Plain English with Derek Thompson - The Big Inflation FAQ: Why It’s So High, How Everyone Got It Wrong, and What's Next

Episode Date: June 13, 2022

Inflation is the story that everybody keeps missing. In 2020, many people didn't expect inflation to rise. Wrong. In 2021, many expected inflation to be brief or "transitory." Wrong. Last month, many expected inflation to peak. wrong. In May, inflation reached its highest level in more than four decades. But there’s a bigger story to tell here. What are the subtler inflation numbers telling us about the future of the economy? And is the media being too pessimistic about the economy given how strong the labor market has been coming out of the pandemic? To answer those questions, Derek welcomes Justin Wolfers, a professor of public policy and economics at the University of Michigan. As you’ll hear, Wolfers is brilliant, straightforward, and incredibly un-shy about telling Derek when he thinks he's full of it. If you think Derek is full of it, or if you would like to drop a more complimentary line, send your notes, questions, and curiosities to [e-mail] Host: Derek Thompson Guest: Justin Wolfers Producer: Devon Manze Learn more about your ad choices. Visit podcastchoices.com/adchoices

What's up, guys, Rachel Lindsay here, and I am teaming up with your favorite Ringer podcasters to deliver the Bravo drama and news that you've been craving on morally corrupt. It's the show about all things Bravo. From the Housewise to Summer House and everything in between, we'll be mentioning it all every week. Check it out on Spotify and the ringer.com. Today's episode is about inflation, how the media tells the inflation story, and how economists see the inflation story. Quote, U.S. consumer inflation reached its highest level in more than four decades in May

as surging energy and food costs pushed prices higher with little indication of when the upward trend could ease. End quote. That was the lead paragraph from the Wall Street Journal's front page on Friday. Here's the top of Bloomberg Friday afternoon. Hot inflation and flagging sentiment. up the ante for Fed Biden. Consumer price index rises 8.6% in May, fresh 40-year high. Sentiment gauge plummets to a record low on higher prices. Look, there's no question that inflation is an economic nuisance and a political problem right now. Maybe the political problem for Democrats.

Gas prices breached $5 for the first time ever in the U.S. in the last week at the same time that food inflation breached 10% for the first time since 1981. Like, any way you put it together, it looks pretty bad for the ruling party. But there is a bigger story to tell here. And that question is, what are the subtler inflation numbers telling us about the near future and medium-term future of this economy? Stripping out the volatile numbers like energy and food, what is core inflation telling us about the U.S. economy? What is it the Fed's most likely to do in the next six months? And how might interest rate hikes ripple through the U.S.

the housing market? And is the media just being too pessimistic, too Debbie Downerish about the economy given, for example, the strong labor market coming out of the pandemic? To answer those questions, I'm very, very glad to welcome Justin Wolfers. Justin is a professor of public policy and economics at the University of Michigan. And as you are about to hear, he is incredibly smart, incredibly plain Englishy, incredibly well-spoken, and incredibly unshy about telling me when he thinks I am totally full of it, which is always welcome on this show. If you think I'm full of it, or if you would like to drop me a more complimentary line, send your notes, questions, and curiosities to plain English at Spotify.com. I'm Derek Thompson. This is plain English. Justin Wilfers, welcome to the

podcast. Hey, Derek, it's a pleasure to be here. So what I want to know, for starters, is how a professional economist processes an inflation report like this. So it's 8.30 a.m. Easton Standard Time on a Friday. You go to the Bureau of Labor Statistics website. That is bLs.g.O.V. You click on this report. What do you look at? What jumps out at you? One thing that will actually help you get a bit of context of that is, first of all, you do a bit of thinking before you get there. And you think, what is it I expect to see? And also have a look at what the professional forecasters in financial markets think that they're going to see. But my eyes immediately are drawn to what's called core inflation.

That's the overall inflation level, but you strip out or remove the effects of gas and food. A lot of people don't like that because the truth is, we all buy gas and food. Right. Gas and food are actually pretty core to people's lives, but it's called core inflation because gas and food tend to be very bouncy in terms of prices and other prices tend to be a little bit more stable in terms of their growth. Is that right? Exactly. So partly it's bouncy and partly they bounce for non-fundamental reasons. So energy prices are up a lot more because of Putin than because of the economy. Food prices can rise and fall because of the weather rather than the economy. So it's a little bit like looking for the signal amidst the noise. And if we want

to know what's going to happen in the future, you care about the underlying rate of price change, and that's what core inflation tells you. So you never get the dramatic headlines out of core inflation. Today's dramatic headline was inflation's 8.6 percent, 40-year high. Sky is falling. The core rate says, well, you know, we're in a kind of one-off moment with Putin right now and everything happening there. So, you know, strip that out and we see a rate of 6 percent, which is certainly high enough to be troubling. And when you look at the other numbers, I should say, I'm not going to try to lead you down a catastrophic trail here. But a lot of the other numbers are pretty high.

