The Daily - How Expecting Inflation Can Actually Create More Inflation

Episode Date: July 28, 2022

To fight historic levels of inflation, the Federal Reserve this week, once again, raised interest rates, its most powerful weapon against rising prices.The move was intended to slow demand, but there was also a psychological factor: If consumers become convinced that inflation is a permanent feature of the economy, that might become a self-fulfilling prophecy.Guest: Jeanna Smialek, a correspondent covering the Federal Reserve and the economy for The New York Times.Want more from The Daily? For one big idea on the news each week from our team, subscribe to our newsletter. Background reading: The Federal Reserve has pushed up borrowing costs at the fastest pace in decades.The New York Times invited readers to share their thoughts about the price rises and asked how much more inflation they expected.For more information on today’s episode, visit nytimes.com/thedaily. Transcripts of each episode will be made available by the next workday. 

From New York Times, I'm Michael Barbaro. This is The Daily. Today. To fight historic levels of inflation, the Federal Reserve on Wednesday once again used its most powerful weapon, raising interest rates. In doing so, one of its biggest goals is to prevent the expectation

of higher prices from actually creating higher prices. My colleague, Gina Smilak, explains. It's Thursday, July 28th. You know, where exactly are we in what has become our long national nightmare of inflation? We are midway through it, I would say. We still have extremely high inflation. And the Federal Reserve is trying its very best to raise interest rates to sort of slow down consumer demand and bring that inflation under control. And so yesterday, we saw them make their second very big rate increase and their fourth increase this year, as they sort of carry out this fight against inflation. this year as they sort of carry out this fight against inflation. Right. And as we've explained with you on the show in the past, as interest rates go up, borrowing money becomes more expensive. So people spend more money on car loans, on their credit card debt, on their mortgages. And as a result, the thinking goes,

they have less money to spend, which is supposed to help bring down prices. That's the way this is supposed to work. Precisely. Interest rates go up, spending goes down, lower demand allows supply to catch up, and when supply catches up to demand, prices moderate. So that's what the Fed is doing right now. They are trying to slow down demand. But there's also sort of a psychological goal to what they're doing right now. They are trying to prevent consumers from starting to think that inflation is going to last forever.

And the reason that they're doing that is because if consumers become convinced that price increases like we're seeing today are going to be a permanent feature of the economy, they might change their behaviors in ways that make that a self-fulfilling prophecy. So explain that. So when we say a self-fulfilling prophecy, we mean the fact that people expect inflation to last might actually make it last. So I think it's useful to sort of take a step back and use an analogy here. Please. So imagine the Fed is your therapist. You've just had a really bad breakup and you go to your therapist and you tell your therapist, I am going to be heartbroken forever. It's over for me. Your therapist is probably going to say to you, don't act like that because if you act like you're going to be heartbroken forever, you are going to mope around your apartment like you're going to be heartbroken forever,

you are going to mope around your apartment. You're going to feel bad for yourself. You are not going to go out and see your friends. And you are not going to rejoin Hinge or Tinder or whatever your dating app of choice might be. And you are more likely to actually find yourself in a situation where you, in fact, are heartbroken forever because you're just going to be sitting there fixating on this. Right. You're fulfilling the prophecy of your unhappiness. Exactly. Your therapist is likely to tell you, this is very painful right now. This is bad. You're in a bad situation, but it is going to end with time and you shouldn't permanently alter your life in ways that make that bad outcome likely

to continue. And I think very much like your therapist in this case, Jay Powell, the Fed chair and all of his colleagues down at the Federal Reserve are trying to tell markets, investors, businesses, consumers right now that yes, inflation is very painful. It is clearly with us right now, but it is not going to be here forever. And you should not change your behavior in ways that might lock it in. Right. People behave in ways that make them economically single, to go back to this analogy. Economically heartbroken at any rate. at any rate. The crucial distinction here is just like with a heartbreak where you have this short-term period where it's clearly going to be bad, but your psychiatrist is hoping you don't change your long-term behaviors. The crucial question here is inflation is obviously bad.

