Why high inflation can become a self-fulfilling prophecy

CNN, CNNBUSINESS

By Anneken Tappe, CNN Business

Soaring prices are weighing on consumer sentiment, but Americans have not cut back on their spending — at least not yet. Now, some economists worry that along with the tight labor market and rising wages, high inflation could become a self-fulfilling prophecy.

America’s job market is on fire, and most workers who have quit have moved on to jobs with higher pay or better benefits. While this wage inflation isn’t a major driver of the pandemic-era price hikes yet, it is adding to a unique inflation situation.

“Strong job growth will continue to put upward pressures on wages, resulting in higher income and more secure jobs,” said Richard Curtin, chief economist for the University of Michigan’s Surveys of Consumers. “This strength will then act to expand consumer demand and motivate another cycle of price and wage increases.”

That leaves little room for prices to come down.

Rising salaries, rapid job growth and pent up household savings mean that disposable incomes in America are still going up even as prices are heading higher. That’s “fueling continued growth of real consumer spending power,” said Bill Adams, chief economist for Comerica Bank.

US inflation has already soared to a 40-year peak on the back of high demand, clogged supply chains, as well as rising energy, food and housing costs. In response, consumer sentiment has fallen to the lowest level since August 2011.

That’s at the crux of why the current economic conditions are so unique: households on average still have pent-up savings from the pandemic, wages are rising and demand is strong. At the same time, the booming inflation is making people nervous about the state of their finances in the years to come.

For months, consumers have watched prices go up, tightening family budgets and changing their thinking behind buying decisions. Many expect high inflation to stick around all year. But it has yet to cause them to really cut back.

For economists, this means they have to factor in the psychological effect the persistently high prices will have on people: If consumers become convinced that prices can only ever go up, they might start delaying purchases. And that could lead to another dreaded scenario: stagflation, which means the US economy enters a period defined by low growth and high inflation.

“Prevention of inflationary psychology is much less costly before it becomes ingrained in the economic behavior of consumers and firms,” said Curtin. But key to that is faith in government economic policy, which isn’t exactly high at the moment, he said.

“Just when difficult decisions need to be made about monetary and fiscal policies, consumers have expressed loss in confidence in government economic policies,” Curtin said.

Earlier this month, the Federal Reserve raised interest rates for the first time since 2018 in an effort to get inflation to come down from its peak. But the central bank’s tools are blunt and it will take time for their effect to show up in the economy.

Making matters worse is the Russia-Ukraine conflict, which has already driven up the price of energy products and is expected to leave its mark on global food prices this year as well.

Ratings agency Moody’s expects the fallout from the military conflict to weigh on consumers’ minds.

“[The] US economy has weathered the Omicron wave relatively well, but the Russia-Ukraine military conflict poses new risk,” the firm said in a March report on the state of the US consumer.

The-CNN-Wire
™ & © 2022 Cable News Network, Inc., a WarnerMedia Company. All rights reserved.