You have groceries up 11.9%. That's the biggest increase since 1979. Now, groceries include food, and food is not a part of cornflation. Airfare is up 37.8%. That's the largest since 1980. Restaurants, food away from home, are up 9%. That's the largest ever. and then fuel oil, which again is not part of core inflation, but people care about it and

oil prices are printed and like size 1,000 font all over the country. Those are up 107%. That is the largest rate ever. So there are a lot of really, really high numbers here. What is the deep story of this inflation print? Like if I'm a freshman in your econ, current affairs 101 class, I raise my hand. Professor, why is this happening? Disentangle the deep story. here. I'm going to go back to what you did and what you just did, and I'm going to teasingly call that the Fox News report. Let's do it. Because if what you want to know is what's going on with the overall price level and people's cost of living, that's the headline inflation number. If what you want to know is where's inflation going, look at core inflation. Is there any

reason to look beneath the surface? An initial answer is for most of the questions you care about, which is what's happening to the overall price level and its future, there's no reason. And so I jokingly called your intro there, the Fox News approach, because what you did is, well, inflation's 8%, but look at all these other prices that are higher. Well, the thing is, with any average, some things are higher and something's a lower, and we usually think you should look at the average. So let's not play that game. Now, it is relevant if you're thinking about things like politics. So we're in a particularly unlucky moment right now, which is the most politically salient prices of gas and grocery stores, right? So we take them out.

out of core inflation because we think they're uninformative about the future, but they're incredibly informative about the real cost of living pressures facing families and also how they perceive them because you see your gas bill, you fill up all the time, whereas, you know, paying for things like education, it's actually much more expensive, a much bigger part of a family's budget, but you don't see those bills anywhere near as frequently. So we're actually at a bad moment where the headlines look even worse than the reality, which is already bad. I think it's a very fair point, and I'm glad that you said that. I think it's a totally reasonable critique. I think it's important to say that there are some numbers that are useful for predicting

the future, and there are some numbers that are useful because they describe the present. So if you are trying to predict the future, you should focus on core inflation, which, as you've said now several times, is lower than headline inflation and certainly lower than the numbers that I just listed. But if you're trying to describe the present and describe the present and describe why consumers are so upset and describe why the Biden administration is in such political trouble and describe why Democrats are in such political trouble in November and so on and so forth. It does make sense to do a little bit of what you call the Fox News game and I'll just call the inflation items game, the itemized inflation game.

No, it still doesn't. What you want to know is what's happening to the cost of living for regular people? That's what the headline CPI measures. What's the average price rise across all the stuff actual people actually buy? Don't tell me about what's the upsetting set that happen to be higher than that, or on the flip side, don't tell me about the optimistic set that happened to be lower than that. For most interesting questions, your answer is going to be look at core or look at headline. Now, not all questions, right?

So, anytime, here's the advice I want to give you listeners, anytime someone's not referring to either the main headline measure or core, ask yourself what questions. is this trying to answer? Often it's what's the most catchy headline I can get. Now, there are some cases right now are actually in a very unusual place in the economy, which is we're still coming out of a pandemic. The pandemic clobbered the service sector,

and it created all sorts of frictions and supply-side problems in the goods sector. So there's a really good economic reason to say what's happening to goods prices separately than service prices. There's not one economy right now in some sense there's two. That's an unusual. thing to say. So the next thing I say is maybe we want to look at what's happening to services

overall, what's happening to goods overall. But let's not get down to what's happening to beef, what's happening to cupcake prices, up 11.8%. Let's make sure that we're answering the question at you or your listener is really interested in asking. That's very fair point. So let's talk about that shift between goods and services, because this is a really important thing that's happening. You know, last year, one of the explanations given, a reasonable explanation, given for why we were seeing such sudden and high inflation was because a lot of Americans were spending their money on durable goods at a time when the pandemic had still shuttered parts of the services economy. And over time, as the economy has opened up, some of that spending has shifted

from durable goods. That's kind of a fancy word for just stuff, really, stuff like furniture or electronics. Washing machines. Yeah. But that spending is now going toward services, and inflation is still high. So what does that tell us? Right. So what's important is the good sector, first of all, got an unusual bump as we all started buying stuff instead of services. And when too many people want to buy the same thing, that's what causes price rises. The other thing about goods, and particularly durable goods, is they arrive here on ships from overseas. And so any problems with shipping or more generally what we call supply chains or any problems in foreign countries end up coming through goods prices.

So the, if you want excuses that economists were making for, oh, look, don't worry about this, it's just a bit of a post-pandemic hiccup, are mostly excuses that would apply to goods inflation. And for months, it had been the case goods inflation was high, but services was sort of looking pretty reasonable. And what's happening right now is we're starting to see inflation move from the goods sector, you know, it's impossible to buy a car, to the services sector. Now that means we're starting to sit all across the economy. That's a lot more worrying. Hmm.

