The stock of excess savings is about gone, and credit cards are maxed out.
Spending, after all, must be supported by income.
L ast week, we learned that the blip down in inflation at the end of last year was just that, a blip.
One of the oldest economic rules of thumb is that inflation begins to seriously decline when the short-term interest rate is above the inflation rate. By that measure, the Fed has been woefully slow to tighten, which made the apparent slowdown in inflation last year a puzzle.
But now, it appears that inflation is doing precisely what economic theory would suggest. The latest January estimate showed that prices were increasing 0.6 percent. If that pace were maintained throughout the year, then inflation in 2023 would be 7.4 percentage points. The peak annual number in 2022 was 7.6 percent. While some decline in inflation is likely in the coming data, that will hardly be evidence of the progress the Fed hoped for.
Why has inflation been so stubborn? As I’ve suggested before, aggregate demand has stayed very high because of inflated government spending and surging consumption. Both have advanced so rapidly that aggregate supply hasn’t been able keep up. In particular, labor shortages have hamstrung firms trying to expand capacity, leaving them no alternative but to raise prices.
Those higher prices usually put the economy into a downward spiral. Since March 2021, cumulative inflation has lifted the price level by 13.5 percent. For someone on a fixed income, that means that his or her standard of living is permanently lower than it was in March 2021 by 13.5 percent. Now, wages for most people have begun to inch up, but the level effect of the inflationary surge is likely to be with us for a very long time. Wage inflation and price inflation are about equal today, but the loss from 2021 and 2022 will only be made up if wages rise faster than prices. There is no sign of that happening.
The Atlanta Fed publishes a handy wage tracker that provides data on wage changes in the aggregate, but also distinguishes between the changes for those who switch jobs (switchers, who usually get a healthy raise) and those who do not (stayers). Of course, the vast majority of Americans do not switch jobs, so the best indicator of the resources available to the typical consumer is the wage-change number for stayers.
When we adjust those numbers for inflation, they’re chilling. Because wages for stayers fell behind inflation over the past two years, their real wages are down 4.7 percent relative to the beginning of 2021. Switchers did better, with their real wages declining only 1.6 percent. Since consumers generally let their consumption follow their income, we would expect most Americans to cut their consumption by almost 5 percent.
That hasn’t happened for two reasons. First, consumers received a massive bailout from the government starting in 2020. The checks from the government were so large that consumers saved most of them. At its peak, the stock of excess pandemic savings reached a bit over $2 trillion. With wages falling relative to prices, these savings boosted consumption, for a time. But the stock of excess savings has declined, by my estimate, to about $500 billion, and will likely be fully exhausted over the next few months. The other factor supporting consumption has been a massive increase in consumer borrowing. Back in 2020, when consumers were unable to work because of Covid-19, they made ends meet by borrowing from their credit cards. At the pandemic’s peak, total consumer loans topped out at $1.6 trillion. Today, that figure has climbed to $1.8 trillion.
Many market observers seem to believe (despite some recent jitters) in a soft landing whereby inflation in wages and prices drops down to the Fed’s target range gradually over the next year, and victory is declared. But even if that happens, the real income loss from the initial shock to prices will be locked in.
Putting it all together: Real wages are down, and consumption, which normally follows, has been temporarily boosted by unsustainable factors. The stock of excess savings is about gone, and credit cards are maxed out. Americans are less able to pay their credit-card bills because their incomes are lower and interest rates are higher. Something will have to give, and it will be spending. Consumption, which in the end has to be supported by income, must inevitably tumble.