Economists Lack the Tools to Fight Inflation
Why a mild recession is likely and what you should do to prepare for it
When will we be done with high inflation?
Over the past year, we’ve had our first bout of high inflation in a generation. People rightfully hate high inflation. When the price of goods rises faster than your income, your quality of life decreases.
With central banks raising interest rates aggressively, a question I get a lot is, “when will we be done with high inflation?”
Read to the end of this post to learn why we probably need a recession to conquer inflation and what you can do to prepare for that eventuality.
A 30-second explanation of inflation
First, what is inflation?
Reported inflation numbers measure the percentage change in prices compared to a year ago. When you hear that the inflation rate is 8%, that means that the cost of goods and services you buy is, on average, 8% higher than last year.
Second, what causes high inflation?
Inflation is about supply and demand; it increases when too much money is chasing too few goods.
All else equal, if the demand for goods goes up or the supply of goods goes down, prices rise and vice versa.
There have been a lot of things that have increased demand and impacted the supply of goods in the economy over the past few years.
COVID
Supply chain strains
Trade conflicts and a trend toward deglobalization
Fiscal stimulus in response to COVID lockdowns
Monetary stimulus
Increased energy and shipping costs
Russia’s invasion of Ukraine
Historically low unemployment
All these factors have created a perfect storm of increasing demand and constrained supply. As a result, we have high inflation.
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Why economist’s struggle with inflation
Economic models make a subtle but crucial assumption; People always respond rationally to financial incentives.
But we all know that most people do not act rationally, and certainly not in every situation.
Central banks worldwide have been raising interest rates at the most aggressive pace in a generation. They have been doing this for the sole purpose of crushing high inflation. Raising the cost of borrowing money, makes it harder to spend money. The less money people spend, the quicker inflation will return to normal. To be clear, lower inflation does not mean prices will go down to where they were two years ago; it means prices will stop going up so damn fast.
In 2022, everything is expensive.
Mortgage/rent
Energy and utility bills
Food
Physical goods
There’s an old saying that “the cure for high prices is high prices.”
Basically, the economic thinking of central banks has been that if you raise the cost of borrowing on top of the higher costs for everything else, people will spend less, and inflation will come down.
Except, people are not rational; they love to buy stuff.
If you ask someone f they plan on scaling back their spending this holiday season because of inflation, they will say “yes.” While I believe they believe that, the data (so far) paints a different story.
If the price of everything—including rent and mortgage payments—increases dramatically as it has in 2022, the rational response would be to cut unnecessary spending from your budget.
What is one of the easiest budget items to cut?
Eating out at restaurants.
Eating out is always more expensive than cooking your own food, and this year the average price increase at restaurants is up 8.6%.
According to data from OpenTable, the number of people in the U.S. who dined in a restaurant in November 2022 is 3% higher than before COVID.
So inflation is running wild, and people are eating out at restaurants in record numbers.
If you’re a central banker, you look at a number like that, and you want to pull your hair out—because inflation will remain high until numbers like that start coming down.
The most likely outcome is that they will continue to raise interest rates, even if that causes a recession. High inflation does not seem to be slowing people’s spending down enough.
I should note that if we get a recession, the odds are that it will be mild. Apart from inflation, the economy is on solid footing, and jobs are plentiful. There is no evidence that we are on the brink of a 2008-style depression-level recession.
How to prepare your finances for a recession
As a possible recession looms, you’ll see a lot of headlines about the financial moves you need to make.
But here’s the truth; to manage your money in anticipation of a recession, you should keep doing everything you are supposed to do in a booming economy.
People who take care of their finances in a strong economy will be the least impacted by the next recession and in the best position to profit from falling asset prices.
Repeat after me:
I will not panic.
I will stick to my financial plan.
If I don’t have a plan, I will create one ASAP.
I will tune out clickbait headlines encouraging me to panic.
Focus less on making money moves dictated by scary headlines and more on managing money to minimize the impact a recession can have on your finances.
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This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
The OpenTable restaurant data is quite surprising and differs greatly from what my restaurant owner friends are reporting. Cheers!