Higher inflation brings lower standard of living

By holding interest rates at less than half the inflation rate, the Fed is focused on stabilizing the financial system. The hope is that the ongoing slowdown in the economy will eventually take the pressure off demand for commodities like food and energy – and inflation will subside.

“With the decline in energy prices - and assuming that sticks - that clearly improves the inflation outlook relative to what I was earlier expecting,” Minneapolis Fed president Gary Stern told CNBC Tuesday. “It should lead to some slowing in the future in headline inflation, and that should also be to the good from the point of view from inflation expectations.”

A lot depends on whether consumers and investors view prices hikes as a temporary, one-time event – or whether they begin to assume inflation will remain high. If that happens, investors demand higher interest rates to make up for inflation’s corrosive impact on their investments. In the 1970s, consumers responded to persistent inflation by demanding higher wages. So far, that isn’t happening.

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“There remains no evidence sign that wage inflation is responding,” wrote Global Insight economist Nigel Gault in a recent note to clients. “When workers see higher prices now, they do not expect a wage hike but rather a drop in their standard of living.”

With the economy shedding jobs and unemployment rising, it’s a tough time to ask for a raise. That means that – unless your paycheck is growing by 5 percent a year – you’re actually taking a pay cut.

Higher inflation also is cutting incomes for retirees living off their savings, and it’s chipping away at the nest eggs of those who hope to retire some day. Savings invested today in a safe 10-year Treasury note are returning about 4 percent – which becomes less than 3 percent after taxes. Factor in a 5 percent inflation rate, and those T-notes are shrinking by more than 2 percent a year.

During the prolonged inflation of the 1970s, house prices also rose rapidly. But today, consumers’ budgets are also being squeezed by falling equity in their home which, until recently, was a critical source of spending power.

“The housing market is still collapsing and you have a huge excess inventory of housing,” said economist Gary Schilling. “Until they are worked off, (house) prices are going to decline and the home equity that people have depended on in lieu of income growth is going to disappear. So, consumers are going to be under fire.”

Declining spending power is already beginning to show up in the results from the nation’s retailers; sales fell in July as the stimulus impact of the government’s tax rebate checks began to fade. Much of that money was spent to make up for higher prices of basic goods. With those checks gone, households will have to make tougher choices on where to cut back.

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