And why is that more worrying? Why is it so much more worrying that you're starting to see that sort of bug of inflation, like the bacteria, virus inflation, start to spread from this contained segment of stuff, durable goods, electronics, to everything else, services, places like restaurants, all sorts of little items that I will not give these specific inflation number for because they don't want to get in trouble again? I think your analogy there of thinking about it as a disease is perfectly, it's a great one. More to the point, we had one-off excuses for what was happening on the good side.

We don't have one-off excuses for what's happening on the services side. So we sort of want to know what's the underlying inflationary impulses in this economy. Once we get rid of the Putin-Ukraine problem, once we get rid of bad harvests, once we get rid of all of these one-off factors, the supply chain constraints, once we get rid of all of these factors. Now, it turns out those factors have very few effects on the services sector. So what you're trying to do is look down the track six months when those one-offs have gone away, we're left with what's going on in the service sector, and it's starting to look a little more inflationary than it was. Now, again, I want your listeners to keep this in perspective.

The headlines you're going to read in the newspaper are 8.6% inflation, the highest we've seen in 40 years, the world's on fire. Services sector inflation is nowhere near that. I think once a lot of these one-off factors are stripped out, first of all, you You can look at core inflation. It's running at 6%. It's still affected by things like snarled ports and the like. The underlying rate of inflation may be a little closer to like, you know, 4%.

That's worrying, but it's not, you know, pants on fire crazy. Right. Let's put myself again in the role of a freshman in your economic current affairs 101 class. And I raise my hand again, and I say, why is this such a surprise to the most important and powerful economist in Washington, D.C. Why does it at least seem like Treasury Secretary Janet Yellen didn't anticipate this? Why does it seem like Fed Chair Jerome Powell didn't see the iceberg until it was gashing the boat? Why do you think inflation seemed like such a surprise, these people who are paid the big bucks

to see stuff like this coming down the pike? Let me give two very simple answers. One is we have not seen inflation in 40 years in the United States. I mean, we've seen 2% inflation, which is near enough that Chairman Greenspan, former head of the Fed, calls that effective price stability. How old are you, Derek? I'm 36 years old. You have never lived through inflation in your life, and you're an informed current affairs commentator. I am 49 and a half, and the Volcker disinflation occurred when I was 10.

So never in my adult life if I lived through inflation. Most of the Fed staff have not lived through an inflation. They've studied it very, very carefully. And in many respects, you know, we'd like to think we've beaten the beast. It may actually be true we have, by the way. It's still not clear. History hasn't been written. If inflation starts falling through 23, this is going to look like a COVID spike

and will continue that 40-year streak of very low inflation. So that's number one. We just haven't had inflation for a long time. There was good reasons to believe. And we hadn't had just a bill than what you're saying. We hadn't had a global pandemic in a long time, too. That was number two, which is. Sorry to steal your point.

The laws of economics, look, I stand up and I teach econ 101, and I have my textbook and I wrote it, and it's all about what happens when markets function. When people like going to work, when people like going to the store, when employers like hiring people, when ships actually arrive at the ports on time. And the thing to understand is we, there is not an economist alive who has ever studied a pandemic economy before 2019. And the rules of economics are fundamentally different because there's lots of quantity constraints all over the place. There's lots of risks all over the place. There's human behavior in all of this. Like, could you predict that people in this state are going to ignore masking mandates? Could you believe that people in that state are going to refuse to go back to bars ever again?

We have, the past is an incredibly imperfect guide to the future right now and probably for another year or two. I think that's a pretty fair. I remember when I was first trying to describe the economy coming out of the worst parts of the pandemic, coming out of the period where more states were really in lockdown, I described it to sort of the kinked hose effect. You know, if you sort of constrict a hose outside for a long, long time, and the water builds up, builds up, builds up, and you let the hose unfurl, and the water just suddenly starts spraying everywhere,

and you can't predict exactly what angle at which the water is going to flow out of the hose because it's just chaos. That's kind of what we were seeing. We were just seeing the chaos of an unkinked hose of an economy. And I feel like we're still dealing with this sort of unkint hose effect. What happens when you have demand running like crazy in the U.S. Because there were a lot of stimulus checks that were passed. There was a lot of saving during the pandemic.

