MBAER Bank - The Swiss Merchant Bank

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mBaer Necessities 10/22

With inflation running at its highest level over several decades and forecasted to stay high in the next year, many people are concerned that the sharp increase in the price level will erode their standard of living and hence their life satisfaction

Robert Shiller also found out that non-economists tend to associate high inflation with the idea that people are behaving badly: business are pursuing excessive profits, politicians are trying too hard to get re-elected, central banks are failing their mandates or ordinary people are living above their means. This may explain the frequent claim that people cannot lawfully benefit from high inflation. Media and professionals even reinforce these mental associations, amplifying anxiety (e.g. Swiss Workers Face Sharpest Loss in Real Wages in 80 Years) and indignation at central banks' reaction to high inflation (e.g. ECB Ms. Schnabel's concerns about a cost-of-living crisis).

It is not surprising that worries about high inflation and the rising odds of recession have depressed consumer sentiment, which has recently reached its historical lows (see Chart 1).

Source: OECD Consumer Confidence Index

In short, ordinary people think that inflation makes them poorer, similar to the introduction of a tax. In addition, if people perceive that greed or incompetence are the root causes of inflation, then they would feel anxious about high inflation, as it may lead to political and economic chaos, similarly to the often-quoted German hyperinflation in the 1920s, associated to Hitler's rise to power.

For economists, the costs of inflation are divided into several categories, including: "shoe leather costs", produced when people try to optimize their cash balances; "menu costs", which are the costs of changing prices; and various distortions to people's and firms' behavior induced by unexpected price changes on contracts, tax laws, accounting rules and the like. Crucially, economic theory suggests that the cumulative impact of these (small) costs eventually leads to lower economic growth and higher unemployment. Hence central banks aim at achieving low inflation.

Non-economists rightly assume that inflation erodes the purchasing power of cash, but they do not realize that inflation also raises nominal income. Since last year, automatic wage indexation and cost-of-living adjustments clauses, coupled with tight labor markets have been generating wage increases in many countries.

Chart 2 shows the unprecedented acceleration of US wage growth since the middle of last year, in line with the sharp increase in consumer prices during the same period.

Source: Atlanta Fed (wage growth tracker), Fred Database (US CPI Headline).

Conversely, there are many reasons why the standard of living may decline but not as a result of high inflation, including for instance a war, a pandemic, or a natural disaster. In these cases, the decline in standard of living will not be met by a rise in wages.

In short, economists think that high inflation may cause just low levels of theoretical harm, be it a costly waste of time and resources in trying to understand the price changes, or just confusion and uncertainty that may ultimately lead to lower growth.

Do economists live on planet Earth? Yes. Consider some facts.

First, despite the wage growth acceleration in the US, the real monthly wage growth actually fell to negative 3.2 percent in the first half of 2022, according to the U.N. Agency ILO. The fact is that nominal wages have more than kept pace with inflation, allowing real wages to grow between the pandemic and mid-2021. But real wage growth may not return, if supply-side shocks do not diminish.

Second, poorer households typically spend relatively more than others on food, heating and fuel - categories that registered some of the steepest price surges over the last year. As poorer households actually experience higher inflation than wealthy individuals, then food-price spikes tend to increase poverty overall. Many governments are using cash and food transfers, school feeding and public works programs that successfully protect the poorest from rising prices. On the other side, policies aimed at making things more affordable with subsidies, such as the US Inflation Reduction Act, may not end up benefitting the targeted households due to the additional tax burden but also because the subsidies may end up funding specific companies.

It is tempting for economists and economic policymakers to sneer at non-economists' opinions and worries about inflation. We challenge the conventional economic analysis, as there is little indication that wages are set to catch up with inflation any time soon. I feel nervous about the current level of high inflation and that central banks are not doing enough to bring inflation under control.

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