The Daily - Why Is It So Hard to Hit the Brakes on Inflation?

Episode Date: October 6, 2022

In the struggle to control inflation, the Federal Reserve has raised interest rates five times already this year.But those efforts can be blunted if companies keep raising prices regardless. And one industry has illustrated that difficulty particularly starkly: the car market.Guest: Jeanna Smialek, a federal reserve and economy reporter for The New York Times.Background reading: Many companies have been able to raise prices beyond their own increasing costs over the past two years, swelling their profitability but also exacerbating inflation. That is especially true in the car market.Inflation stayed far above the Federal Reserve’s goal in August, as prices climbed more quickly than economists 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 The New York Times, I'm Michael Barbaro. This is The Daily. Today, in its aggressive campaign to lower inflation, the United States government is running up against a stubborn obstacle. Companies that keep raising prices. My colleague, Gina Smilak, has been studying the problem and how it's been playing out in one of the country's largest industries, the car market. It's Thursday, October 6th. No, it's nice to see you in person. I just washed my hands. I got one of those fancy cups of coffee next door, and they didn't put enough milk in.

You know, this is really not relevant, but do you find it fascinating as someone who studies consumer behavior that oat milk has just completely won out over all the other milks? Like there was an almond phase, there was a soy phase, and then like, I feel like oat just blew them away. Well, so oat was like the OG profit gouger, right? There was a minute there where oat milk was super expensive because there was only one producer.

Yeah, it was like a pre-pandemic scarcity issue. Yeah, yeah. It trained us all to be ready for this. Very much so. All right, shall we get started? Yeah, let's do it. Okay.

Gina, just to orient everybody, at this point in the ongoing conversation that you and I have been having about the scourge of inflation in the United States, we're at the stage

where the Federal Reserve keeps taking out its biggest, heaviest tool, higher interest rates, and a little bit like a hammer, slamming it over the head of the economy every couple of months, hoping that by making the cost of borrowing money more expensive, it will slow spending and therefore bring down prices and reduce inflation. So how is all of that hammering going at this point in the process? So how is all of that hammering going at this point in the process? It's not going great, at least so far.

So just like you said, the Federal Reserve has this one tool to slow down inflation. That's interest rates. They have been raising interest rates quite a bit this year, five times in total with three really big rate increases in order to sort of make it more expensive to borrow and spend money with hopes of slowing down consumer demand. The idea is that if you slow down consumer demand, supply is going to outstrip demand. And when that happens, prices either fall or at least they climb a lot more slowly. That's how you get slower inflation. And so this is the Fed's recipe for cooling off the economy, bringing inflation down. Unfortunately, for all of us and for the Fed, that process takes a while to play out. You know, the Fed raises interest rates, but it's not the case that inflation just comes down tomorrow.

It's a process that has to trickle out through the economy. It sometimes takes, you know, a year, two years to fully work. And so what we're seeing now is that although the Fed has carried out what is really the most aggressive rate increase cycle since the early 1980s, we haven't actually seen inflation start to slow in a big way yet. It's moderating a little bit, but it's still painfully high, sort of top of mind for pretty much all consumers in America. Okay. And what's your understanding as somebody who covers the Federal Reserve about why this hammer is not doing its job? Why inflation remains so unusually high despite five rate increases? So right now, one big factor that's making this take a while is that the companies who set prices are really reluctant to stop increasing them quickly. And why is that? A simple way to think about this is that companies got used to being able to charge quite a bit more. Kind of addicted to raising prices. Exactly. I

think that's true. And they're addicted because this has been really good for corporate profits. Profits, obviously, are the difference between how much you can charge and how much your costs are. So what we saw in sort of this mid-pandemic era is that as companies faced rising costs because supply chains were all messed up, factories were shut down amid the pandemic, they started to pass those along to consumers. Right. They pretty quickly realized the consumer demand was so strong that they could actually pass quite a bit more than just those costs on to consumers. They could charge a lot more than their costs had increased. And so what