People literally couldn't spend their money on what they wanted to. Now that hose of demand is unfurling at the exact same time that one of the most critical nodes of the global economy in China is still practicing a COVID-Zero policy by which they are shuddering their largest metros on purpose to stop anybody from contracting this disease. I don't know how you model that global economy in 2018. Like, where's that white paper? It just doesn't exist. So it's not that I think the Obama, excuse me, that Biden White House is blameless or that the Fed is blameless, but rather that I can understand why the model for this economy

simply was not top of mind for a lot of people. Yeah, I think that's exactly right. And, you know, look, emotionally all of us want to move on from the pandemic, and we wish the virus weren't here. And the thing to keep reminding ourselves is it is still a pandemic economy, even if it's not in the sense that people are going back to work. You know, I went back to work the other day and I found rotting fruit on my desk. There was rotting fruit that needs to be cleared away throughout the entire economic machinery, right? And then realize we're part of a global economy, and I'm so glad you raised China. because risks still remain out there.

There's obviously the risks of new variants, and we're seeing that bite us on the bum even right now. And China, this idea that they could possibly achieve COVID-Zero strikes me as just utterly insane. China is deeply important to the global economy, and so very likely, it's not a sure thing, but very likely is going to be a source of even more shocks, shocks that you and I back in 2018, 2019,

would have thought were massive changes. You know, imagine closing down the way, world's second biggest economy, that may happen any day, month, or whatever of the week over the next few years. It's honestly, it's impossible to imagine how or why they're trying to do this, especially without MRI vaccines. But I don't want to go down the cul-de-sac of trying to explain Chinese epidemiology. I want to bring wages into this a bit. Nominally, that is, just by looking at the dollar amount, wage growth has been fairly strong in the last few years, particularly at the bottom end for low-wage. work, like in retail and restaurants. And this is somewhat related to a phenomenon. We've heard a little

bit about called the Great Resignation, probably misnamed, but this is about the record high number of workers quitting their jobs to get new jobs, typically, that pay more money. The problem is that workers are also consumers. And for consumers' prices, as we've been reviewing, are going up really quickly. And in many cases, going up faster than wages are going up. Un-spool this a little bit. Tell me a little about how you're looking at the wage component of the economy right now. Right. Let me take a big step back and do so in a way that will be guaranteed to upset your listeners. But I'll just give you a fact that's really, really important.

When you look across countries or when you track data in individual countries over years, decades or centuries, there is no relationship between your real wage, which is how much your salary buys and the rate of inflation, which is to say when prices rise by 10%, you know, eventually wages catch up. Now, there's a lot of pain in the eventually, right? If your wages rose 3% this year, it's probably what I'm going to get from the University of Michigan, and prices rose 8%. I'm feeling 5% bummed out. So that's real pain, but I didn't lose that 5% forever. And I know there's a bit of a trust me here, but no one's real wage is determined by the inflation rate. And so there's a tough transition, but the current moment isn't going to determine your long run spending power.

So that's really important. Wages matter for a different reason. The most important cost of many businesses is paying your workers, and if their costs go up, then they'll have to raise their prices. So you might think that the rate at which wages are growing is a pretty good indicator for what's going to happen to inflation in the future. You want to adjust for productivity growth, right? So if people are getting more done, we can afford to pay them more, and that doesn't cause your costs per unit to rise. And so the fact that nominal wages growth, which is how much money your employer puts out, not adjusted for inflation, the fact that that has not taken off too far says that businesses aren't seeing enormous cost pressures, which says that we have reason to be

optimistic that future price rises, future inflation, is going to be a little calmer. The fear that people have is what happened in the 1970s, which is, you know, if prices rise by 8% and then unions demand or an 8% wage rise to keep up with that, then that will cause prices to rise by another 8% to restore profit margins, which will lead workers to demand another 8% and wait, no one wins. Workers don't see their real wages rise, firms don't see their real profits rise, but inflation takes off. That's what's called a wage price spiral. That would be terrifying. Now, there's no evidence of that right now. If anything, wage growth is started to slow over the last three, four, five months.

And that's why some of us are a little optimistic that maybe price growth, that is inflation, might slow over the next few months. There's been a debate within the economic community and to a certain extent within the political community about this concept of greedflation. The accusation being that a lot of companies, especially companies with a lot of pricing power, are using this opportunity, using the inflation crisis. as an excuse to raise prices to become extremely profitable while at the same time, you know, holding down wages. And that one of the big reasons why we're seeing higher prices in these

items that I will not list the individual inflation rate in, the reason we're seeing all of these higher prices is basically because corporations got a lot greedier in the last few years. How do you adjudicate that debate at the moment? Right. So I'll give an empirical answer and then a theoretical one. And I'll just do it like I wouldn't Econ 101. Empirically, there's almost no evidence for this claim. So you would have to show me either evidence that greed rose or show me that the areas where greed rose the most

caused inflation to rise the most. Neither of those cases have been made, which means this is just a story. And there are lots of stories, right? Inflation could also be caused by pixies at the bottom of the garden. The second is just a conceptual confusion behind this. Yes, corporations are greedy. They're profit motivated, they're hungry.

