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Inflation and the state of the economy: What history can teach us


The bear woke up — the inflation bear, that is.

For roughly the last 40 years, inflation has remained historically low — even in the face of a low-interest rate, high-spending environment. So, what’s happened to change that now?

During the last four decades, interest rates decreased not just from their highs in the 1970s and 1980s but dipped as low as 0%. U.S. debt continued to grow and U.S. military debt, especially at the start of the millennium, further drove up government spending, which wasn’t offset by higher revenue. For instance, America’s yearly military spending doubled from $400 billion in the year 2000 to $800 billion in 2010.

Then the close of the year 2007 brought with it the financial crisis, better known as the Great Recession. The Great Recession started in December 2007 and ended in June 2009 — making it the longest recession since World War II.

As outlined by Federal Reserve History, during the Great Recession: “Home prices fell approximately 30 percent, on average, from their mid-2006 peak to mid-2009, while the S&P 500 index fell 57 percent from its October 2007 peak to its trough in March 2009. The net worth of US households and nonprofit organizations fell from a peak of approximately $69 trillion in 2007 to a trough of $55 trillion in 2009.

“As the financial crisis and recession deepened, measures intended to revive economic growth were implemented on a global basis. The United States, like many other nations, enacted fiscal stimulus programs that used different combinations of government spending and tax cuts. These programs included the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009. The Federal Reserve’s response to the crisis evolved over time and took a number of nontraditional avenues.”

These “nontraditional avenues” are referring to such measures as credit easing and large-scale asset purchase (LSAP) programs.

Tax and accounting firms are often among the first to see the impact of inflation and recession: small business costs rising and profits falling, individual deductions increasing, and 1040 calculations changing. Clients need new direction as they set up business structures and make strategic choices that account for “the bear.”

Reflecting on these events, Bryce Engelland, financial and economic analyst for Thomson Reuters Institute, said in an October 2022 webcast, “All of this is the economic equivalent of going up to the sleeping inflation bear and swatting it on the nose, but the bear didn't wake up. In fact, it actually fell further asleep. Inflation didn't go up during this period. It actually went down.”

That is until now. The bear woke up.

What changed? What does inflation do to the economy? What’s next? These are a few of the questions Engelland looked to answer during his recent presentation “Crash Course: Inflation and the Economy.

To gain a greater understanding of inflation and what it does to the economy, let’s first take a step back and start with the basics.

What is inflation?

There are two ways to describe inflation: it is a decrease in the purchasing power of money or time, or it’s an increase in the price of goods without the corresponding increase in the value of those goods. In short, your money will not go as far today as it did yesterday.

To further illustrate, consider the example provided by global management consulting firm McKinsey & Co., “For example, in 1970, the average cup of coffee cost 25 cents; by 2019, it had climbed to $1.59. So for $5, you would have been able to buy about three cups of coffee in 2019, versus 20 cups in 1970. That’s inflation, and it isn’t limited to price spikes for any single item or service; it refers to increases in prices across a sector, such as retail or automotive — and, ultimately, a country’s economy.”

The cause of inflation doesn’t necessarily stem from one source but is rather a way to describe an inefficiency that is created through an economic imbalance.

According to McKinsey & Co., annual inflation typically in the range of two percentage points is what you’ll see in a healthy economy and is what economists consider a sign of pricing stability.

“There can be positive effects of inflation when it’s within range: for instance, it can stimulate spending, and thus spur demand and productivity, when the economy is slowing down and needs a boost. Conversely, when inflation begins to surpass wage growth, it can be a warning sign of a struggling economy,” McKinsey & Co. stated.

The consulting firm noted that soaring energy costs, labor mismatches, and supply disruptions accelerated U.S. inflation to 7.5% in January 2022, its highest level since February 1982.

Traditional causes of inflation

To better understand the causes of inflation, you must look at factors stemming from both the demand side and supply side.

