You’ve probably heard inflation is rising. Given it affects how much our hard-earned dollars can buy and reflects the health of the economy, knowing how high it will likely go is important.
And a crucial race has begun between inflation and wages. Both are rising, but the closer the race, the worse for your paycheck — a phenomenon you may not realize.
Inflation measures the general increase in prices of everything we buy.
The good news is that right now inflation isn’t high, and it isn’t rising fast. Inflation in the last year has been about 2.5 percent – versus a historical average of about 3.2 percent. And since the Great Recession hit in 2008, inflation has hovered around 1.4 percent per year, on average, so we’ve had a long break from even average inflation.
That’s lulled us into thinking inflation isn’t a big issue. In fact, inflation hasn’t been a big deal for U.S. consumers since the 1980s. In that decade, it averaged about 5.5 percent, and in the 1970s it averaged about 7 percent. So, if you’re under age 40, you probably have never worried about it.
You may have heard that the nation’s central bank – the Federal Reserve – wants inflation about 2 percent. Since inflation does sap the purchasing power of our dollars, that seems like a bad deal for us consumers. But inflation is also a measure of the economy’s health.
Think of it like the economy’s blood pressure. Too low or too high spells trouble, but around 2 to 3 percent reflects a healthy level of economic activity. We all want that.
Economic theory also holds that if we expect inflation to increase, it will cause us to spend more. Considering two-thirds of the economy is based on consumer spending, more spending is a good thing. The theory goes that we’ll buy more stuff today because it will be more expensive tomorrow. But at these low inflation levels, there’s little evidence inflation spurs spending.
Ask yourself, are you worried about inflation to the point you’re going to buy more today? Did you even know what the inflation rate was? Probably not.
Now, if inflation is much higher, say 5 percent or more, that could cause you to buy a big-ticket item, such as a car, sooner rather than later.
Just exactly what the inflation rate is depends on which rate you pick, so inflation can be a slippery number. The inflation numbers quoted above are the Consumer Price Index, or CPI, which is what most people think of when it comes to inflation.
But the Federal Reserve prefers to use something called the “personal consumption expenditures,” or PCE. This is a more conservative measure of inflation, so it measures lower than CPI. Further, the Fed uses “core” PCE, which cuts out volatile food and energy prices. Core CPI just hit 2 percent, which is the preferred rate the Fed wants to see.
The Federal Reserve has tools to clamp down on inflation — mainly by increasing interest rates — before it rises too high. And the Fed has signaled it has no problem letting PCE rise above 2 percent for a short time.
Inflation is also slippery because when the inflation numbers are tame, you may still feel the pinch of higher prices.
For example, when gas prices spike and it costs an extra $10 to fill up our tank, or our grocery bills rise, we feel inflation the most — even though energy and food aren’t included in some inflation measures. So, the different measures of inflation can be confusing, and reports that inflation is low or under control sometimes don’t align with what we’re feeling day-to-day.
Now back to race between inflation and wages. Because inflation erodes the purchasing power of our money, to figure out what your paycheck is really worth, factor in the inflation rate. If you make $50,000 a year, and inflation is 2.5 percent, after a year your purchasing power (your real wage) has fallen to $48,750. Now say you get a 3 percent raise, or $1,500 added to your $50,000 salary. Your nominal wage may be $51,500, but your real wage is $50,250.
But we tend to ignore the effects of inflation, and just focus on nominal dollars, a phenomenon called “money illusion.”
Wage growth — also a slippery number — is currently, according to one widely-used measure, at about 2.8 percent. The best case for workers is that wages increase at a rate faster than inflation, so our real wages rise at a healthy rate. The peak of wage growth during the last economic cycle was 4.4 percent (September of 2007), and in the cycle before that it was 5.4 percent (November 2000), according to Federal Reserve data.
So, for our real wages to grow at a healthy rate, inflation should rise not much more than the current rate, and wages should grow as fast as in previous cycles.
About the Author: Robert Frick is the corporate economist for Navy Federal Credit Union. He holds a B.A. (Journalism) and an M.B.A. from the Pennsylvania State University, and was a financial and business journalist, including working as a newspaper business editor and senior editor for Kiplinger’s Personal Finance magazine. He was also editorial director of a financial publishing firm and is an expert in behavioral economics, having published more than 50 articles on the subject, and having worked as a researcher, writer and speaker for the Allianz Center for Behavioral Finance.