and some of them like to screw consumers. That's absolutely true in 2022. It was absolutely true in 2021. Inflation is about the rate of change of prices. So if you want to tell me that high inflation is due to high greed, you have to tell me that greed got bigger. Now, I think most of the people who are telling me that greed's a big factor in 2022 also think it was a big factor in 2021 and also think it was a big factor in 2020. So this doesn't give you higher inflation. It doesn't say we shouldn't be worried about greed. Greed means that some corporations screw consumers, but they do it consistently. So you, the listener who's feeling screwed by your cable company, it gives you crappy service at high prices, you're right. But you were right last year as well. And because of that,

that's not a contributor to inflation, although it's a contributor to lower living standards. The rate of screwedness is not increasing. Would be my guess. Yes, it is a relatively stable, high level of being screwed by various companies. I think that's a fair final judgment. You've made a couple different arguments about how we actual core inflation, I don't want to say actual inflation, core inflation,

is significantly lower than headline inflation. And I wonder if you think there's any indication at all that we might be at the peak of both, whether all of the numbers, the numbers in the 72-sized font on the New York Times front page, and the actual felt inflation in people's lives, whether all of this might start to come down over the next few months. And I want to do a little bit of a classic economics on the one hand, on the other hand, here. On the one hand, there have been

so many people predicting either transitory inflation or predicting peak inflation of the last few months that I don't want to put too much stock into the idea that, oh, no, no, no, now things are about to get better. Now I have all the confidence in the world that this is the moment that is peak. On the other hand, here's some articles of evidence that suggest that we might be near peak inflation. Number one, auto inflation, vehicle inflation has been a pretty important contributor to overall inflation. And carmakers are saying their microchip supplies are going to be back to normal in the second half of this year. That's pretty good news. Number two, in the past week, it feels like a lot of general retailers, Target, Amazon, Walmart, Gap, have all released some kind of statement saying we're seeing excess inventors.

People aren't buying as much at leisure as they were six months ago or as much as we expected them to buy. So now we have to discount all this stuff before we have to throw it into a landfill. Okay, well, discounting means prices are coming down. The housing market, if you look at mortgage originations, you look at, you know, inventories in places like Los Angeles, San Francisco. The housing market, I think, is turning a corner. Where are you on this question of whether this is it? This is the top of inflation.

Well, there's an old rule with forecasting either. a number or a time period, but never both. Because everything's eventually true. There's another rule of forecasting, by the way. So you're absolutely right to say people have been saying the peak is coming any moment now for quite a while. And it turns out when economists as a tribe make mistakes, they tend to keep repeating those mistakes over time.

If you want to impress people at a dinner party, you call that autocorrelated. So if we've been making this mistake of calling the peak too early month after month, that suggests, and it's because people don't change their mind easily enough, quickly enough. They're not open enough to new information. That would suggest that the same people have been making mistakes, including myself, are going to continue to do so, so you should feel less optimistic that the peak is coming any moment now. A different answer. How do you know when you're at the top of Everest?

Well, you don't know until you're exactly at the very top, but you know it's a really freaking high altitude. So don't even start looking until the altitude's really high. How do you know when you're at the top of the inflation peak? Well, it's got to be pretty darn high. 8.6 feels pretty high. So maybe it is time to start looking. I think you're right to say that there's a bunch of factors that suggest the short-run

future is not quite as bad as the past, including, remember gas prices rose, but remember inflation is the rate of change of prices. So gas prices can remain high, be frustrating, stretch the family budget, but stop contributing to inflation because they would have to keep rising, right? And so that's another one. As you said, housing prices are off. Now, you know, whenever you're thinking about this, you know, you want to skate to where the puck is. And it turns out in some parts of economics, we know a little bit about where the puck's going.

So one part that's actually still worrying is the way rents work. So we know that a lot of people, when it's time to renegotiate their rent, their rents are rising. But if my rents, if my contract runs January to December, the landlord hasn't been able to reopen my rent. But if all my friends have seen their rents rise, I know exactly what's happening in December. And so in some sense, how's price inflation? We know where it's going because we know what's happening to renegotiated rents, but that's not what we count. We count all rents when we measure it in the CPI report.

So what's going to happen is even if new rents start falling, the overall average rent will continue rising, maybe for another six months. So we have all these distortions that sort of mean, what's going on in an underlying sense is not always exactly what we see in the numbers. And so one of the things it is going to take over is rents are going to continue to rise over the next few months, even if new leases aren't getting more and more expensive. But, you know, I think it wouldn't surprise me if today was the highest inflation number we see. That's interesting. I think there was a really good explanation of the rent input. And I think it's important to say that, right, even as it's clear to me that certain elements of the housing market are doing a bit of a U-turn, if people who have been trying to buy a house in some of these metros where inventory has just been pathetic, if some of these people suddenly pull out of the housing market because they say at this mortgage rate level, I really just can't afford that kind of house that I want.

