Economic Warning: Could Persistent Inflation Trigger a 2008-Style Crisis?
Despite Cooling to 3.3%, Inflation’s Persistence and Rising Defaults Suggest a Severe Recession May Be Our Only Path Back to Normalcy
By Willie Costa & Vinh Vuong
May’s CPI print has markets jumping for joy and Treasurys sliding, but are we celebrating too much, too early? If you’re a regular reader of this blog, you already know the answer to that question: markets are looking to Powell for reasons to continue celebrating, like Oliver Twist saying “please, sir, I want some more.” CPI held flat on the month but still increased 3.3% from a year ago, whereas most economists had been looking for a 0.1% monthly gain and a 3.4% annualized rate. The component inflation rates, which is what people often feel the most bitterly, tell a different story: shelter, for instance, increased 0.4% on the month (up 5.4% from a year ago), but prices were held in check by a 2% drop in energy and a 0.1% increase in food. Motor vehicle insurance, however, remains up more than 20% on an annual basis. Inflation across many necessities is still massively higher than the headline number:
- Car insurance: 20.3%
- Transportation: 10.5%
- Hospital services: 7.2%
- Car repair: 7.2%
- Electricity: 5.9%
- Food away from home: 4.0%
Inflation has been above 3% for 38 consecutive months now, and this compounding effect not only ruins consumer confidence, it also makes making ends meet increasingly difficult. So while one’s preferred talking heads declare the fight against inflation to be turning, people must remember what they already feel, both instinctively and every time the bills come due: inflation may be getting better, but affordability is getting worse.
Fed officials, to their credit, have been taciturn regarding rate cuts despite external pressure to do so, saying they need to see more than one or two months of positive data before cutting rates. There’s good justification for the reserved approach: we’ve seen good CPI prints lead to irrational exuberance and higher inflation in subsequent months. In fact, this isn’t the first time that such a phenomenon has occurred: CPI dropped precipitously between 1974 and 1976, only to increase ever higher through 1980–1981. The parallels with our current situation are nearly lockstep:
So if inflation is doing so well, how come many Americans are still feeling the pinch? As we’ve discussed several times before, there’s a big difference between deflation (what you feel in the wallet) and disinflation (the slowing down of how quickly your dollar loses value over time). Pundits and politicians love to discuss the inflation rate, but rarely talk about how that rate affects purchasing power. Despite recent “wins” against inflation, CPI has increased by almost 21% since January 2020, with a solid uptick beginning after stimulus spending and increasing sharply during 2021 when experts labeled the inflation caused by those trillions in spending “transitory.” Did the CPI slope change in mid-2022 automatically? Of course not: it changed because the Federal Reserve decided to take action and begin hiking rates, though one must wonder how much better affordability would be if they had done their job sooner: the line of constant annual 2% inflation shows just how off the mark we continue to be. CPI inflation may be up “only” 3.3%, but in reality it’s up almost 21% since 2020.
Granted, CPI is not the Fed’s preferred inflation metric — PCEPI is — but even with the preferred PCEPI metric inflation has trended to more than twice what it would’ve been had we maintained a constant 2% annual rate. While there are differences between the two metrics (including how they’re constructed, expenditure weights, seasonal adjustments, and revision), there’s no denying the massive gap between where we are and where we should be.
Of course, not all of this can be laid at the feet of the Fed: the covid pandemic was not caused by quantitative easing or poor rate policy, and the massive expenditures (at all levels of government) that followed and have continued since — including PPP, stimulus checks, the Fed building up its balance sheet, or increasing available funding to depository institutions to meet depositor needs — could all be seen, even in hindsight, as necessary steps to confront unforeseen events that threatened to upturn the financial markets. Promoting stability within the financial system is literally one of the Fed’s mandates. But there is a notable difference between exogenous shocks (such as a global pandemic or bank failures), which are impossible to predict, and the basic tenets of macroeconomics, the most important of which (for the present discussion) is the inverse relationship between inflation and interest rates.
The Fed’s decision to leave rates unchanged certainly boosted (potentially irrational) market optimism, but at what cost? The continually high rates are a boon for savings accounts and CDs, but for those who must increasingly rely on debt — including revolving debt such as credit cards — the continued persistence of inflation plus high interest rates is squeezing what little affordability they might still be enjoying. Unfortunately, this squeeze is felt by the majority of Americans, 77% of whom are indebted (to an average of over $66,000 per person). Consumer revolving debt has increased steadily since mid-2021 and shows no signs of slowing, currently topping out at over $1.06 trillion. As inflation stubbornly persists, rates must remain high in an attempt to combat it, and therefore the cost of servicing this debt also remains high.
One may be forgiven for wondering whether “another 2008” might occur, this time triggered by a credit event. The lumbering economy, undying inflation, and a high-rate environment are already taking their toll on businesses: the number of defaults in 2024 has been rising at the fastest rate since 2008, and more than one-third of businesses that defaulted in 2023 were repeat defaulters.
It’s now been eleven months since the Fed last raised rates at the July 2023 meeting, and — shockingly, for some — inflation still hasn’t resolved itself. The Fed may be “considering” leaving rates unchanged — which would be a mistake — but cutting rates with inflation persisting over 3% would be suicide.
The more time that passes, the greater the likelihood that the only path back to affordability and normalcy will be through a recession. Unfortunately, as inflation proves to be more persistent, the longer we delay, the more severe that recession is likely to be.
