Inflation and the Economy: What to Expect in the Second Half of 22

Inflation is at its highest point in more than 30 years, and many people are struggling with the rising cost of food, gas and other basic needs. The Federal Reserve has raised interest rates in an attempt to curb soaring prices.

Stephen Brincks is an assistant professor of finance at San Diego State University’s Fowler College of Business. The SDSU News Team asked Brincks what is driving the rise in inflation and whether the U.S. is headed for a recession.

What are the main factors that have contributed to the inflation we’re experiencing?

Inflation is being driven by a combination of supply-side factors, such as higher commodity and energy prices, and demand-side factors, such as strong wage growth and increased consumer spending. Inflation started in early 2021 due to supply chain issues arising from the pandemic, extremely stimulatory Federal monetary policy, and record government spending. The supply-side inflation combined with a tight labor market caused record wage growth (6%+) in the second half of the year. Record wage growth is contributing to higher inflation as consumers spend record amounts on goods and services. U.S. and European policy responses to the war between Russia and Ukraine have caused oil and gas prices to increase further.

What is the role of corporate profit margins in driving up inflation?

Corporate profit margins are contributing to the inflationary cycle, along with wage growth in what is called a wage-price spiral. Strong wage growth allows corporations to raise prices without losing sales because consumers are willing to pay up for goods and services. Strong profitability creates a strong labor market that fuels wage gains. Those wage gains allow workers to purchase marked-up goods and services in a self-perpetuating cycle.

Is wage growth in the lowest income brackets keeping up with increases in inflation?

Unfortunately, wage growth for workers in the lowest income bracket is not keeping up with inflation. According to the Wharton Budget Model, wages only offset one-third of the increase in inflation for workers in the lowest income bracket. Significant increases in rent payments are the primary reason.

Explain the Fed’s reasoning behind the interest rate hikes. Are there more to come?

When inflation is too high, the Federal Reserve can use two primary mechanisms to lower inflation. The Federal Reserve can raise the Fed Funds Rate, which increases short-term interest rates, and engage in quantitative tightening to raise long-term interest rates. Currently, the Federal Reserve has raised the Fed Funds Rate by 1.5% and is expected to raise interest rates by at least another 2% over the next year.

Historically, how successful are interest rate hikes at taming inflation and staving off recessions? Are we headed toward a recession now?

Interest rates are designed to slow down the economy by increasing the cost of capital for corporations and reducing consumer spending. Historically, increases in interest rates eventually slow down inflation by reducing economic growth. Recessions are an unfortunate but typical side effect of slower economic growth. Because inflation is so high, the Federal Reserve is rapidly raising interest rates. The likelihood of a recession over the next 18 months is very high — likely more than 50%. Historically, there has never been an economic cycle when inflation was this high and unemployment this low that didn’t lead to at least a mild recession.

The median home price in San Diego is now approaching $1 million. What is the likely impact of interest rate hikes on the real estate market? 

One of the goals of raising interest rates is to slow down housing price increases, so higher interest rates should reduce home sales, slow the rate of housing price appreciation, and slow the rate of rental price increases. It’s possible that housing prices and rents will fall if a significant recession occurs. The recent Fed actions have increased mortgage rates and caused the total monthly mortgage payment to increase by over 33% from a year ago. Interest rate increases also slow down the economy and typically increase unemployment, which reduces the number of home buyers and reduces the demand for rental units.

Will interest rate hikes lead to higher unemployment?

It’s very unlikely that inflation will come down unless the unemployment rate increases. Since the Federal Reserve will increase interest rates until inflation slows down, it’s very likely that the Fed will have to cause a recession to lower inflation. It’s not the Federal Reserve’s primary goal — the goal is to lower inflation — but higher unemployment is often a side effect of interest rate increases.

Any advice for people on how to weather inflation and the current economic climate?

We are in a very uncertain economic environment. There are some prominent economists, such as Larry Summers, who believe a multi-year mild to significant recession may be the result of the Fed's fight against inflation. It’s a good idea to keep a rainy-day fund in case the economy weakens and avoid overextending your spending. One of the positive side effects of inflation is higher interest rates for bank checking and savings accounts. The rate of interest should be above 1% right now and above 3% by next year. If your bank isn’t paying you this rate, then switch to another bank that pays a higher interest rate. Stocks and bonds have sold off recently, so it’s a better time to make investments than in the past.

Do you have any advice for people with low incomes who may not be able to save or invest? Students living on very little, for example.

There are support services available to help students facing economic uncertainty, such as food banks. SDSU has an economic crisis and response team available to help students that need resources. If students have the ability to work additional hours, there are many unfilled jobs at the moment.

Interview lightly edited for length.