By Gwendolyn C De Baca, Regional Economist
What is Inflation and Why is it a Problem?
Inflation has been a hot topic during the past several months. The Federal Reserve increased its benchmark rate by 0.75 points on June 15, 2022, and the members of the Federal Open Market Committee (FOMC) are reportedly considering raising rates again by another 0.75 points in late July. These aggressive moves by the Fed are in response to signs of increasing inflation, most recently from a staggering Labor Department report indicating that prices in June 2022 increased by 9.1% from a year earlier, a level of inflation not seen in 40 years.
Let’s take a closer look at what inflation is, how it’s measured and when it’s a problem.
Inflation measures how much more expensive a set of goods and services has become over a certain time period. It generally means a degradation in the value of a currency. A dollar will buy less today than it did 25 years ago. For example, in May 1997, the average price of a gallon of whole milk in the United States was $2.61. Today, that same gallon of milk costs $4.20.
A certain level of inflation is good. It keeps consumers spending. If prices were expected to fall in the future, people would not buy now. They would wait. Therefore, inflation keeps current spending active.
Economists at the Federal Reserve target an annual inflation rate of 2%, a rate they believe allows for stimulating demand for goods and services without excessively moving prices beyond current wage income. However, if inflation rates go too high they can become a problem, since prices outrun people’s wages. This causes people to prioritize certain purchases and pull back on others. This produces less economic interaction and possibly leads to economic recessions.
To avoid these issues, economists aim to understand how prices are changing for the average consumer. They do this by looking at a fixed basket of goods and seeing how the average price of those goods has changed over time. So, if a person were to go to the grocery store and fill their basket with the things that they need (milk, bread, bananas, etc.), how would the price of that basket have changed over time?
The U.S. Bureau of Labor Statistics (BLS) compiles an estimate designed to answer this question. The Consumer Price Index (CPI) is the weighted average of a basket of consumer goods and services purchased by households. This is the measure of inflation that is most often referenced by economists.
The graph below shows the CPI for the United States from 1983 – 2022. Food and energy prices tend to be more volatile, and so it is sometimes informative to look at the CPI excluding these items. In the graph, the CPI index excluding food and energy prices is a much smoother line. They are both useful measures, but if one wants to simply look at the movement of prices to see a general trend, looking at the CPI index excluding these items can be useful.
The Federal Reserve, whose desire it is to keep inflation in check, often looks at another measure called the Personal Consumption Expenditure (PCE) price index. Like CPI, the PCE measures inflation but uses a different methodology. The CPI sources its data from consumers, while the PCE sources its data from businesses. It’s possible for businesses to absorb higher costs and not pass them on to consumers. Looking at both can speak to cost pass-through or not.
Inflation can be caused by an increase in demand or a decrease in supply, or both. A recent study from the Federal Reserve Bank of San Francisco separated components of the PCE price index into supply and demand components, breaking out which price movements were explained by a shift in supply and which were attributable to a change in demand. They found that supply shocks accounted for half of the recent price increases, while changes in demand explained one third. The remainder of the components could not be definitively classified into supply or demand factors.
Products that experienced demand-driven price changes include items like used cars and electricity, while items like food and household products were more likely to encounter supply-driven price changes. Recently, the war in Ukraine has pushed prices for food and commodities higher, while lockdowns in China have exacerbated weaknesses in the supply chain. Moreover, during the COVID-19 pandemic, many items used at home along with restaurants and museums experienced demand-driven price changes.
Understanding the degree to which price changes are affected by supply versus demand shifts helps to put in perspective the Federal Reserve’s sway over inflation pressures. Supply factors are out of the Federal Reserve’s control. For example, the Federal Reserve does not have the ability to stop the war in the Ukraine. Jerome Powell, Chair of the Federal Reserve, has indicated that he would like to execute an economic “soft landing,” where inflation is brought under control with minimal negative impact on employment. In the end, however, COVID lockdowns in China and the war in Ukraine might have a larger influence on inflation than rate increases by the Fed.
What About Unemployment?
A complicating factor for the Fed is that high inflation rates are theoretically tied to low unemployment rates because each influences the other. A tight labor market pushes wages higher, which increases costs of production, which generally translates to higher commodity prices. Aside from keeping inflation in check, the Fed also desires to maintain a healthy rate of employment, or, to say it from the flip side, a healthy rate of unemployment.