From the demand side, there are several ways in which inflation can typically be created. These include:

  • Aggressive money supply expansion. In this classic case of hyperinflation, governments print vast amounts of money and inflation soars month after month.
  • Greatly increased consumer and government fiscal spending. In this case, governments infuse a large amount into the market and the market responds with a jump in demand that supply can’t keep pace with.
  • High government debt. Through issuing a large number of bonds and the large amounts of deficit spending, governments can create inflation.

Now, let’s take a look at supply-side inflation. These causes include:

  • Mismatch in supply versus demand. This is when the type of supply doesn’t match the demand, resulting in inflation for those things that are in high demand. To illustrate, Engelland provided the following example:

“So, for instance, there's this case where if the market is anticipating a high demand for furniture, and so it stocks large volumes of furniture, but what people actually want is cars. Then, while there might technically be enough value in the supply, the type of supply doesn't match demand, and this can result in inflation for the things that are heavily in demand that can outstrip the deflation that results in oversupply.”

  • Supply shortfall and delays. This is where a temporary shortage results in prices going up very quickly for people who don’t want to wait for the resupply to arrive.
  • Self-reinforcing cycles. This is perhaps the most dangerous cause of supply-side inflation. In this situation, as prices go up, labor demands higher wages to compensate, and this, in turn, pushes prices up even further.

“What becomes really dangerous is when markets began anticipating inflation to continue going out far into the future and, therefore, they begin pricing and future inflation right now, and this becomes a self-fulfilling prophecy across the market, and this kind of inflation is very hard to break. So, we often want to break inflationary cycles before they reach this point,” Engelland said.

What inflation does to money, the economy

Why is inflation bad? The answer may seem obvious but it’s worth exploring to gain a better understanding of how inflation impacts economies.

“The reason that inflation is an extreme threat to an economy is because it effectively breaks money itself,” Engelland said.

Why does Engelland mean? Money fulfills three basic principles:

  • Medium of exchange: Money acts as a medium of exchange with relative liquidity and a reduction in transaction costs. This doesn’t impact much and works in a low inflation or high inflation environment.
  • Unit of account: This is how we use inflation to measure value and allow comparisons of different items or services. This can be damaged by inflation.
  • Store of value: This allows us to transfer buying power from current times into the future. It allows money to exist on its own rather than a pure medium of exchange. This is what inflation targets and effectively destroys and, when this destruction starts to take place, what follows is large-scale disruption to the economy as a whole.

When inflation begins attacking the economy it sets off a chain of negative events that requires government intervention to diffuse.

For starters, inflation causes inefficiency by confusing price signals. “If the prices are constantly changing, going up and down, it's very hard for consumers to make actual informed decisions on what items have the best value. And because of that we tend to make inefficient decisions and it leads many customers to back away and not make a decision at all,” Engelland said.

Second, it makes long-term investment less attractive. “If my money is going to lose 10% of its value over the next few years, even an investment which increases the value of that money by 10% is still losing it in the long run,” said Engelland. “In such a scenario, as a consumer, it might be better for me just to spend now rather than thinking about long-term gains and benefits. And obviously, when an economy only thinks about the short term, there are always long-term costs associated with it.”

Third, inflation decreases real income, which increases poverty. As prices rise, wages rarely rise quick enough to keep pace. The end result: a net loss and, thus, increased poverty.

Fourth, inflation increases financial market volatility. “Anyone who looks at the S&P 500 right now, or any stock market, knows that there is no market out there that likes inflation and that tends to cause prices to swing wildly, which can, therefore, cause its own problems,” Engelland said.

In an effort to close the valve and stop inflation, governments are going to take action and intervene. Unfortunately, the steps that governments can take are, often times, uncomfortable in their own right.

“Often, dealing with inflation is like trying to burn off the flu with a fever. It's not fun for the flu but it's also not fun for you,” Engelland said.

On the demand side, governments may look to stop inflation by restricting fiscal spending, increasing taxes, or raising interest rates and reserve requirements. “What all of these do is they take excess money in the money supply and effectively remove it from the equation by either putting it in banks or shutting off the taps themselves,” Engelland noted.

