But what exactly is going on and why are some economists, policymakers and business leaders starting to worry?
Frequently Asked Questions
- How much is inflation going up and why?
- What’s driving the biggest changes in inflation right now?
- How bad can this get?
- How concerned should you be and what should you do?
- Who wins and who loses when inflation goes up?
- How do government spending and the growing deficit affect inflation?
How much is inflation going up and why?
Inflation rose to 5 percent between May 2020 and May 2021, the Labor Department reported Thursday, which was higher than expected and the biggest jump since 2008. A major reason for the spike is the comparison to prices now versus a year ago, when much of the country was on lockdown. Consider airlines and hotels. Virtually no one was traveling last spring, causing airlines and hotels to massively scale back services, lay off employees and cut prices. Now that the economy is reopening and people are traveling again, hotel prices are up 10 percent versus a year ago and airfare is up 24 percent.
Economists expect many of these eye-popping price hikes to be short-lived as the economy adjusts and the comparisons to a year ago get less dramatic.
It’s notable that the last time inflation was so high was in 2008 during the Great Recession. Historically, inflation has moved around the most — first moving lower and then spiking — during and just after recessions.
What’s driving the biggest changes in inflation right now?
Most of the May inflation spike comes from parts of the economy that are reopening (such as travel) or in areas that saw unusually high demand during the pandemic, which may not persist much longer (like bicycles). That’s why Wall Street, the Biden White House and top economic policymakers at the Federal Reserve still think the situation is under control.
Consider that roughly a third of the May inflation increase was due to soaring used car prices, which are up nearly 30 percent in the past year. It’s a classic story of supply and demand. There has been heavy demand for used cars as people didn’t want to fly or take public transportation. Meanwhile, there’s little supply largely because rental car companies purchased far fewer cars in 2020, so they aren’t selling many now on the used car market.
It’s a similar situation for home appliances like washers and dryers (up 27 percent), furniture (up 9 percent) and bikes (up 10 percent). Gas is also up sharply as demand rebounds (56 percent rise over last May).
As the economy adjusts to a post-pandemic world, key materials such as lumber are in short supply as suppliers cope with reduced capacity and an overwhelming surge in demand. Yet suppliers will adjust. Shortages will dissipate. Factories will eventually produce more furniture, washers, cars and computer chips. The question facing the economy is how long it will take.
How bad can this get?
If inflation gets too high, the Federal Reserve is likely to have to raise interest rates to try to slow the economy down and prevent spiraling inflation of the type last seen in the United States in the late 1970s and early 1980s. That kind of Fed action has led to a recession in the past.
The economy isn’t at that alarming phase yet, but these are big price jumps and a highly unusual situation. Coming out of the pandemic is akin to a “lights on” effect where demand for so much stuff comes back at lightning speed. There’s a real possibility that it’s too much for the economy to handle.
Former treasury secretary Lawrence H. Summers, a Democrat, put it this way in a recent Washington Post op-ed: “The primary risk to the U.S. economy is overheating — and inflation.”
Economists’ concerns are threefold. First, they worry Americans will start believing price hikes are here to stay. That could have a major drag on the economy if it makes people spend a lot now to try to beat more price hikes and then stop spending later this year or next. Second, the U.S. government injected historic amounts of aid into the economy, which is adding more gas to an already juiced-up economy. Third, wages and rents are starting to rise, and those effects could be here to stay.
Price increases on goods (think: cars and bikes) tend to be short-lived because companies eventually produce more. But price increases on services, including rent, often stick around for years to come, especially if companies bump up wages by several dollars. Businesses often turn around and pass those extra costs on to consumers. Then employees ask for more pay again and the price hike cycle begins.
How concerned should you be and what should you do?
Right now, it’s a yellow traffic light situation. People are on alert, but there’s no panic or slamming of brakes.
The key is question is how much inflation will stick around. That’s why economists and Wall Street traders are closely watching rent and other services for signs of a spike. Rent is up a modest 1.8 percent in the past year, but it’s risen 0.2 percent each month for the past four months. Rent is likely to move even higher this summer as the eviction moratorium expires and landlords adjust to higher home prices, while people return to cities they abandoned in the pandemic.
