Rust Never Sleeps And Neither Does Inflation

David L. Sollars holds a doctoral degree in economics from Florida State University. He is dean and professor of economics at Washburn University School of Business. The views expressed in this article are his own.

In 1979, Neil Young and Crazy Horse released a hit rock ‘n’ roll album, “Rust Never Sleeps.” Those of us in a particular age group remember it well. We also remember rampant inflation in 1979 (13.3%).

Since then, the United States has enjoyed relatively mild to low inflation over the last four decades. In the decade before 2020, inflation, as measured by the Consumer Price Index (CPI), was often in the 1-2% range. Inflation, even when low, creates several problems: reduced purchasing power for consumers, reductions in real wealth, higher debt costs and uncertainty in capital goods investment and business. It has an economically corrosive effect — much like the rust Neil Young sang about.

Worse problems arise when inflation is unexpected and volatile. Following the short pandemic-related “shut-down recession” in early 2020, U.S. inflation was less than 2% and even approached zero (see Figure 1). Then, inflation spiked again, with the year-over-year change in CPI increasing to 9% in the summer of 2022. It then began a decline to 3% in the summer of 2023. Inflation has been running at a constant 3.5% for the last year.

WHAT IS INFLATION?

Inflation is the measurement of price level changes for things that we purchase. A year-over-year change in the CPI is the most utilized measure. Computed monthly by the Bureau of Labor Statistics using a massive national data collection system, CPI measures the weighted average prices for a basket of goods and services representative of aggregate U.S. consumer spending. As an index, it allows a comparison of the purchasing power of a dollar over time

Figure 1: Monthly Inflation Rate, Year Over Year Percent Change in the U.S. Consumer Price Index (CPI). Source: Federal Reserve Bank of St. Louis.

For example, the market basket of goods and services that cost $100 in January 2020 would require $122 to purchase today, as of the time of writing in April 2024. If you wonder why your shopping cart seems more expensive, the answer is that it is more expensive.

It’s important to note that a declining inflation rate doesn’t mean the price level decreases or things get cheaper – it simply means prices are not going up as fast.

WHAT CAUSES INFLATION?

Economist and Nobel laureate Milton Friedman once said that “inflation is everywhere and always a monetary phenomenon”: governments or central banks conducting too-expansionary monetary policy or fiscal policies, resulting in too many dollars chasing too few goods and services.

During the early stages of the pandemic, the Federal Reserve pushed interest rates to zero and flooded the banking system with liquidity. Likewise, the federal government suspended all fiscal sanity and injected stimulus into the economy at a rate not seen since World War II. In some ways, it was successful — the shutdown recession was short-lived. However, as Professor Friedman also pointed out, the effects of such monetary and fiscal policies create “long and variable lags” in their economic impact.

Recent news reports of the Fed’s deliberations suggest they are somewhat puzzled, as inflation has remained above the 2% target despite several rounds of raising interest rates. Likewise, while fiscal policy has returned to a normal range, annual federal deficits continue at levels associated with war-time crises.

OTHER CAUSES OF INFLATION

Supply shocks can also result in higher prices. Disruptions in world oil supply are an example. These changes, however, are transitory and don’t result in long-term inflation. Some (primarily politicians) have argued that our recent bout with inflation is due to “corporate greed.” This is a red herring. Economists would say that corporations are always greedy. Those companies would love to charge you more, but competition holds market prices in check.

Figure 2: Trend in Average Hourly Earnings, Private Sector, Adjusted for Inflation. Source: Federal Reserve Bank of St. Louis.

HOW INFLATION AFFECTS CONSUMERS

Inflation means the typical market basket of things we buy is more expensive. It shows up in the prices of individual goods as well. One of my favorite indulgences is the Big Mac Extra Value meal at McDonald’s — please don’t tell my cardiologist! I used to pay $6, but it cost $10 today.

If wages kept up with inflation, meaning our real wages remained constant, then it wouldn’t be a big problem. However, real wages have declined post pandemic and only recently began recovering to pre-pandemic levels (see Figure 2). Your family’s January 2020 take-home pay of $1,000 per week would have to be $1,200 today (20% more) just to maintain the same purchasing power.

A bigger problem is that fighting inflation involves raising interest rates for everything: mortgages, cars, credit cards, consumer debt, etc.

Many households are very leveraged, which is just a nice way of saying they use debt to get by month to month. Higher interest rates mean they must pay more monthly interest, reducing their spending on other things. This increased cost of borrowing isn’t included in the CPI but affects households similarly.

HOW INFLATION AFFECTS SAVERS AND INVESTORS

Short-term interest rates have returned to more historic levels, but even then, inflation is a corrosive force. Your one-year 5% rate CD returns only 1.5% in real terms. Your balanced 401(k) retirement fund has had difficulty keeping up, even with relatively decent recent returns. Overall, household wealth, which was on an upswing before 2021, has moved sideways over the last three years.

If you have a fixed-income pension (one not adjusted for inflation), then the real value of your monthly check has permanently eroded. Social Security payments and some federal government pensions are adjusted annually for inflation but remain a small part of many people’s retirement income.

POLITICAL IMPLICATIONS OF INFLATION

Inflation breeds uncertainty for consumers and investors. Recent polls show that two-thirds of respondents think the country is headed in the wrong direction. Some voters have a certain nostalgia for a former controversial president based on their recollection of the economic conditions during his administration.

Rent, fast food and groceries for low and middle-income families are taking up a larger share of their income than ever. A recent study by a group of Harvard-based economists suggests that U.S. consumers’ higher borrowing costs explain much of the current negative economic sentiment.

WHAT CAN YOU DO ABOUT INFLATION?

Disclaimer: I am not a financial advisor. That said, some assets hedge better against inflation. Precious metals such as gold (up 50% since January 2020) and other commodities tend to be better inflation hedges.

For homeowners, rising real estate values keep pace with inflation even if property taxes and insurance premiums increase.

Some investors hold inflation-indexed government bonds in their portfolios. Specific sectors in the equity markets, such as energy, have also tended to increase in value during inflationary times. “Investing like Warren Buffett” is a bit cliché, but buying long-term blue-chip companies or even a broad-based index fund is better than stuffing depreciating cash under your mattress (or leaving it in your checking account).

More advice: do the Dave Ramsey thing and get out of debt to avoid those increased interest costs.

Rust may never sleep, but its corrosive effect is felt over time.

I celebrated a “big” birthday this year. Let’s pretend that for my first birthday in 1965, my grandfather gave me a pristine $1 bill, which I have kept in an envelope until this year. Today, it would buy a dime’s worth of equivalent goods, as it has lost 90% of its purchasing power over the intervening six decades.

Inflation, when high or even at low levels over time, constantly eats away at our income, wealth and economic well-being.

TK