Governments can also intervene on the supply side, which could mean export restrictions, where applicable; targeted supply subsidies; or food and energy price controls.

One effort that the government took in 2022 is an energy credit for individuals within the Inflation Reduction Act — incorporated into individual 1040s in the year 2022.

Engelland continues: “[Tackling intervention from the supply side] can come from export restrictions where applicable, where maybe you have a shortage of goods that is causing inflation. If you're exporting a large amount of those goods, retargeting those exports for the domestic market can stop that inflation. At the same time, targeted supply subsidies can have the same effect. While you are, therefore, putting more money into an already soaked system, what these can do is, on net, bring down inflation by increasing supply enough to make up for the difference. And then finally, you can put in price controls often for food and energy. And while this might result in shortages, sometimes the inflationary gains can be greater than the shortage pain. All these also have something in common, which is that all of them hurt.”

Measuring inflation

How inflation is measured matters.

Why? Have you found news of inflation — and whether or not there’s reason for concern — to be confusing or even conflicting? If so, you’re not alone. Often, the conflicting information stems from the fact that inflation is being measured differently.

“For example, one source can tell you that inflation last month was above 10%, but another will tell you that it's only 5%. One measurement may say that everything is fine, but another one is signaling a five-alarm fire,” said Engelland. “None of these are necessarily wrong, mind you, but they're each measuring inflation in different ways, each of which can make different sacrifices to see things differently. Figuring out which measurement to use, and their weaknesses, is vital if we want to have a deeper understanding of what's going on.”

There are four different options — headline, core, Consumer Price Index (CPI), and Personal Consumption Expenditures (PCE) — to consider in measuring inflation. Let’s take a closer look.

Headline vs. core

Headline inflation is, in short, the total inflation in an economy. It includes consumer goods and services like energy, food, new and used vehicles, medical care services, and transportation services, but this also makes headline inflation highly volatile and highly responsive. It does more accurately respond to the price pressures felt by consumers and is typically the “transitory” part of inflation.

As noted by Corporate Finance Institute (CFI), a finance training, certification, and skill development platform: “Most central banks use headline inflation or a similar measure as their target variable. The reason being headline inflation is a broad measure that closely represents the basket of goods and services consumed by most households. Some major central banks that use headline inflation are the Bank of England, the European Central Bank (ECB), and the Reserve Bank of India.”

To better see the direction of inflation trends, headline inflation is often substituted with the less volatile core inflation.

Core inflation — or core CPI — specifically removes food and energy prices from the equation, which results in a more accurate representation of the price changes in goods and services. It is designed to strip out transitory movements found in headline inflation, making core more stable.

“These categories are excluded because their price changes can be highly sensitive to influences outside of broader economic price levels. (Many food and energy resources have also been securitized as exchange-traded commodities, which boosts their price volatility.),” stated boutique investment management firm Hilton Capital Management. “For example, corn prices can increase if severe weather damages crop yields and forces shortages. However, extreme weather may not impact the price levels of other goods and services, such as medical services or apparel. If increased corn prices were included in the core CPI calculation, it could lift the whole index, suggesting that the entire basket of goods is experiencing higher inflation, not just corn.”

The firm added that, “The Fed’s primary goal is to maintain maximum sustainable economic output and employment while keeping prices relatively stable. Broad measures of core US inflation without undue influence from external events are key to the Fed’s policy analysis and decision making.”


Now let’s look at CPI versus PCE. CPI, which measures the monthly change in prices paid by consumers, is one of the most popular measures of inflation and is closely followed by financial markets, businesses, policymakers, and consumers.

The Bureau of Labor and Statistics calculates CPI. As explained by BLS, “CPIs are based on prices of food, clothing, shelter, fuels, transportation, doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected each month in 75 urban areas across the country from about 6,000 housing units and approximately 22,000 retail establishments (department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments).”