we saw was that corporations were actually pocketing quite a bit more profit off of this. This was a good period for them. The reason demand was so strong is because consumers both had been stuck at home for months just saving money, and they've gotten repeated checks from the government. Then as they came out of lockdown and started to get jobs and started to change jobs, they got pretty decent wage increases. And so all of that fueled this sort of very solid consumer demand the corporations have really been taking advantage of. And so what we've seen over the last two years is that corporate profits have been really solid. You know, companies like GM, Costco, Ford, John Deere, these household names that you know of,

they are all still taking home abnormally large profit margins. But you know what's surprising about that is that by now, all those government checks you just mentioned to stimulate the economy are presumably spent. The pandemic supply chain issues are more or less resolved. And the Federal Reserve, as we just talked about, is making borrowing money more expensive. So shouldn't that lead companies to have to lower prices when taken together? Right. You would think that because, like you said, supply chain issues are improving.

They're not 100% cleared up yet, but they're getting there. And there are several things that should be holding down consumer demand. The Fed's been as robust as it had been, it's still pretty strong relative to what was normal in, say, 2019. And so what we're seeing is that companies who have gotten very used to these fat profits are, at least for the moment, trying to protect them. They're trying to hang on to those big profits. And so they're still putting up prices very rapidly as they do that, even in instances where their own costs are starting to fall as those supply chains heal. Right, which means they're making even more money. Exactly.

So that would seem to lead us to the conclusion, if companies can still do this, and consumers are still willing to pay those higher prices, that Americans turn out to be less price sensitive than perhaps we had imagined. Because when companies keep raising prices, even in the absence of so much higher demand, we the consumer keep paying those higher prices. It does seem to be that that is the case. And I think that we're also just seeing an era of upheaval in the economy. You know, the pandemic changed a lot of things. I willing to pay more for them temporarily. And I think the question that economists are asking is, does this pricing power that companies have now last? And I think that's a huge mystery in the economy and a big mystery

related to inflation. Okay, so the situation that this leaves us in is that the Federal Reserve needs to break an addiction that both companies and consumers are feeding. And the best way they can do that is by lowering this hammer over and over and over again until enough consumers scream uncle and stop buying all the things we're talking about and companies get the message that they have no choice but to lower prices. Right. That's effectively the idea. The more you raise interest rates, the more you cool down the economy, the more consumers feel like they don't have the wherewithal to spend all of this money, the more companies are going to have to start competing for a limited pool of consumers again.

And how do you compete? You lower your prices. Right. Or you don't put them up as quickly. And so that is really what the Fed is hoping for. And Fed officials have specifically called out these profits as something that they're watching. You know, they are hoping to see these profit margins shrink as a sign that it's working. And a really interesting case study that allows us to sort of probe into what's happening here is the car market. And it's a case study that gives us some reasons for hope, but also a couple of reasons for worry.

We'll be right back. So, Gina, explain why the United States car market gives us both hope and some worry when it comes to the government's ability to break this corporate addiction to higher prices and profits. So I think it's important to give a little bit of background on what happened in this market. So there are basically two markets here, the used car market and the new car market. And both of these markets have just gone on a wacky journey over the course of the pandemic. The coronavirus outbreak in China is wreaking lots of havoc on supply chains around the world. We saw supply for cars, new cars in particular, just absolutely dry up as factories shut down. General Motors, Honda, and Toyota are, amongst others,

having to delay production. And as important parts that companies needed to build these cars just basically became impossible to find. Right, like computer chips. Computer chips, exactly. Critical components in everything from PCs to cell phones, refrigerators to new cars. And so we haven't had enough cars.

