There’s a big hole in the Fed’s theory of inflation—incomes are falling at a record 10.9% rate

There’s a big hole in the Fed’s theory of inflation—incomes are falling at a record 10.9% rate
Inflation is being starved of its oxygen. The purchasing power of after-tax household income has plunged 10.9% in the past year. MARKETWATCH

The most concerning thing about Thursday’s report on U.S. gross domestic product for the first quarter wasn’t that the first line of the first table showed that real GDP fell at a 1.4% annual rate. It was the little-noticed news on line 34 showing that real disposable incomes fell for a fourth straight quarter.

Incomes are perhaps the least-appreciated factor in driving economic growth, because everything starts there.

Unwinding stimulus

Over the last four quarters, the purchasing power of after-tax household incomes plunged by $2.2 trillion (in 2021 dollars). That’s a 10.9% decline, by far the largest in the records dating back to 1947.

Of course, the decline in incomes is merely the unwinding of the massive support that households received from the government in 2020 and 2021 via direct pandemic stimulus payments, the child tax credit, and enhanced benefits for unemployment insurance, food stamps and Medicaid, and more.

This means that the Fed is chasing a shadow. Because if our current spike in inflation is all due (as many people argue) to an overly generous federal government giving its people too much money, then our inflation problem is about to go away.

As economists Yeva Nersisyan and L. Randall Wray of the nonpartisan Levy Economics Institute of Bard College conclude in a paper published this month ahead of the GDP report: “Most of the government’s income support has already disappeared, so going forward it is not an important contributor to demand in the economy.”

The faucet has been turned off. Without all the extra money from Uncle Sam, U.S. households will have to live within their means once again. Demand will slow, and so too will inflation, according to the ironclad economic laws of supply and demand.

Inflation would be starved of its oxygen.

Mission to destroy demand

If consumer demand—fueled by free money from Washington—has overheated the economy, then our inflation problem is solved even before the Fed really gets going. “There is no excess income left to drive the economy beyond capacity,” say Nersisyan and Wray

But the Fed is determined to quash demand. That’s what raising interest rates FF00, +0.00% is all about: Slowing demand in an overheated economy by raising the costs of borrowing.

Already, we can see signs that even the promise of higher interest rates is reducing demand for home purchases. Higher interest rates could also push down demand for motor vehicles and other large consumer purchases (although aside from mortgages, American households have been taking on very little debt in the last two years).

Higher interest rates would also affect business investment decisions (although once again the conventional wisdom ignores the evidence that businesses base their investment decisions almost entirely on net costs (profits) rather than gross costs (interest payments). And profits are high, especially if companies can raise their prices.

Bears and birds

The Fed has a real problem here: Consumer spending (outside of housing) isn’t very sensitive to the level of interest rates, and neither is business investment. But the financial markets are quite sensitive to interest rates. The Fed might keep jacking up interest rates, only to find that the only thing they’ve accomplished is a bear market.

History shows that the Fed typically has to raise interest rates enough to destroy jobs, not just demand. Soft landings are rare birds.

What if our inflation problem isn’t due to too much demand but to other forces? In that case, the Fed might be making a big mistake by slowing demand.

The real causes

What could those other forces be?

It’s likely a combination of factors, starting with supply shortages. The pandemic and now the war in Ukraine are disrupting supply chains in precisely the areas with the largest increases in prices: fuel, food and durable goods, particularly electronics.

Mainstream economists love to make fun of liberals who put the blame on profit-maximizing companies, correctly pointing out that corporations have always been greedy. But these economists, wedded to unrealistic models of perfect markets, can’t see that lots of the price increases that have been announced are clearly opportunistic. Businesses admit as much on earnings calls and in anonymous surveys.

Microsoft MSFT, +2.26% isn’t being forced to raise prices for software it developed decades ago. Energy suppliers base their investment decisions on long-term profitability, not short-term supply shortages. Quasi-monopolists such as Tyson TSN, +2.21%, Netflix NFLX, +5.82% and Amazon AMZN, +4.65% may try (and sometimes fail) to raise prices opportunistically even if their profit margins are already high.

We do know that higher wages aren’t a major cause of inflation, because wages aren’t keeping up with inflation, even for lower-paid workers who jump from job to job in search for better incomes. Real compensation per hour is actually falling, even though productivity is higher.

The prospect for stagflation—low growth with high inflation—is real. “The appropriate solution to inflation would be to work to alleviate supply-side constraints,” say Nersisyan and Wray. To do that, unfortunately, “we need more domestic investment, not less.”