Many economists argue that globalization, technology and demographic changes mean that unemployment now might not face the same pressures as were seen in the 1960s, which could allow for a lower natural rate of unemployment.
Zero unemployment is unattainable. The labor market is fluid. People move around, new technologies push people around, even demographic changes influence unemployment. In the 1960s, the United States economy was of a certain size. But just on the cusp of entering into that economy was a unique, very large cohort of young workers called the baby boomers. The economy needed to nearly double in order to absorb all of this new labor. Therefore, the interaction between the economy’s and the labor pool’s size meant that there would “naturally” be a high amount of unemployment due to the sudden excess in labor. The estimated natural rate of unemployment was as high as 6.2% in 1979 because of this excess amount of young baby-boomer labor.
But as that cohort was absorbed into the U.S. economy and resized it, the estimated natural unemployment rate declined to 4.4%. The current U.S. demographic makeup doesn’t have enough young workers following the baby boom generation to elevate unemployment the way the young boomers did.
At 3.6%, the national unemployment rate is estimated as below this natural rate. Fed Chairman Jerome Powell has said that the natural rate of unemployment is likely well above 3.6%, indicating that the Fed sees an unemployment rate increase as an acceptable tool to ease labor-induced upward pressure on prices. One can read between the lines to infer that the Fed is not afraid of restricting the U.S. economy to raise unemployment. Since the Fed does not have the power to increase the supply of goods, its only recourse is to lower the demand for those limited goods. They believe the current low unemployment rate gives them acceptable room to undertake such a maneuver.
The Congressional Budget Office constructs an estimate for the natural rate of unemployment, shown below. This estimate reached its peak of 6.2% between 1977 and 1979, and is expected to decrease to 4.25% by 2032.
Inflation expectations can play a powerful role as well as they can become self-fulfilling. If people anticipate higher prices they will demand higher wages now, which perpetuates the upward spiral of wages and inflation. However, given the success of the Fed’s aggressive rate hikes in the 1980’s to combat a previous bout of highly persistent inflation, people generally assume that the Fed will repeat such an action, even if it means pushing the economy into a recession.
How Will Inflation Affect the Utah Economy and Unemployment?
In spite of the Fed’s efforts, inflation could be around for a while. Supply chain challenges and higher energy prices will remain outside of the Fed’s control. Therefore, the Fed may have to work against the economy for some time before inflation subsides. If so, Utah is in a stronger position than most states to weather such a restraint. Utah leads the nation in job expansion. The state’s June 2022 unemployment rate is historically low at 2.0% and significantly lower than the national level of 3.6%. If you know a trip to the economic valley is coming, the best place to start that journey is from the top of the mountain. That is where Utah is.
How will higher prices affect jobs in the sectors that have seen the fastest job growth in Utah?
Inflation increases input costs and limits demand. In addition, a rise in interest rates will inflate borrowing costs, cutting into profit margins and limiting a company’s ability to expand and hire more workers. The degree to which this happens depends on the industry.
Recently, Utah has seen strong job growth in the retail trade, leisure and hospitality, manufacturing and construction sectors. How might increasing costs affect these industries?
Increasing input costs are particularly important to consumer staples companies which sell items that people use daily, like food and household goods. Customers in this space are highly price-sensitive, which limits the amount by which these companies can increase their prices. These companies will have a difficult time passing the higher costs onto consumers, which could limit or reduce employment growth in this sector.
Looking at the high inflationary period in the late 1970’s and early 1980’s, the retail trade sector saw a decrease in the employment growth rate. It did not see large layoffs. Consumer retail purchases can be price sensitive, but in the time period shown, the overall employment level never dropped. One can surmise that the sheer volume of new baby-boomer consumers kept it afloat. Maybe the inflation lowered their retail consumption per capita, but their sheer volume overcame that reduction and kept retail needs growing. Such might also be a lesson to inject into the current Utah economy. Utah’s current demographics are like the U.S. boomer demographics of yore. There are more young people on the way up in Utah than there are older people above on the way out. The increasing net gains, just by sheer numbers, can keep Utah’s retail sector growing even if per capita retail purchases might happen to fall.
Leisure and Hospitality
Discretionary spending often declines during an inflationary period, as many consumers feel that they have less money to spend. Such pullbacks generally affect travel, leisure, and large goods industries.