They pull out of the housing market. They're sitting on all this money that they were willing to put on a down payment. So what do they do? Maybe they say, honey, I'm sorry, we can't get a house. Let's go to Hawaii. Okay, well, what does that do? If a lot of the people make that decision and take the money they were going to put toward housing toward leisure, then that pushes the money that was going to go into the services

economy and inflation can still remain somewhat elevated. That's another thing that could potentially happen even if you see inflation come out of the housing market. Is that right? I'm thinking here because it's not obvious to me because the thing is when there's a high house price, there's one loser, the person who has to pay it. but there's also a winner which is the person who sold the house. So I don't think a price hike necessarily, definitely a price, like, I'm not sure that the wealth effects work out exactly the way you just suggest.

In the next three to six months might they work out like that, even though in the medium to long run, they wouldn't. So if you decided not to buy my house, you now have more money in your pocket, you go to Hawaii. I now have less money in my pocket. I don't go to Hawaii. that's what I'm thinking about. I'm not very good at doing economics standing up. And I'm not very good at doing economics on the fly. So maybe let's just move on to the what can be done here.

What can be done? You know, the Federal Reserve is obviously raising interest rates. I get lots of questions from listeners about the spooky magic of the Fed and how this group of economic magicians wield such power over the economy. So maybe again, in a kind of 101 sort of way, can you explain what the Fed is trying to do right now and through what mechanisms, its statements and its interest rate hikes,

are designed to cool off inflation? Right. There's two ways to reduce inflation. There's the hard way and the easy way. And it turns out if you tell people you're going to do it the hard way, you might get the easy way. So let me tell you the hard way. The hard way is that you raise interest rates.

We know that the Fed controls interest rates. If you raise interest rates, then I'm not going to break ground on, buying a new, on building a new house. So building a new house is new economic activity as opposed to you buying my house. I might not start a new factory. I might not start a new company and so on. It also might affect the exchange rate. So higher interest rates lead people to do less stuff. Doing stuff is what we call output, GDP, economic activity. If people are doing less stuff, there's fewer jobs. And if people are doing less stuff, they get less income from doing

less stuff. They buy less stuff. And if you're running a store and people aren't buying your stuff, what do you do? You lower your prices or you raise them less quickly. So the short version is they either create a recession or at best a slower economy than we might otherwise have hoped. and then in a recession, everyone's desperate, so they reduce prices. So that's the hard way. And that does sound pretty hard. I just want to pause here because, you know, there's a lot of, I've overseen a lot of debates online, especially from between sort of, I would say, maybe the center and the left.

And the left will say, we need to, you know, speak out about the fact that the Fed is trying to destroy demand. The Fed is trying to do something that is terrible, which is destroyed demand. And the sad slash just realistic answer is, yes, that is what they're trying to do. The Fed is a little bit like an anesthesiologist putting a patient, like putting inflation under without killing the economy, right? Like the same way that what's happening to a human patient undergoing general anesthesia is not good outside the context of necessary surgery. Like they're being laid out. Like they're being incapacitated.

I think actually it's not a great. I love your analogies. But actually, the way anesthesiologists used to work, I used to live around the corner from Philadelphia. hospital and they would put you under, I think, either with ether or a mallet to the head. That was literally what they used to use. And I think it's more like a mallet to the head than it is a modern-day general anesthetic. Let me revise. The Fed is like a 19th century anesthesiologist.

Yes, I really mean it. All these hard money folks, or even just people who are feeling the pinch at home saying this 8% rise in the cost of living is killing me, If it was there, and they say you've got to do something, if it was their job to bring the individuals in, the millions of people who stand to lose their jobs and one by one have the very difficult conversation with them that you have to go home and tell your family, you do not have a job anymore, you've been picked to suffer so that the rate of inflation will come down. It really changes how you think about it. It's a very human, very real, very painful thing to do.

that's why I think there's a very strong case for yes I know inflation's 8.6%. There's a bunch of reasons where maybe I think it's not really that bad. And if I just wait a little longer, maybe I'll learn it's not so bad. If so, then I don't need to deliver that mallet to the head. I don't want to deliver a mallet to anyone's head unless I'm absolutely sure that they need it. And so that I think would be the sensible left response of, you know, there's good, we don't know where this is going a year from now. There's so many COVID-related disruptions. Let's just wait and see if we can bring inflation back down just by letting the economy heal itself a little. And you mentioned that

there's an easy way, or at least a relatively easy way compared to the hard way. So maybe talk about the easy way is, let me go back a step. Economists think that inflation expectations are absolutely critical. So here's the way to think about it. Imagine that you run a restaurant and you have to make up your menu for the next year. You think yourself, well, how much my cost is going to rise next year because I should raise my, and if I think my costs are going to rise by 2%, then probably I should raise my prices by 2%. Or you could say, how much of the other restaurants going to raise their prices? If everyone else is going to raise their prices by 2%, that if I want to maintain my competitive position, I should maintain my raise my prices by 2%, but no more, but also no less.