Do people recognize that it's bad now, but expect it to fade with time? Or do they know that it's bad now and think it's going to stay bad forever, and thus change their behavior? And so what does it look like for all of us, the spending public, to start fulfilling the prophecy of inflation, or to not fulfill the prophecy of inflation or to not fulfill the prophecy of inflation? So there are behaviors that combat inflation and there are behaviors that contribute to inflation. And there's a lot of research on what those might be. And there are a lot of data points that the Fed tracks to try and figure out whether we're

at an inflection point where people are going to sort of tip into that category of expecting inflation and beginning to contribute to it. Those metrics basically say that inflation expectations are creeping up, but they're pretty stable and under control at this point. But they don't tell us when things are about to change. And so for the last couple of weeks. OK, can you hear me? I can.

All right, perfect. Hello? Hi, this is Gina Sm people from all over the country. Just talking to them and trying to get a sense of how they're thinking about inflation, what they think is going to happen next with inflation, and how that is influencing their behaviors today to get a sense of where on these interviews as well as this economic research that go in either direction, either contribute to inflation or combat inflation? So let me start with two behaviors that seem to combat inflation. So when we were talking to people, one thing that we often heard is that they were pulling back on spending. I reached for avocado in the store and I jerked my hand back like it was about to be burned when I saw the price was $5.50 per avocado. One guy saw avocados go up so much in price that he just said, this is not it for me right now.

So, you know, that's something we can do without. Starbucks was the big one for me because that was like my one thing. We talked to a lady in South Carolina. I was like, if I could just go get this one coffee, I'll be happy. Who is seeing Starbucks increasing price so much. I was like, okay, this is absurd. It's like $6.11 for just a venti iced coffee with a little bit of cold foam on top.

That even though it's her favorite treat, she's decided to just stop buying it for now. That's like $180 a month. That's like one of those things where you're like, do I really need this? And then I talked to a guy who is in the Navy out in California. So I actually moved from my place because they raised rent about $200. And he saw his rent go up so much that he traded down to a one bedroom. Renting is tough,

I think, for everybody right now. So what we see here is that people are cutting their consumption in a short-term way because they don't expect price increases to last forever. And so the unwillingness from consumers to pay up to buy these products, that can help inflation to moderate over time. I want to zero in on one of the examples you just gave, because I think understanding the mechanics of it will be helpful. How does somebody deciding not to purchase a $6 coffee at a place like Starbucks contribute to inflation going down? What are the mechanics of that? So obviously this Starbucks transaction is just one transaction. But pretend your coffee shop is the economy. And that $6 purchase that was

foregone represents all the purchases across the economy that people are skipping out on because prices are going up. When people are buying less, demand is going down. It means that constrained supply, you know, the lattes that are in short supply, they're able to catch up with the demand that does exist and that allows prices to moderate. At the same time, there's this really important psychological component here, which is by buying the $6 latte,

that customer would have been communicating to Starbucks that go ahead and raise the prices because I'm willing to pay them. By not buying the $6 latte, what she's communicating to Starbucks is, I am not willing to bear this cost increase. I will stop buying things if you raise prices this much. And that helps to let everybody know

that prices can't continue to increase at this pace. And thus, a company that sells coffee will in theory respond maybe by lowering prices, which is good because it contributes to lower inflation. Or by not increasing prices in the future, which is also good because it means that inflation won't be high forever. Got it. Okay, what's the second behavior that contributes to inflation going down?

So another thing you'll often see from people who think that this is just a temporary situation is they try to just kind of supplement their income on the side by working a little bit more. That can be good for two reasons. A, it can obviously help people deal with the inflationary burst. B, it means that there are more workers in the economy putting in more hours. When more workers are putting in more hours, they produce more stuff. If you have more stuff, supply keeps up with demand better, and that can actually help inflation to moderate. So a good example of this is, say I'm a waitress at a restaurant, and I'm facing all these higher costs, and I know I

need to cover them. One option I have, if I think that these costs are going to be temporary, them. One option I have, if I think that these costs are going to be temporary, is to just work more hours, try and make a little bit more money so that I can cover my rising costs. As I work more hours, as I increase my labor supply, it means that my employer is able to sell more dinners without having to hire somebody else to work alongside me. The fact that it's not having to hire from one of my competitors likely means that it doesn't have to pay more in wages. And that means that higher labor costs aren't getting passed along to the consumer through menu price hikes.

