We’re Just Getting Poorer. Less “Inflation” Than “Stuff Getting More Expensive.”

We aren’t going through an “inflation” so much as a collective impoverishment.

• Prices are going up.  The October CPI was 8.11%.
• Wages are not keeping pace with prices.  Wages in September grew 6.3%, slowing down after a peak of 6.7% in August.  Per the Atlanta Fed’s excellent wage tracker.

So we are a couple of percentage points poorer relative to last year.  It really is that simple.  A recent Bank of England explains the dynamics quite nicely.  The details are UK-specific, but the general points apply anywhere prices are rising faster than wages.

for given GDP, rises in the relative prices of goods and energy make us collectively worse off. And that’s exactly what’s happened over the past couple of years, thanks first to the pandemic and then Russia’s cut in gas exports. Over that period the price of the UK’s imports has risen by 20% more than the average price of its output….

As a result, real income for the non-North Sea economy as a whole – how much our collective output is actually worth, in consumption terms – has fallen by over 5% since the end of 2019.

Here is where inflation kinda sorta kicks in…

It’s understandable, faced with this extraordinary squeeze, that people and firms in the UK economy have sought to protect their real incomes – whether pay or profits – through compensating rises in wages and domestic prices. Unfortunately, and at least collectively, those efforts will not make us better off. It’s not as if one group or sector is worse off only because another, within the (non-North Sea) UK, is better off. The rise in import costs has depressed the purchasing power of the country as a whole. So all that can be done is to shift the losses from one place to another.

So what can the Fed (or the UK’s MPC in this case) do about it?  Not much.  He makes an argument for slowing the economy further to keep inflation expectations anchored.  But that amounts to accelerating the economic slowdown being driven by prices going up faster than wages.  If the Central bank does nothing, the economy will still slow down.  Because stuff got more expensive.  So we buy less stuff.

Monetary policy cannot undo the hit to real income. Nor could it ever have done. One often hears that people are worse off “because of inflation”. This is not quite right. Implicitly, it presumes that monetary policy could have prevented prices from rising so fast without doing anything to nominal incomes. Unfortunately, that’s not the case. Even assuming policy had been tightened sufficiently aggressively, and sufficiently early, to have knocked eight percentage points off the current rate of inflation, it would also have depressed nominal income growth by at least as much and almost certainly quite a bit more. Unemployment would be materially higher and nominal wage growth materially lower. Ultimately, this reflects what is known as the “neutrality” of monetary policy: in the long run it has no impact on real economic variables (things like real output or relative prices). It can’t boost structural productivity, for example. Nor can it offset the consequences for real incomes of (say) disruptions to supply chains in Asia or Russia’s curtailment of the supply of gas to Europe. Indeed, in the first instance, at least for a period of time, tighter monetary policy lowers GDP and real incomes. I will say more about this shortly. For the time being, a better short-hand description is this: the pandemic and the war have led jointly to higher inflation and lower real incomes; the MPC will ensure the inflationary effects do not persist into the medium term; but the real-income hit exists either way, and will be reversed only to the extent the underlying shocks themselves go away.