So that then just says, wow, what I think inflation is going to be determines how I raise my prices. Well, inflation is the average of how everyone raises their prices. So that then says if people expect inflation to be low, they won't raise their prices by much, and therefore inflation will be low. It's a miracle, right? So if the Fed can posture now and act macho and say, we will tolerate absolutely no inflation, then if I'm a restaurant sitting down to write my right out next year's menu, I might think, you know, the Fed promised me that inflation, they're going to destroy inflation no matter what. So therefore, I can be pretty confident my costs aren't going to rise by much. Therefore, I won't raise my prices by much.

And so that's why the Fed really has to, whether it means it or not, has to convince all of us that it does mean it. Yeah. I think it's so interesting. And this has been a theme on past economic podcast, just how, because the Fed has such power with its interest rates, it also has power to talk about what it might do in the future and to talk about how it thinks about the future. Because this mere expectation that the Fed might act or might.

not act, exerts its own power over people's decisions, investors' decisions, and companies' decisions. And I think this is actually really relevant to what we're talking about before. Remember, I learned that you're 36 years old, Derek, which means that if you were running a restaurant, you've been used to raising your prices by 2% a year, every year for all of your life forever. You are not like the 70-year-olds among us who are deeply fearful of inflation, who remember inflation, who've had to change their lives around inflation. If the whole economy looks like folks like you, then there's good reason to think folks who've not really faced it will believe the Fed. They believe that inflation is not a normal part of economic life. It took a global

pandemic to create it. And so maybe 2023, inflation starts to look a lot lower. In an ironic way, and this is a point that I think Jason Furman was making on a Twitter space that I heard with you, in an ironic way, isn't it precisely people's fear that a recent, accession might be imminent, that might get them automatically to pull back spending, essentially destroy their own demand by their own volition that might contribute to the short-term reduction of inflation. Because if individuals start to say, oh, I'm starting to get afraid of the economy, so I'm not going to redo my kitchen. I'm not going to go on this vacation. I'm not going to buy that couch. I'm not going to take on this loan. If you add up the 170 million

households that are making those kind of decisions, they pull back a little bit of economic activity, that would on its own interest rates be damned probably be enough to pull down headline and core inflation. Isn't that right? Let me take you into my Econ 101 classroom. Thank you. So I'm going to say yes, and. So the way I teach it is there are three things that drive inflation. One is the supply side when costs rise, okay? And we've talked a little about that, Putin, gas, etc. There's a lot of supply side kinks going to

or work their way out of the system over the next year or two. The second is inflation expectations. And so the story I was actually telling earlier. And the third is excess demand. People want to buy more stuff than people can, than companies can produce. The story you were just telling is, if I threaten you with a future recession, you'll stop buying stuff. And so your story works through excess demand. It says, therefore, people stop buying stuff. There won't be excess demand that will reduce inflation. But the truly easy story literally just works for inflation expectations. We don't even need to believe there's a recession coming. All we have to do is believe that my costs are not going to rise by much next year. And I believe that because I believe

inflation is going to be low next year. And I believe that because you told me. And then I won't raise my prices by much. And then inflation will be low. It really is a self-fulfilling prophecy. So we don't even need. So the truly easy way is the self-fulfilling prophecy. the truly hard ways create the recession and cause people to pull back, and you were suggesting a halfway, which is threaten the recession, and that might lead people to pull back. But that pulling back has a real cost, too. Absolutely. The last question I want to ask you about is, well, look, clearly whether or not the Fed is

persuaded by my metaphors and my halfway solutions, they are determined to raise interest rates. We're looking at probably 50 basis points, 75 basis points later this year, maybe even two different, two separate raises in the next six months. What are you looking at in terms of your outlooks for a recession in the next year to 18 months? Again, I know that you've just given me your warning, that you're not going to make a prediction that has both a number and a date at the same time to avoid hyper-specificity, but just evaluating the health of the economy. It's to avoid accountability. And I understand, right. This is a public podcast that people can link back to in 18 months. But taking into consideration, everything that you know about the health of the economy right now

and what the Fed is likely to do in at least the next six months, where do you think people should land on the likelihood of a recession? The number of mentions of the word recession right now in the press, in public discussions among economists, is wildly out of step with any actual economic indicator. In fact, if you draw a graph using Google trends data of the number of mentions of a recession and you plot that against the state of the economy. We never ever see a disjunction this large of the unemployment rate down at 3.6%, one-tenth of a percentage point from being at a 50-year low,

an economy creating 400,000 jobs a month, which, Derek, through your entire career as an economics journalist, you would have called an economic boom. We've never seen an economy that healthy, creating that many mentions of the word recession. It doesn't make any sense. I can't promise you and I can't promise your listeners that there'll be no recession. But I do know the single best indicator of the future path of the economy is how is it going right now.