Leisure is a major industry in Summit, Wasatch, and many southern Utah counties. This industry’s impact can be gauged in Summit County, where it accounts for 34% of employment. Summit County has faced strong headwinds due to the COVID-19 economic setback, with jobs in the leisure and hospitality sector down 8.3% from 2019.
The chart below shows that employment growth in the leisure and hospitality space stalled during the point at which inflation was growing at its steepest rate. Job growth can be expected to ebb if inflation rates continue to rise, but assuming the Federal Reserve manages to reduce the increase in prices, the sector may dodge impactful job losses.
Much like leisure, demand for durable goods, like cars or appliances, can decline with rising inflation as consumers hang on to their durable goods longer. Statewide, manufacturing jobs grew 7.6% over the past two years.
Recessions usually generate pullbacks in manufacturing activity. This could slow some of the overall Utah job count, but it could have an outsized impact on Box Elder and Juab counties as manufacturing accounts for a large proportion of these county’s employment. Manufacturing activities in 2021 comprised 31% of Box Elder’s employment and 23% of Juab’s. However, given that annual growth in the sector is expected to increase by 1.9%, any overall impact on jobs in the state should be minimal and short-lived.
Real estate is typically considered an inflation hedge as people seek to put their money into inflation-resistant assets. However, an increase in interest rates by the Fed will increase borrowing rates, possibly limiting some buyers.
Employment projections for the construction industry anticipate annual increases in jobs in Ogden-Clearfield (5.2%), Salt Lake (4.2%), and Provo-Orem (5.1%). Moreover, Utah, Summit, and Wasatch counties saw large increases in housing unit permits in 2021. Utah County’s housing permits were up 48%, but the largest increases were seen in Summit and Wasatch counties, which rose 187% and 183%, respectively. Although Provo, Salt Lake City, and Ogden all saw significant price increases for homes over the last year, these same locations are now seeing a drop in asking prices amid rising interest rates. 47.8% of homes listed in Provo have had their prices cut in May 2022. 45.8% have been lowered in Salt Lake City, and 42.6% in Ogden, according to data by Redfin. Despite these recent downward pressures, the momentum provided by increased interest in Utah homes over the last several years should keep employment in the construction sector positive while slackening demand might give the sector a chance to catch up.
With inflation and interest rates on the rise, the U.S. economy seems destined to slow. The country’s industrial production declined in June 2022 and manufacturing output fell. Industrial production fell by 0.2%. Retail sales, buoyed by a strong labor market and stimulus measures, were a main driver of the economic recovery over the past several years, but the outlook is mixed. The U.S. Commerce Department reported that retail sales increased by 1.0% in June 2022, following a 0.1% decline in May 2022, the first decline in monthly spending this year.
The question for many is whether the Fed’s rate increases will push the economy into a recession. If the U.S. economy enters a steep recession that is prolonged, the effects on the economy and employment will be more widespread and impactful. The 2008 recession had a profound effect on unemployment that stretched beyond the official end of that recession. U.S. unemployment reached its peak of 10.0% in October of 2009 from 4.7% in November of 2007. Similarly, Utah saw a peak of 8.0% from January 2010 to May 2010 compared to a low of 2.8% in November 2007.
However, recent estimates by the Federal Reserve Board Members indicate that while they expect the economy to cool over the next couple of years, a steep recession like the one in 2008 is unlikely. The median estimate for 2022 real GDP was revised downward from 2.8% to 1.7% at their most recent meeting. Real GDP growth is expected to stay at 1.7% in 2023. Their unemployment expectations increased slightly to a median estimate of 3.7% in 2022 and 3.9% in 2023, both up from a median expectation of 3.5% in March 2022.
Inflation will have an impact on some industries, but Utah’s strong economy, led by a 2.0% unemployment rate, should allow it to absorb and weather any inflation-influenced economic slowing. On average, Utah’s unemployment rate has stayed 1.5 percentage-points below that of the United States. Even if the U.S. unemployment rate rises to the highest range of the Fed’s expectations and reaches 4.2%, Utah’s unemployment rate should still be under 3.0%, an unemployment rate that is not economically stressful. If the economy enters the shallow downturn predicted by the Federal Reserve Board Members, Utah’s economy should fare well.