And so my improved labor supply could actually help to keep prices for consumers under control. So here again, we see how people's pretty natural and intuitive responses to keep prices for consumers under control. So here again, we see how people's pretty natural and intuitive responses to rising prices, lowering their spending, for example, in this case, asking for more hours at work, can help fight inflation. Exactly.

After the break, the behaviors that make inflation worse. We'll be right back. Okay, so what are the examples of reactions to inflation that make inflation worse? So let's go back to our waitress here. If our waitress thinks that this inflation is going to last forever, that not only are prices going to stay high, but they are going to continue rising, and that that's going to go on year after year, month after month, for a long time. She's probably not going to just plan on increasing her hours indefinitely. Instead, she's going to ask for a big wage increase. And if she doesn't get it, she's going to leave the company and try and get a different job somewhere else that will pay her a lot more. As that happens, the company that is paying her a lot more, whichever restaurant ends up being her employer, is going to have to charge customers more for the eggs and toast she's serving up every day because her labor costs have increased a lot.

They know she's a valuable employee. They want to pay her for it, but they also do need to make a profit. And so we're going to see higher prices on the menu. And that is how you get an inflationary spiral. You know, this is the bad news outcome, where higher expectations for inflation lead to higher wages and higher prices in a sustainable way that kind of chase each other.

Right, so quote-unquote bad economic behavior in this moment is people quite naturally asking for a raise, which forces their employers to pass those costs on to the consumer, which therefore keeps prices high, if not perhaps higher. Exactly. I think I'd call it more worrying than bad. But the situation we get concerned about is one in which high prices drive higher pay, and that drives higher prices, and we get into an upward spiral. Got it. And what else represents worrying economic behavior in this moment? So another behavior that is concerning is when customers start to buy things today believing that prices will be higher down the road.

So if you see people splurging on big purchases because they're convinced that that guitar, that car, is going to be more expensive in three months, that's pretty concerning. And why is that concerning? It's concerning because it pushes up demand in the moment and higher demand at a moment when supply is limited and when inflation is already high is a recipe for even higher inflation. And when people are willing to accept the fact that prices are climbing today, it can sort of embolden companies to charge more down the road. It sends this signal that inflation is just part of our everyday life.

And that signal goes out to consumers, but it also goes out to the businesses they buy things from. Interesting, right. The guitar maker sees that I want to buy a guitar because I'm worried the prices are going to go up, so they can then raise prices. As a result, there's not really a universe in which guitar prices are going to be going down. Exactly. Or in a universe in which guitar prices are going to be stabilizing.

Got it. It feels, Gina, like a typical consumer could very easily toggle between the behaviors that you've been describing, the ones that contribute to inflation and the ones that you've been describing, the ones that contribute to inflation and the ones that combat inflation. In fact, I think of my own experience. In the morning, I might skip the expensive coffee, which seems like it's going to help lower inflation.

And then at night, I'm on Amazon, and I'm going to splurge on something because I'm worried the price is going to be going up in the next few months. Therefore, I might be contributing to inflation. And I have to imagine this is a pretty common experience in the economy right now. Absolutely. I think that people are very uncertain about what is going to happen next with inflation. And I think we really saw this with one of the people we interviewed. Hello? Hey, Dan. It's Gina Smilick. How are you? Dan Burnett. Good,

good. How are you doing? He lives in upstate New York. He lives in the Catskills. I'm 58. I'm retired at this point. I retired a year and a half ago. And he had a really interesting experience with inflation. Yeah. So the first place I noticed it was definitely with respect to food. Like bacon, I noticed went up a couple dollars a pound. Last year, he started to notice in the bacon aisle that the cost of bacon was going up really a lot. I looked pretty quickly for ways to shift and, you know, avoid or minimize the impact of that increase. So, yeah, I definitely started changing where I shop. And so he did sort of the first part of what we discussed earlier.