Another good indicator is what’s happening with bond rates. Despite the worse-than-expected inflation data, bond yields barely moved Thursday. The interest rate on the 10-year U.S. Treasury bond is still about 1.5 percent. Typically, if Wall Street is really worried about inflation, bond yields rise because investors are worried their earnings will get eaten up by inflation, so they demand a higher yield to compensate.
Americans worried about inflation can buy some Treasury Inflation-Protected Securities. For many, a more practical solution is to try to lock in prices now on rent, housing and other ongoing expenses for as long as possible — look for longer-term leases of two or more years and 30-year mortgages, for example.
Who wins and who loses when inflation goes up?
The biggest loser when inflation rises is the poor because they spend so much of their income on basic necessities. They don’t have a lot they can cut back on. It’s especially painful when rent, food and transportation all rise at once. Right now, transportation is up 11 percent from a year ago, while groceries overall are up less than 1 percent.
Businesses working on fixed contracts also suffer big losses because they cannot pass along the higher prices to their customers. Many small businesses are expressing concern that it is harder for them to adjust prices, for example. Retirees and people with a lot of savings also tend to suffer because inflation makes their money worth less. They can’t buy as much.
The key winner from inflation is anyone who holds debt because it is cheaper to pay back. People who own land and their homes also don’t mind because their costs generally don’t rise as much. Finally, governments tend not to mind some inflation because it makes debt look cheaper.
How do government spending and the growing deficit affect inflation?
Higher government spending and higher deficits (when the U.S. government spends more money in a year than it brings in from taxes and fees) tends to drive inflation higher.
Some economists voiced concern when Democrats passed President Biden’s $1.9 trillion relief package in March that it would overheat the economy, leading to higher prices. Biden is also proposing to spend $4 trillion on infrastructure, though he would like to offset much of that spending with tax increases that should mute the inflationary effects.
Still, interest rates remain at historic lows. It’s cheap for the U.S. government to borrow money right now and the amount of money coming out of the annual U.S. federal budget to repay the debt is very low. This is why many economists are encouraging the Biden administration to make strategic investments in infrastructure, education and research, though there is debate about how big to go.
What do experts and policymakers say about the rise?
Like many things in Washington, inflation has quickly become political. Democrats say it’s a sign of a reviving economy. Republicans say it’s a sign of an out-of-control economy and bad policies.
Treasury Secretary Janet L. Yellen raised some eyebrows over the past weekend when she said she expects inflation to hit 3 percent this year. That’s higher than some were predicting, but she was quick to clarify she thinks it will come down after that, stressing, “I personally believe that this represents transitory factors.”
Senate Republican leader Mitch McConnell put it this way: “The latest data reinforce what too many Americans have been experiencing firsthand: the Biden administration’s partisan spending bill has blunted our nation’s economic recovery.”
The Federal Reserve has a target of 2 percent inflation a year, but Fed Chair Jerome H. Powell has been clear that after years of running below this 2 percent inflation target, he would like to see inflation run a bit higher than 2 percent for a while. But many wonder if inflation does stay above 3 percent for several months whether the Fed will have to act.
“The [Fed’s] inflation-dismissal message is becoming more and more difficult to sell to market participants,” wrote Lindsey Piegza, chief economist at investment firm Stifel. “Furthermore, for the average American, suffering the effects of higher prices on everything from cereal and eggs to autos and lumber, another six to 12 months of elevated inflation will prove extremely painful.”
Is this a global issue? What’s happening in other countries?
Inflation is picking up across much of the developed world as major economies emerge from lockdown. Still, the United States is seeing higher inflation than many of its developed peers — largely for good reasons. The U.S. economy has bounced back much faster than Europe, Japan and other parts of the world thanks to aggressive stimulus and early vaccinations.
According to the Organization for Economic Cooperation and Development, the United States saw the fastest GDP growth of any major economy in the first three months of 2021. But there is a point where inflation would become a concern for the United States, and policymakers around the world are watching.