Rising prices have angered people. It reduced consumer confidence, despite the economy being growing and unemployment rates low.
However, it is difficult to understand exactly how inflation is impacting, benefiting and confusing people. Everyone knows that the cost of living has increased. However, unless someone constantly has a calculator at hand, they are unlikely to know whether their salary is keeping up with inflation, whether the stock market has actually reached a real peak, or whether a lottery win is as good as the professionals say. Of marketing.
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There’s a fancy term that defines the common human failure of not seeing beyond inflated prices, largely caused by inflation. This widespread inability to recognize how much money is really worth is known as monetary illusion.
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Irving Fisher, an economist at Yale, wrote a book about this almost a century ago. British economist John Maynard Keynes popularized the idea. And behavioral economists have studied it extensively. But perceptions tend to be forgotten when prices remain relatively stable, as was happening in the United States until about three years ago.
When inflation rises by about 2% every year, who really cares? You can live normally without giving much thought to the slow erosion of the value of your money, although the most attentive will realize that even with a 2% annual inflation rate, prices double every 36 years.
Now, after a period of living with high inflation, everyone is prone to suffering from monetary illusion in one way or another.
Let’s consider that, according to the government’s Consumer Inflation Index calculation, a March 2021 dollar is worth less than 85 cents today. When I think about that number, the dollars in my account seem especially meaningless. (And I’ve been working full time since the summer of 1977. The calculator says every dollar I made at my first job is only worth 19 cents in 2024 money. Yikes!)
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Of course, everyone already knows that the purchasing power of the dollar has fallen. When the prices of products you see every day increase – a liter of gasoline, a loaf of bread, a cup of coffee – you realize that the prices have gone up.
Still, it’s easy to get caught up thinking that a dollar is simply worth a dollar, and always has been.
Stocks and lottery
Some aspects of the impact that inflation has on markets are well known, but I believe that the profound effects of inflation on stocks and bonds are still largely underestimated.
First, certain parameters of the costs of inflation are clear. Because the Federal Reserve (also known as the “Fed”) is fighting inflation, short-term rates are high. And several consecutive months of negative inflation readings have made it unlikely the Fed will cut rates anytime soon. In the bond market, which reacts to signals from the Fed and investors’ assessment of inflation and economic growth, yields have soared. Therefore, several consumer credit rates have increased. These include mortgages, credit cards and personal loans.
Additionally, this month’s realization that the Fed is in no rush to lower interest rates has paralyzed the stock market.
I recently wrote about a lesser-known aspect of inflation. The frequent enthusiastic references to new peaks in the S&P 500 during the recent rally failed to take into account rising consumer prices. (They used what economists call nominal, not real, prices.) When adjusted for inflation, it wasn’t until March that the stock market reached a new peak for the first time in years. I relied on an analysis by Robert Shiller, a Yale economist who has long used inflation-adjusted data to pierce the veil of monetary illusion. Due to the setbacks of recent weeks — high inflation and a faltering stock market — the market has fallen below peak levels in real terms.
Using nominal returns in an inflationary era can lead to the wrong conclusion that the market is generating phenomenal returns.
Another product of monetary illusion that state governments are relentlessly exploiting are lottery prizes. As I mentioned in March, many of the recent huge premiums have been artificially inflated by questionable marketing practices, high interest rates, and inflation.
When exploited by skilled marketers, money illusion can get careless people so excited that they end up investing hard-earned money in illusions like lotteries and booming stock markets.
Dissatisfied workers
The old refrain that the rent is too high is resonating now. High housing costs are included in government indices and are responsible for much of the recent official increases in inflation.
Salaries are another persistent problem. Several surveys show that many workers believe that their salaries have not kept up with the cost of living. Whether they followed it or not is debatable. Official data on average salaries is volatile and difficult to interpret.
Meticulous research by economists David Autor, Annie McGrew and Arindrajit Dube shows that for people on lower incomes, real wages have increased, eliminating nearly 40% of the long-standing pay gap that existed between the richest and poorest workers. in the United States.
Still, because inflation of essential goods like food, housing and transportation puts more pressure on people with lower incomes than on the rich, it’s not clear whether these wage increases are properly analyzed.
In fact, research carried out by Stefanie Stantcheva, a scholar at Harvard and the Brookings Institution, based on Shiller’s previous work, concludes that this is not quite the case.
People tend to give the government responsibility for the pain of inflation and themselves credit for the raises they received, even as they get angry because those raises don’t seem to be keeping up with the cost of living.
This is a fundamental question when inflation is high.
“Money Illusion,” a classic paper published in 1997 by economists Eldar Shafir and Peter Diamond and psychologist Amos Tversky, demonstrates that in periods of high inflation, employers can get away with giving workers raises that amount to pay cuts substantial when adjusted for inflation.
Suppose inflation is rising at an annual rate of 4% and you receive a 2% raise. You just took a real pay cut. If there is no inflation and your salary is reduced by 1%, you will also get a pay cut, but you will lose less than in the case of high inflation. The strange thing is that workers tend to consider larger pay cuts as fairer.
This makes sense, the authors say, when you take monetary illusion into account.
Where are we now
At this moment, consumer opinion surveys record a smaller distortion than that recorded in similar periods with regard to economic growth and employment. Stanford economists Neale Mahoney and Ryan Cummings believe inflation and persistent dissatisfaction with price levels could be the cause.
By analyzing previous periods of high inflation, they made some rough calculations that show that the negative effects of inflation on consumer sentiment fall by 50% every year. In other words, they have a half-life of about a year.
Mahoney updated the search at my request.
In the three years to March, prices rose 17.9%. According to Mahoney’s model — and, crucially, assuming that the inflation rate immediately falls to the level of the Fed’s forecast of 2.5% per year — there would be an 8 percentage point increase in consumer sentiment by November. It turns out there will be a national election during that period.
Both Mahoney and Cummings served in the Biden administration. If they are right and inflation does fall quickly and stay low, the improved national mood could influence the outcome of the election.
But inflation has defied economists’ forecasting efforts in recent years. I don’t make assumptions.
I certainly hope that inflation falls and that it is safe to live a normal life without thinking about monetary illusion. But it will be a long time before I stop noticing the contraction in the value of the dollar.
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