If you don't have enough new cars, you also don't have enough used cars. And so we had a situation where there were just no cars on lots. Look, if you bought a new car last year, you could probably sell it for maybe even a little bit more this year. People would pay basically whatever they could to get their hands on a car. Used car prices are up 42% in a year. Honk if you're hoping it's transitory. Used cars typically, as we all know, the day you drive your car off the lot is the worst day of its life, right? Usually is the case that once you've purchased a car, it goes down in value and it goes down in value steadily every year. Well, suddenly, as anybody who leased a car

recently knows, your dealer was emailing you saying, hey, your car is worth more now. Bring it back, please. A lot of people are turning around and getting some really big dollars out of those leasehold agreements, buying out the lease and then selling it on the open market. Not bad if you can get some of that. Wow. So we just were in the situation where there were so few cars that everybody was trying to get their hands on them. And instead of depreciating the way they usually do, used cars started to go up in price. Fascinating. Actually, the auto part of this is a big part of the inflation story. A third of this gain in inflation was just used cars. And so this was a big fueler of inflation, actually. I think you can think of it as one

of the ground zeros for what we saw happen with inflation in the pandemic era. for what we saw happen with inflation in the pandemic era. Okay, so what happens once the Federal Reserve takes out the hammer, tries to bring down prices to the used car market? I think this is why the used car market is the hopeful, or at least hopeful-ish, part of this story. So when the Fed starts raising interest rates, you do begin to see a pullback in the used car market. Demand for used cars begins to wane. And that makes some amount of sense because if you think about it, used car buyers are fairly price sensitive. Prices are really high, as we all know. And suddenly it

costs more to take out a car loan. And so between all of that, it's become a lot more expensive to buy a car and fewer people are doing it. Right, because the interest rate, when it goes up, affects all borrowing rates, not just homes, but also the rate you pay to finance your car, to borrow money and pay it back in monthly installments for your car. Exactly. Auto loans are a little bit more expensive. Cars are a lot more expensive. And that combination just makes the affordability equation not work out for a lot of people.

And so at a wholesale level, which is where companies go to buy the used car inventory that they then sell to consumers, you do see a rebound in what's available. And you see wholesale prices for used cars start to come down. So when the used car dealer that you go to purchase a car from is buying its inventory, those prices aren't as high as they were previously. That's a good sign.

That's a good sign. And that relates to, in part, what the Fed is doing. Exactly. But you keep referring to wholesale prices. Right. So this is the complication in this story that I say makes it a hopeful-ish rather than a purely hopeful story. Because wholesale prices and consumer prices are telling two slightly different stories right now.

We've seen wholesale prices start to nosedive, which is exactly what you would expect. Less demand, more supply, lower prices. But you've seen consumer prices basically hold the line. The used car dealers, they're paying a lot less for these cars at auction, but they're still charging on average $28,000 for a used car in America, which is where they reached at sort of the height of the car shortages. There's a lot of money.

Right, exactly. So it hasn't gone up more, but it hasn't started to meaningfully come down yet. what you're saying is rising interest rates are doing what they're supposed to do. They're lowering demand, which means that the car dealership is paying less for the car. But now you're saying the car dealer, still addicted to these high profits, is squeezing as much profit out of that lower wholesale price as it can and not passing it on to the consumer. That doesn't seem like the way this is supposed to work. Exactly. So this is a hopeful story in that supply and demand do seem to be playing out here, but hopeful-ish in that it also seems to be taking some time to get the whole way to consumer prices. Okay.

