What to expect when you're expecting inflation

Worrying that prices will rise in the future has historically ensured they rise even faster. Should we be relieved that that link seems to be broken?

Published June 5, 2008 10:50AM (EDT)

Inflation expectations are on the rise, reports the Wall Street Journal. According to the most recent Reuters/University of Michigan consumer-sentiment survey, released last Friday, "consumers, on average, expect prices to increase 5.2 percent in the next 12 months, the highest level for an expected rise since 1982."

What this means is that average Americans have gotten so used to seeing the price of gas and various food staples rise, week after week after week, that they have become convinced it's only going to get worse.

This explosion of consumer nervousness has some interesting implications. The first is that economists and central bankers and employers get the heebie-jeebies when inflation expectations start to perk up. That's because, historically speaking, rising inflation expectations are considered a self-fulfilling prophecy. Workers who are convinced that prices are going to rise demand higher wages from their employers. Employers, in turn, raise the prices of their goods and services to pass on the cost of higher wages, and in anticipation of a surge in the costs of their manufacturing inputs. A vicious cycle gets embedded in the economy; the kind of cycle that's very hard to break. Last time it got really bad, in the 1970s, Fed chairman Paul Volcker had to raise interest rates all the way up to an enormous 15 percent to get the beast under control.

The second is that, perversely, plenty of economists believe that inflation is not as bad it might look. Never mind the high prices of gas and food -- such commodities are notoriously volatile in price, and can drop back down as quickly as they rise. That's why energy and food prices aren't even included in the so-called core inflation rate that the Fed focuses on to determine whether inflation is really getting "embedded" in the economy.

However, just as many people think the Fed is wrong to discount the impact of energy and food price rises. Combined with other aspects of how the government computes inflation, they'll tell you that the real inflation rate right now is higher than what the official numbers are telling us. Bill Gross, founder of the bond investment company Pimco, believes that the real inflation rate is 1 percent greater than the government stats indicate.. Kevin Phillips would argue it's much worse.

But not all prices are going up. Merrill Lynch's David Rosenberg argues that the cost of toys, furniture, consumer electronics, clothes, new vehicles and many other mainstays of the economy are falling. We just happen to notice food and gas more, wrote the New York Times' David Leonhardt in a much-talked-about column last month, because we buy groceries and gas quite frequently.

Paul Krugman did a nice job of explaining in his blog last week why it makes sense to pay more attention to the price trends of goods and services that are more "sticky" -- i.e., less volatile. But here's the paradox, which I haven't seen addressed directly in the myriads of commentary devoted to inflation in the econoblogosphere this week. Consumers may be paying attention to the wrong data when they form their inflation expectations -- or, to be more fair, to only a subset of the relevant data -- but those expectations, in and of themselves, theoretically have a profound effect on where the economy is headed.

So does it matter whether or not gas and food prices are volatile or not, if the mere fact of their appreciation makes consumers expect inflation to rise in general, which in turn ensures that inflation gets locked in? Doesn't that mean the Fed should pay more attention to where gas and food prices are headed, given their outsize effect on consumer psychology?

But there's even one more twist. As a number of economy watchers have pointed out so far, rising inflation expectations are not having the same influence on the general economy as they used to. Wages, notably, aren't going up.

There are a bunch of reasons for this, perhaps foremost among them, as Paul Krugman noted in his column this week, the much-diminished power of organized labor to demand concessions from management. Rather than give in to workers, employers upgrade their technology or outsource production. Workers have no leverage to demand wage increases, and thus their expectations of increasing inflation don't lock in the dreaded wage spiral.

Where that leaves us I'm not sure. It's probably a good thing that we are in less danger of getting swirled into an inflationary maelstrom than in previous decades, but at the same time, as Barry Ritholtz notes at the Big Picture, we're also more at the mercy of an economic downturn. And given the rate at which energy and other commodity prices are rising, it's not at all clear to me that the ever-dropping prices of cellphones and flat-screen TVs are adequate compensation. What we end up with is an expectation that things are going to get worse, but we are powerless to do anything about it, except cut back on steak and summer road trips.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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