And how it's going right now is it's in a good place with a lot of momentum. Some of that momentum is going to slow. But that indicator is saying there's no reason to be looking for a recession. Then I ask my recession talking friends, what are you looking at? What's the indicator that's blinking red to you? And they go quiet. They don't say, you know, they're yield. curve. They don't say this sector of the economy. They don't say China. There's this deep pessimism

which will be with unemployment's 3.6 percent can't keep going down, can it? And if it can't keep going down, that must mean it's going to go up. And so without being able to tell you a how or a why, they're claiming that there's going to be a recession. But the usual indicators that would cause that talk aren't flashing right now. So I want to fight back against professional pessimism and say, hey, it looks like things are going pretty well. And that's not the best time to call a recession. Now, the most coherent answer I get is the Fed's about to raise rates, and that causes recessions. So it is true that the Fed could overdo it. Guess what else is true? The Fed could underdo it. Not all mistakes turn out in a direction that screw all of us.

And so that's also a possibility. I think that's a pretty fair answer. I was going to say that, you know, to speak up for your friends who are predicting a recession, because I myself am pretty embevolent on the question. I think this is just a strange enough economy that you shouldn't have any degree of confidence or any high degree of confidence that was going to happen in the next two years. I think the easy answer to the question is there going to be recession is, well, the last time inflation was this high, was the late 1980s or late 1970s. And there was this Volcker caused recession, this recession that was in large part caused by rising interest rates. Interest rates are rising, so history will repeat itself. Now, I think to say that history is literally repeating itself is wrong,

because the economy in 2022 is not the economy in 1980. That wasn't a pandemic. That wasn't a global supply chain crisis. It was very, very different. The one question that I guess I want to land on with you is, let's say I'm in entire agreement that the risk of recession is overblown by the media, that there is a vast pessimism bias in news media, a vast negativity bias in news media. How do you account for consumer sentiment?

Your University, the University of Michigan, does the survey going back decades, decades, asking consumers basically, how do you feel about stuff? How do you feel about the economy, your personal finances? And right now, Michigan consumer sentiment, the preliminary number for June is 50, which is one of the lowest numbers in the entire series of this report. If the economy is so great, why are consumers so miserable? Yeah. So let me say a few things. One, we actually know that inflation's high.

We know that consumers hate inflation. That would seem to be a pretty direct explanation, right? The second one is consumer sentiment is an indicator that comes from asking people how they think the state of the economy is. One of the things, sadly, that's happened to that in particular, but also an array of other economic statistics, is people have become infinitely partisan. And so it turns out Republicans thought that the economy was in terrific shape in November of 2020, and they thought it was in horrific shape in December of 2020, and the reverse for

Democrats. And I worry, and these, these are relatively new effects. These really are post-Trump effects. And so I worry that all public opinion polling is becoming somewhat broken by partisan divides. And I think the third answer is, and this is closely related or coheres with that, well, how would we actually go and look in data if consumers are really pessimistic? we could look at consumer spending. Crucky, that's pretty strong, right?

We could look at what they're actually doing. We could look at new business startups. People seem really optimistic about the economy. They're starting new businesses at almost record rates. So when you look at what people are doing, it's completely at odds with what they're telling the consumer sentiment index. So if I want to think about it that way, people's actions tell me a whole lot of optimism rather than pessimism.

I find this actually one of the most interesting things about the economy. right now. The Federal Reserve just came out with a report, I think it was maybe three weeks ago, one of their annual surveys. They asked Americans how they felt about the national economy and how they felt about their own financial well-being. Twenty-four percent of Americans said the national economy was good or excellent. That is one of the lowest, I think it's the lowest rate in the history of this particular series. Seventy-eight percent of Americans said their own financial well-being was at least okay. That was the highest in the rate in the history of the series, there is a really, really, just like, sociologically fascinating gap that has opened up

between people's evaluations of their own household and the national economy. I called this the everything is terrible, but I'm fine phenomenon. And the everything is terrible, but I'm fine phenomenon explains a lot about this gap that you're describing. And I think you're right. I think to a certain extent it has to do with just the fact that people don't like inflation, but it also do with the fact that partisanship has poisoned our evaluations of national affairs in a way that make it really, really difficult to figure out what people are actually saying when they make evaluations of the United States of America. Justin Wilfers, thank you so, so much for this education. I really appreciate it, and we'll have you back on the pod very soon. It's a great joy.

Thanks, Derek. Thank you very much for listening. Plain English is produced by Devin Manzi. If you have a comment, a concern, a question, an idea for a future show, email us at plain English at Spotify.com. That's plainface English at Spotify.com.