What is Going on With the Economy?

Hint: It’s not about inflation

Okay, I admit I fibbed a little in the subtitle.  It is about inflation, but not in and of itself.  It’s more about the acceleration of inflation, and of the acceleration of rising interest rates.

First, let’s backtrack to the confounding economic data we are seeing.  Poll after poll seems to confirm that Americans are feeling more and more gloomy about the economy and about the general well-being of the country.  A CNN/SSRS poll conducted in July 2023 showed that 37% approve of President Biden’s handling of the economy, down from a high of 51% in Aug-Sep 2021. It should be noted that this is up from a low of 30% in June-July 2022, a point from which it’s held very steady at 34-37%.

The same poll reflected 71% stating that things are going “Pretty/Very Badly” in the country today, with 29% saying “Very/Fairly Well.”  This is astonishingly lower than even during the 2020 height of the Covid pandemic, but still a bump up from 22% Jan 2021, when the Jan 6 insurrection occurred, and up from the lowest point of 21% in June-July 2022.

Another poll conducted by The AP-NORC Center for Public Affairs Research in mid Aug 2023 showed essentially the same results: 36% of U.S. adults approved of Biden’s handling of the economy.

The focus on inflation and cost increases here is justified by a new Quinnipiac poll released on Sep 13 that showed overwhelmingly that 83% are worried the most about “Price of gas/goods” or “Cost of housing/rent”.  

These despondent attitudes persist despite some pretty positive recent economic news, even concerning inflation.  Almost every basic economic indicator shows signs of positivity and growth in the economy today.  Unemployment is at near-record lows, inflation-adjusted wages have risen significantly, inflation has abated significantly, and GDP continues in solid territory.  In any other time, this would feel like a time of prosperity and celebration.

So why are people feeling down about the economy today, when the worst of inflation seems to be behind us? As I just mentioned, inflation has eased to the point where the month-to-month rise is at very historically tolerable levels, in the .1%-.4% range over the last 6 months, although it did jump to .6% from July to Aug, almost all due to gas prices spiking up temporarily. 

But the problem is the shock and acceleration of recent inflation and rising interest rates.  Both things have risen at historically fast rates and therefore have had a traumatic effect on everyone’s consciousness.

Since WWII, there have been 3 periods of extreme accelerated inflation and interest rate growth.  For the purposes of this article I will use mortgage rates to reflect rates in general, as it affects housing, which was one of the main worries of respondents in the aforementioned Quinnipiac poll. The 3 periods are the following:  1970’s, early 1980s, and 2020-2022. The 1970’s was a particularly challenging time, and featured the notorious “Stagflation” epidemic, named for a combination of “stagnation” and “inflation”, when inflation was rampant despite unemployment being very high.  There was a lot of economic pain during that time, and the fact that this recent 2-year period is comparable says a lot about why people feel the way they do.

But, again, it is more about the rate of increase (acceleration) of inflation and interest rates causing a shock to the system instead of inflation itself. 

I'm not a trained mathematician, but it seems intuitive to use velocity and acceleration as analogies for percent change of inflation (velocity), and the rate of the percent change (acceleration).  A yearly inflation rate of 3% consistently would be like driving down the road at 30 MPH. Once you reach that speed and stay there it becomes comfortable and you don’t really notice after a while. The higher the percentage change, the more uncomfortable it is, but if it’s consistent there’s at least some feeling of stability.

But if you accelerate from 30 MPH to 60 MPH, you’ll notice it, and the less time it takes the higher the acceleration is, and the more you’ll notice it.  Consider the equation “Force = Mass x Acceleration”. In this equation, the higher the acceleration, the more force you will notice or feel.

Again, not being a trained mathematician, the best and simplest data I could think of to use is the year-to-year percentage change and consider the percentage points difference across years.  An inflation rate of 5% one year and 5% the next would have no acceleration.  For the purposes of this article, a rate of 5% one year to 7% the next would have an acceleration of 2 percentage points, and therefore the discomfort level would be higher.  Mortgage rates are just static interest rates, not rates of change like inflation, but in my mind the concepts are similar:  the higher the rate over the shorter amount of time theoretically produces the most discomfort.

According to the Federal Reserve Bank of St Louis, the annual inflation percentage point increase from the end of 2020 through the end of 2022 totaled 6.8 points (this is the % change for each year added together).  This is the highest 2-year increase since 1972-1974, when it was 7.8 points.  The next closest one is 1978-1980 at 5.9 points. So in the last 76 years, the most current 2-year rate of year-over-year inflation increase, or inflation acceleration, is the 2nd highest it’s ever been. And the highest was over 50 years ago.

Similarly, if we look at the recent 24-month period from Dec 2020-Nov 2022, mortgage rates increased by 4.42 percentage points, from 2.66% to 7.08%.  This acceleration of mortgage rates was exceeded only 2 other times since 1971 (when the earliest data is available for mortgage rates):  the 15 months from July 1980-October 1981, at 6.25 points; and the 25 months from April 1978-April 1980, at 6.97 points.

This clearly shows that the rate of the rise, or acceleration, of inflation and mortgage rates during the 2020-2022 2-year period was at historically high levels.  But there is a further aspect that makes this potentially worse for this current generation. The relative levels of both inflation and mortgage rates were higher during the previous periods, which theoretically should mean that the population in 1970s and 1980s was more used to higher inflation and rates than the population in 2020-2022, and therefore should have felt less intense discomfort when the acceleration occurred.

Regarding inflation, the time period just preceding the large acceleration level was already quite high, a bit above the baseline 3.2% in 1972 that was used as the starting point for the first period of high inflation acceleration.  The 4-year period before 1972 had a yearly average of 4.95% inflation, essentially 5%.  It just happened to dip down to 3.2% in 1972 before ramping up significantly. Similarly, the 3-year period before the next high acceleration period starting in 1978 (I’m using 3 years here because the 4th year would be the last year in the previous high acceleration period) had an average of 7.13% inflation.

If we look at the 5-year period before the 2020-2022 timeframe of the most recent high acceleration period, the yearly average is 1.54%, an historically small amount that could be argued was practically unnoticeable by the population. 

Regarding mortgage rates, there is a similar relationship. Mortgage rates during the 1970s were well above 8% most of the decade and steadily increased into double digits just preceding the first and second periods of high interest rate acceleration.  Contrast that with mortgage rates never exceeding 5% in the 2010’s, and in fact mostly being below 4%.  It actually reached an astoundingly low 2.65% in early 2021, which is basically free money when we account for inflation.

One could argue that it’s all relative, so each period of high acceleration would feel similar across populations regardless of the absolute starting point, but I don’t agree. I think the starting point matters, in the same way that we feel safer driving 30 MPH vs. 45 MPH vs. 60 MPH vs. 90 MPH.  The faster you go, even with no acceleration, the more discomfort you feel.

Therefore, I would argue that the populations during the 1970’s high-acceleration periods were starting from a worse, more uncomfortable place than the more recent high-acceleration period. A 5% increase in inflation would be much more noticeable and painful than 1.5%, but if consistent over a large amount of time would feel steady and people would get used to it, and subsequent changes would be more tolerable.  But a near-zero inflation rate of 1.5% would feel much better, and a significant increase from there would be more shocking to the general population.

This is where the traumatic “shock” comes from that I believe is causing the very negative outlook for the economy. To be sure, there are other factors, such as lingering cost increases in insurance that lag the rest of the economy because complex calculations have to be done to bills that are due later in time.  But it seems that this historically high level of inflation and mortgage rate acceleration, jumping from a historically comfortable baseline level, would perhaps be the most painful inflation and mortgage rate increase in our modern history.