He started to substitute away from bacon. He didn't buy bacon if it was really expensive. And then he decided he wanted bacon, but he started driving to an Aldi and Walmart that are about 50 minutes away from where he lives so that he could get better prices, which is a classic sign of believing that better deals are possible and believing that inflation is not going to be consistent throughout the economy. That strategy definitely was helpful. The problem that I've run into since then

is that gasoline has really skyrocketed in price. Fast forward a year and Dan is watching inflation climb across this broad array of categories. You know, that's really frustrating because I'm traveling to try and save money on groceries, but then I don't really know how much I'm saving because I think I'm losing a good chunk of those savings on the expense of driving to get there. And then he's having problems with his car. And it needed some new rotors and brake pads. And he goes to the auto shop to get his brakes changed. When I asked how much that would cost, the literal quote I was given was,

the literal quote I was given was, well, we used to quote people $250 to $350 for that, but now it's $350 to $450. So right there, that's like a $100 increase or a 33% increase in something that's an unavoidable expense. I mean, I have to get that fixed, but that's a really substantial increase. And he asks what happened. Why is it so much more expensive? Like, what is this? Is this just labor or parts or whatever? And he said it was all parts. He said the parts have gone up tremendously.

He said they've about doubled for some of them. And so, like, this has been going on a while. And he said, no, this is the last six months. And also he said, I was lucky that they could get my parts. A lot of parts are unobtainable now. And so they have cars. They just tell people they can't fix because they can't get the parts. And so Dan takes it on the chin, is willing to accept this price increase, but it really gets him thinking that a lot of prices are increasing across a lot of the economy. And that breadth makes him nervous. And what do you expect inflation to do going forward?

I don't really see it going away. You know, like even this car repair place, you know, they claim they hadn't increased their labor charges yet. But, you know, certainly over time they will because they're paying more for all the stuff, all their food, all their fuel, all their housing expenses and stuff. So at some point, they're going to have to increase that and they will increase it. And so Dan is clearly thinking about his future. And you had mentioned that you and your sister own a condo in Florida. And I wonder, you know, he's a retiree, but he does have an income because he owns a condominium with his sister in Florida that they inherited from their mother. And so as Dan thinks about his future, he's realizing that, A, the condo fees are going up and he does not want to eat that when he's eating all these other really high costs.

And so rather than, you know, dealing with those fees increasing himself, he's definitely going to pass that on to his consumer. We're going to increase the rent to the people who rent from us. So he's going to raise the rent. So his response to inflation in his life is to inflict inflation on his tenant. Exactly. Do you think that you'll raise it just exactly commensurate with how much your costs are going up or will you raise it a little bit extra? Yeah. So that's a tricky question. And I think the next part of Dan's story most clearly illustrates that.

Because Dan told me when I asked him if he was going to raise the rent by more than his costs are increasing. He initially said, we may do it more or less commensurate with what our expenses are. The reason being we have some tenants that have rented from us for many years and who are good tenants. No, you know, we have really good tenants. We don't want to scare them away. But then he stopped and thought about it for a minute. And he said, and the reality is actually the rental fees, because we see the advertisements and what people are asking, and those have really skyrocketed. So if we look around and we see that everybody else is increasing their prices, and we don't think we're going to scare the tenants away by increasing our prices by even more, I might consider that because I need to maximize my income, given how much my costs are increasing.