While CPI does have its benefits, such as the rapid release of data and information based on household service data from the Census Bureau, it does have some drawbacks. One of the more notable drawbacks is that it doesn’t compensate for consumer substitution.

“Let's say I'm going to the grocery store to buy bananas and I've noticed that the price of bananas has doubled. I definitely don't want to pay that much for that item. Under CPI, it takes it and says, ‘Hey, he didn't buy the banana. Okay, that's how we're going to treat this.’ What it fails to recognize is that, instead of buying bananas, I bought apples instead where the price went up relatively less. So CPI doesn't capture that kind of minutiae and that can cause it to overshoot actual inflation,” Engelland explained.

Now, contrast this with PCE. It is based on data prepared by the Bureau of Economic Analysis (BEA) using the same data collection that is used to calculate gross domestic product (GDP), foreign trade, and investment statistics. While it cuts out energy and food prices for added clarity, it includes a much broader range of items and expenditures as compared to CPI. It is also able to handle consumer substitution within its math formulas. This results in a much lower inflation number compared with headline CPI inflation.

“[PCE Core] is the preferred measure of the Federal Reserve, which means that it is best used to understand what the Federal Reserve will do in response. It also tends to be the more robust measurement that shows the sticky inflation that's going to be very hard to remove and is unlikely to go away just because food or energy prices decrease,” Engelland said.

What’s interesting, said Engelland, is that PCE Core inflation has remained relatively low since the large spikes experienced about 40 years ago. This begs the question: where did inflation go?

“Economists spent the last 40 years wondering why it was staying asleep. Imagine a bear that terrorized the countryside for a few decades only to fall into a 40-year hibernation with no obvious end,” Engelland said.

Where did inflation go?

As stated earlier, inflation has essentially been missing for last the 40 years, and doing so in a low-interest rate, high-spending environment. Inflation wasn’t acting as it usually did. Why? Finding the answer requires looking at government spending in a new way.

A better way of visualizing a government’s debt is to look at its ability to handle increased indebtedness in conjunction with the rise in spending. To do this, turn to a debt-to-GDP ratio.

“Now, traditionally, economists would take 100% ratio as the red line that countries never want to cross without risking high inflation. The U.S. crossed this line in the 2010s and we still didn't have inflation increase. But the reason for this was actually seen a few decades earlier because, when we looked to Japan, we saw that they were able to not just cross this line but leap over it,” Engelland explained. “Japan experienced multiple lost decades of low growth, which the government tried to break using extremely high spending and very low-interest rates. In fact, Japan crossed that 100% line in 2001 and then crossed the 200% line in 2019. All of this was, however, not going to result in inflation.”

So, how can countries spend and borrow so much without experiencing inflation? As Engelland explained, one of the best theories is: “In the same way that countries can borrow more as their GDP increases, a country which is the world's reserve currency or has a very well-respected currency like Japan, is able to tap into global GDP growth because, as other countries grow, they increasingly need U.S. and other well-respected debt in order to be able to prop up their own value and expand their own economies in a stable fashion.”

This, then, leads to one of the greatest theories for why it disappeared: “The growing world was able to effectively soak up that excess government spending and excess money supply created by those loose policies. And, as we started going forward, economists began to suspect that, because of this, the old rules no longer applied because for 40 years we'd effectively been able to break them,” said Engelland. “No matter what we did to the inflation bear it never woke up, until now.”

The current crisis

It’s March 2020. Things are looking grim as the COVID-19 pandemic begins to reveal it’s not just a health crisis but also a financial crisis. States begin to implement shutdowns in order to prevent the spread of COVID-19, financial markets are panicking, and unemployment is surging.

A massive government response was called for and delivered. For instance:

  • Multiple trillion-dollar economic relief packages were released, including direct checks to U.S. citizens.
  • The Federal Reserve intervened in the financial markets with trillions of dollars more in support.
  • U.S. debt-to-GDP, which had been leveling off at the 100% mark, jumped above 120%. The U.S. economy was effectively flooded, greatly increasing economic demand.