So if that's the hopeful-ish story, what is the worrying component of the car market? So I think the part of the car market that continues to broadcast why this might be a long journey is the new car market. What we've seen in the used car market, which is that higher rates and higher costs are sort of bringing supply and demand back in line, has not showed up in new cars yet. You're still seeing pretty big price increases in the new car market. The average new car in America costs roughly $48,000 right now, and new cars are up about 10% from a year earlier based on the latest Consumer Price Index report. And while that's not the absolute highest rate of increase we've seen in the pandemic,

it is really high. You know, by way of context, the Fed aims for roughly 2% inflation a year. So 10% inflation in a good, it's a very big rate of increase. And so I think the question is, you know, what has gone wrong here? And I think you can kind of break it in to two buckets. One is new car supply remains extremely disrupted. Even though supply chains are beginning to heal in many parts of the economy, it's still really hard to build enough new cars these days. I think the other really interesting thing here is what it says about our divided income spectrum. Explain that. One thing that you'll hear a lot when you talk to dealers in the new car market is that the segment that they just see rip-roaring demand from, the people who will pay anything for cars these days, are richer customers. People in sort of the upper middle income spectrum on up have really amassed a lot

of savings over the course of the last couple of years, and they've been spending them down only slowly. So they're sitting on these big cash piles. If they want to purchase a big, fancy new car, they are very much capable of doing that. And they're much less interest rate and price sensitive than lower income consumers because often they're buying in cash. Right. The interest rate to them means nothing when it comes to buying this car because they're not borrowing any money to buy it, which is how you would be affected by the rising interest rate. It would be passed on to you in higher monthly costs. That's not an issue here at all. Exactly. And the other big way that rising interest rates affects consumers is that higher rates trickle through to labor market

prospects, right? You know, if the Fed is raising interest rates, it's going to slow down the job market. And that makes someone who's buying a used car, who's at the lower end of the income spectrum, it makes them less economically secure. They might lose their job. Exactly. People who are at the lower end of the income spectrum are much more vulnerable to job loss. People at the upper end of the income spectrum tend to be less vulnerable. And when they do lose jobs, it's fairly easy to transition. And so I think we are probably seeing a situation where those folks feel a little bit more secure. They have a little bit of savings. And so while this purchase may be a splurge for them, it's not completely out of the question that they can afford it. So just to summarize all this, Gina, what's happening in

the used car market is a somewhat welcome scenario for the Fed, whereas what's happening in the new car market is not at all a good scenario for the Fed. And if we project this out to the rest of the economy, a larger observation that I'm having is that the Federal Reserve's policy of raising interest rates to slow spending is kind of regressive, right? I mean, the group of consumers it really hits and hurts and slows the spending of are those who don't have all that much money. I think that that is partially a correct way to think about the Fed's policies. Fed interest rate increases also affect rich people, which people are much more likely to own risky assets like stocks. And so they can really see their wealth diminished. But I think the kind of day-to-day economic life effects,

the, you know, I'm not going to be able to buy a car this year. I'm not going to be able to buy a couch or a house or whatever the case may be. Those effects are felt most clearly on the lower end of the income spectrum. And so I think you can say that, think of it as regressive in that way. But while interest rate increases and the pain they bring can be regressive, so is inflation. Actually, the car market is a great illustration of this. Used cars got so expensive that poor people just can't afford them anymore. Right. You know, and I think it's important to note that that kind of inflation is very unhealthy for the economy.

Poor people in the economy tend to spend a lot more of their income on things they really need, on necessities, on food, on gas, on clothes, on cars to get to work, transportation, etc. And as those prices go up quite a bit, it imparts a lot of hardship on those people. And so I think that that's something to keep in mind as you think about how Fed policy works and what it's trying to accomplish. Right. And of course, if the Fed succeeds in its approach here, it is going to bring those dangerously high inflation numbers down, which means it's going to meet a lot of these lower income consumers where they are, which is supposed to be healthy. That is the goal. That is the goal. Of course, if you are a lower income consumer who loses their job in the process, it's not going to feel a lot better to you. But the idea is that inflation affects everybody. And so we do need to have some

short term period of pain in order to bring inflation down. That is how the Fed thinks about this. Understood. But and correct me if I'm wrong here, it seems like a relatively small group of consumers in our economy, better off Americans, who can live with these price increases and are willing to pay them as illustrated by the new car market, in some ways can protect a market from the Fed's efforts to lower inflation by raising interest rates. Is that more or less right? It is clearly the case that richer consumers can be a sustained source of demand that make it harder to wrestle inflation down. It is also the case that they're only part of the market. A lot of consumption happens below those sort of richer groups of people. And so it's not like these policies are ineffective or that they're just not going to work because rich people exist. It just might be the case that it is harder to