You know, we'll have to see. It's not my decision alone. I have to make it with my sister. But it may not be a linear increase. If we think people will pay it and not pat an eyelid, we'll do that. If we think people will pay it and not pat an eyelid, we'll do that. And that is the situation where you get to a point where I think you're really in an inflationary psychology. When you have everybody kind of looking around at one another, noticing the prices are increasing, noticing that their costs are increasing, and trying to just kind of pass it along the chain as much as possible, that's the moment where you can get into the situation where prices are just kind of feeding on themselves up and up and up. Right. And of course, if Dan raises his rent, then in theory he's contributing to higher rent in the whole region around him,

which means that everybody in that region needs to earn more money to afford their rent. And therefore, they might ask their bosses for raises, which would make their bosses pass those costs on to consumers, on and on. As you've explained, this is how our behavior can contribute to higher inflation. Exactly. This is why people like Dan, who think that inflation is going to continue to be very high, are the Fed's worst nightmare.

Finally, Gina, you and our colleagues have told us repeatedly on the show that raising the interest rate over and over again might eventually tip the U.S. economy into a recession, which is a word that makes lots of people scared. If and when that were to happen, does that change how somebody like Dan and lots of other Americans are going to behave in this moment? And does it change it in ways that we think will either help or hurt inflation? You know, one interesting thing is I asked Dan what could sort of vanquish inflation in his mind, and he said...

Yeah, I tend to think the economy is a big shift, and it has a lot of momentum. Of its own accord, it'll just keep moving in whatever direction it's moving in unless something happens to make it change. And so we have inflation, you know, everyone's thinking about it and everyone's thinking about increasing prices. And so I think that'll continue unless something really happens to make it stop. I mean, obviously, maybe if there was a recession, which no one really wants, but if there were, maybe that would make it stop. I mean, obviously, maybe if there was a recession, which no one really wants, but if there were, maybe that would make it stop. The only way he sees out of this is if we go into recession. Obviously, that is one answer to really high inflation. If you have a recession, demand goes down, unemployment goes up, wages

often stop growing so quickly, and all of those things can lead to slower inflation. But it's a very painful outcome. Right. This is one reason that the Fed wants to convince everybody right now that inflation is going to remain under control over the longer term, because the idea is if you could stop this inflationary psychology from taking hold, if you could stop this inflationary psychology from taking hold, if you can stop people from getting to this point where Dan is, then maybe you don't have to have such a painful recession in order to stamp inflation out.

Right. The Fed's goal is to get someone like Dan to stop acting like we're in the land of permanent inflation without a painful recession. The Fed's goal is to not let most of America ever get to the point where Dan already is. Well, Gina, thank you very much. We appreciate it. Thank you for having me. We'll be right back. Ladies and gentlemen, the president of the United States.

Here's what else you need to know today. Hello, everyone. Hello, everyone. I've just tested negative for COVID-19 after isolating for five days. On Wednesday, President Biden walked into the White House Rose Garden and told the nation that his COVID-19 infection was over. Biden, who tested positive last week and isolated in his residence, has now tested negative for the virus on two different occasions. Thankfully, I'll now be able to return to work in person, but I want to thank you all for your well wishes, your prayers over this past week and the calls I've gotten. And the Biden administration has offered to release a convicted Russian arms dealer in exchange for the release of two Americans now held in Russia. Brittany Griner, the basketball star, and Paul Whelan, a former Marine.

Griner, who has been detained on drug charges, has been held in Russia for five months. on drug charges has been held in Russia for five months. Whelan, who was detained on espionage charges, has been held there for 43 months. In return for their freedom, Russia would win back Viktor Bout, a former Soviet military officer convicted by an American court of trying to sell weapons that would be used to kill Americans. Finally, in a major reversal, Senator Joe Manchin of West Virginia has reached a deal with fellow Democrats

to spend hundreds of billions of dollars to combat climate change and lower health care costs. combat climate change, and lower health care costs. Just a few weeks ago, Manchin said he opposed such a bill because he feared it would increase inflation. But after intense negotiations and changes to the bill, Manchin says he can now support it. Today's episode was produced by Jessica Chung, Will Reed, and Rochelle Banja. It was edited by Liz O'Balin, with help from Lisa Chow. Contains original music by Mary Lozano and was engineered by Chris Wood.

Our theme music is by Jim Brunberg and Ben Landsberg of Wonderly. That's it for The Daily. I'm Michael Bilboro. See you tomorrow.