However, there’s a complication: the supply chain falters. Vulnerable due to the high-efficiency, just-in-time (JIT) manufacturing set up that was in place, the threat of creating a detrimental self-reinforcing cycle is becoming real.

The initial result was scarcity of goods to hit the shelves, then came price increases. This was then passed onto the second-hand market through arbitrage. Now, throw into the mix a geopolitical conflict with one of the largest energy producers in the world.

The inflation bear woke up.

Inflation spikes

Inflation begins to spike with PCE Core inflation passing 3% in April 2021, the highest reading since 1992. Once inflation began, fears of it becoming self-reinforcing prompted companies to start increasing prices.

Looking to essentially break the main cause of inflation as they see it, which is too much money for too little supply, The Federal Reserve responded with the fastest interest rate hike in its history with multiple 75% basis-point hikes throughout the year.

“But the result of this is that, again, you are using a fever to break a flu and that can be very bad for the U.S. economy,” said Engelland. “And that brings us to kind of the question that a lot of people are asking, myself included, which is: ‘Are we going into recession?’”

Is a recession incoming?

“Well, the most basic definition of a recession has already been met with two consecutive quarters of GDP decline. We are in that baseline rough estimate of what a recession is,” said Engelland. “But that is kind of like saying that all sparkling wine is champagne. It's an analogy that's technically correct but might be missing a little bit of something.”

As the National Bureau of Economic Research’s Business Cycle Dating Committee works to determine exactly what is happening with the U.S. economy, there are some mixed signals that are raising eyebrows. The mixed signals can largely be attributed to the significant labor shortage.

“GDP is flashing recession and that's not good. Manufacturing, if not indicating a full recession, is at least going for glaring weakness. Yet financial markets, regardless of their overall fall, are signaling that they expect inflation to be relatively transitory with the five-year inflation expectation for five years staying stable,” Engelland said.

The expectation by many that, in five years, inflation will subside and not become a self-reinforcing cycle is obviously a big positive. But now throw into the mix the unemployment rate and things get interesting.

Among the factors to consider is that, during the pandemic, a large number of people left their jobs to, perhaps, start their own company or turn a side gig into full-time employment. This removed them from the general labor pool but, if their business venture proved successful, it created further demand for labor.

“The overall result of this is much the same way that inflation can be the result of a mismatch in supply and demand. Large scale employment like this with a huge number of open jobs is also a result of a very similar mismatch,” said Engelland. “And for recession to happen, especially a bad recession that lasts a long time and goes quite deep, you would need one, specifically the labor market imbalance, to eventually break. So, it's a question of what is going to break first? Is it going to be the labor market or is it going to be the inflation?”

There are indications that inflation will break first — unless something significant “upsets the apple cart,” said Engelland. Enter the estimated $400 billion student debt relief.

If the program moves forward — at the time of publication, the program remained in limbo as court orders had blocked the program — Engelland said the increased spending that would result wouldn’t hit until a few years down the road and, by that time, inflation would ideally be broken. So, in the near term, resuming student debt payments, which have been frozen since early 2020, will pull more money from the system than it theoretically puts in — thus tempering inflation.

For post-publication updates on the status of this legislation and other government inflation-related efforts, we recommend two resources:

  • Thomson Reuters online news contains tax research updates and analysis from Checkpoint Edge. Visiting the site or signing up for daily notifications will alert you when and what a final bill contains — and get straight to the real impact on tax clients from a tax expert point of view.
  • To put new regulations and calculations into practice in client returns immediately, visit the how-to videos in Thomson Reuters “Feature in Focus” YouTube playlist. Here are how-to videos for Checkpoint Edge and UltraTax CS, detailing the tax research and filing tips that we shared today and many more.

“Simply put, student debt relief will likely cause inflation down the road but it may help break inflation before we get to that point,” said Engelland. “And timing is all important in this case.”

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