vanquish inflation in a world where rich people have so many savings, where even middle class people have a lot of savings and where they're willing to spend out of those savings. So does that mean to go way back to the top of our conversation, that we are just going to have to stay on this path of taking out the hammer and continuing to raise interest rates. Because we have an economy in which there are plenty of people who turn out to be a lot less sensitive to these price increases, we thought. I think it is pretty clearly the case that inflation is not slowing as rapidly as the Fed had hoped it would. Fed officials are really nervous

about how long it's been high, and so they do plan on continuing to raise interest rates at least through the end of the year, the beginning of next year, in order to try and sort of tamp down the economy, control these prices. And that could be a pretty painful process. You know, earlier in this process, they talked a lot about a sort of soft landing where

the economy could just be set down gently and inflation would slow and everything would be kind of okay. And the window for that is really narrowing. Fed officials themselves will tell you that it's becoming less and less likely as inflation stays high because their top priority is really getting those price increases back under control. And so if you don't get a soft landing, you get a hard landing. What does that look like? A hard landing is painful. So in a hard landing, unemployment jumps and you either have people losing their jobs or you have people not getting jobs and people are getting worse raises, no raises, bad outcome. Nobody wants that to happen. Some people think it may be the necessary cost of getting inflation

down. But there's also still some, if small, reason for hope. And that ties back to the profit question that we talked about earlier. The idea is that if corporations start to believe that consumer demand is going to be persistently slower because of all of these rate increases that the Fed has been making, they might actually take a harder look at those profits and say, hey, you know, if I continue to charge more, if I continue to put up my prices, I'm going to start losing customers. And so we might see a situation where companies start to change their behavior, eat into those big profits, and charge lower prices or put up their prices more slowly. And that would help inflation to moderate and could potentially make it easier for us to achieve that sort of mythical soft landing. But they will only do that when they believe they have no other choice. So they're going to do that if they believe that consumer demand is durably slowing.

So they're going to do that if they believe that consumer demand is durably slowing. And now it's just a question of whether they believe that in time for a soft landing. And if you had to say what that window of time looked like, Gina, are we talking about weeks or are we talking about months? Everything in Fed land kind of happens in months, I would say. But I think that the question is live right now. The Fed has already done a lot of rate increases. It's clearly signaled that it's going to do some more. And I think the big question is, does it keep pushing them higher and higher and higher until something breaks? Or does it start to see signs that momentum is slowing and it doesn't have to do that? And I think that's a question for probably the next 60 to 90 days.

Well, Gina, thank you. I appreciate it. Thank you for having me. We'll be right back. Here's what else you need to know today. On Wednesday, OPEC, a coalition of oil-producing nations that includes Russia, said it would slash oil production by 2 million barrels a day, a move vigorously opposed by the U.S. that could increase gas prices across the country.

Russia favors the decision because higher energy prices will help it finance its war on Ukraine. The timing of the decision is politically perilous for Biden because it risks raising gas prices, which have recently fallen right before the midterm elections. And the Times reports that U.S. intelligence agencies believe that the Ukrainian government authorized a car bomb that killed Daria Dugina, the daughter of a prominent Russian nationalist outside of Moscow in August. Up until now, Ukrainian officials have denied any role in the assassination. According to the Times, U.S. officials have expressed anger over Ukraine's role and warned it that such assassinations could provoke similar attacks of Ukrainian officials by Russia.

Today's episode was produced by Will Reed and Eric Krupke. It was edited by Mark George, with help from Lisa Chow and John Ketchum, contains original music by Marian Lozano and Alisha Baetube, 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.