamic has been emerging for much of the past decade. The price of every major commodity has marched upward for most of that period, interrupted only during the 2008-2009 financial crisis. The price of oil was $26 a barrel at the end of March 2001, and $108.47 on Monday.

“What really matters is how fast China and India and the Middle Eastern countries recover,” said Robert Weiner, a professor of international business at George Washington University who studies energy markets. “As long as they keep doing that, that will put upward pressure on the price of oil.”

The world’s central banks, including the Federal Reserve, have typically ignored the ebbs and flows of commodity prices, instead focusing on “core” measures of inflation that capture the underlying trends.

But if commodity prices must now be added to other inflationary pressures, policymakers may need to keep interest rates higher than they would otherwise. The European Central Bank appears poised to raise rates this week, reacting to higher fuel prices.

But for the United States, that option is less attractive than in the past because of the effect higher rates could have on the already burdensome federal budget. In the early 1980s, the Fed successfully ended double-digit inflation by aggressively raising interest rates, though at the cost of a deep recession. The same sorts of interest rate increases now could be ruinous for government finances.

In 1981, when the federal government’s cost to borrow money by issuing a three-month Treasury bill spiked to 14 percent, government debt was only 40 percent of the nation’s overall economic output. Now it is above 90 percent.

Even with the rise in rates that the Congressional Budget Office forecasts, from near zero today to 4.4 percent in 2017, the cost to service the debt is set to rise to $600 billion a year, and aggressive Fed action to address rising commodity prices would make that burden even greater.

“It’s not that the Fed won’t be able to raise interest rates,” said Diane Swonk, chief economist at Mesirow Financial, “it’s that it will be very painful when they do for a variety of reasons.”

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