Rising prices have made people grumpy. They have depressed consumer confidence, despite a growing economy and low unemployment.
But exactly how inflation is hurting, helping and confusing people is hard to understand. Everyone knows that the cost of living has increased. Yet unless you’re constantly pulling out a calculator, you’re unlikely to know whether your wages are keeping up with inflation, whether the stock market has actually hit a real peak or whether a lottery jackpot is as sweet as the marketers claim.
There’s a fancy name for the common human failure to see past the gaudy prices largely created by inflation. This widespread inability to recognize what money is really worth is known as money illusion.
Irving Fisher, a Yale economist, wrote a book about it nearly a century ago. John Maynard Keynes, the British economist, popularized the idea. Behavioral economists have studied it extensively. But their insights tend to be forgotten when prices are fairly stable, as they were in the United States until three years ago.
When inflation increases annually at 2 percent or so, who really cares about it? You can function well without thinking about the slowly eroding value of your money — although old-timers notice it because even at a 2 percent annual inflation rate, prices double every 36 years.
But now that we’ve been living with high inflation for a while, everyone is prone to money illusion, to one extent or another.
Consider that a March 2021 dollar is worth less than 85 cents today, according to the government’s Consumer Inflation Index calculator. When I keep that number in my head, the dollars in my bank account look especially unimpressive. (And I’ve been working full-time since the summer of 1977. The calculator says that every dollar I earned in my first job is worth only 19 cents in 2024 money. Yikes!)
Of course, everyone knows by now that the purchasing power of the dollar has dropped. When the price of products you see every day has gone up — a gallon of gasoline, a loaf of bread, a cup of coffee — you know prices have risen.
Even so, it’s easy to slip back into thinking a dollar is simply worth a dollar, and that it always has been.
Stocks and the Lottery
Certain aspects of inflation’s toll on the markets are extensively chronicled — yet, I think, the profound effects of inflation on stocks and bonds are still widely underestimated.
First, a few things about inflation’s costs are clear. Because the Federal Reserve has been fighting inflation, short-term rates are high. And several consecutive months of bad inflation readings have made it unlikely that the Fed will cut rates soon. In the bond market, which responds to the Fed’s signals and to traders’ judgments about inflation and economic growth, yields have surged. As a result of all this, a range of consumer credit rates steepened. These include mortgages, credit cards and personal loans.
In addition, the dawning realization this month that the Fed is in no rush to lower interest rates stalled the stock market.
I wrote about a less well-known aspect of inflation recently. The frequent exuberant references to new peaks in the S&P 500 during the recent bull rally didn’t take rising consumer prices into account. (They used what economists call nominal prices, not real ones.) On an inflation-adjusted basis, the stock market only in March approached a new peak for the first time in years. I relied on an analysis by Robert Shiller, a Yale economist, who has long used inflation-adjusted data to pierce the veil of money illusion. Because of setbacks in the past few weeks — high inflation and a faltering stock market — the market has fallen below peak levels in real terms.
Using nominal returns in an inflationary era can lead you to the erroneous conclusion that market is generating phenomenal returns.
Here’s another product of money illusion, one that state governments are exploiting relentlessly: lottery jackpots. As I wrote in March, a spate of recent huge jackpots have been artificially pumped up by questionable marketing practices, high interest rates and inflation.
When used by skilled marketers, money illusion can make unwary humans so excited that they will pour hard-earned money into chimeras, like lotteries and frothy stock markets.
Unhappy Workers
The old refrain, that the rent is too damn high, is resonating now. Steep housing costs are embedded in government indexes and account for a substantial part of recent official inflation increases.
Wages are another nagging problem. Numerous surveys show that many working people believe their wages haven’t kept up with the cost of living. Whether they actually have kept up is debatable. The official data on average wages is volatile and difficult to interpret.
Meticulous research by the economists David Autor, Annie McGraw and Arindrajit Dube shows that for lower-income people, real wages have risen, erasing nearly 40 percent of the longstanding wage gap between richer and poorer workers in the United States.
Even so, because inflation in essentials like food, housing and transportation stresses lower-income people more acutely than the rich, it’s not clear that those wage increases are well appreciated.
In fact, research by Stefanie Stantcheva, a scholar at Harvard and the Brookings Institution, building on earlier work by Professor Shiller, finds that it’s not.
People tend to blame the government for the pain of inflation, and to give themselves credit for raises they have received — even while feeling angry that those raises don’t seem to be keeping up with the cost of living.
That’s a core issue when inflation is high. “Money Illusion,” a classic 1997 paper by the economists Eldar Shafir and Peter Diamond and the psychologist Amos Tversky, found that in periods of high inflation, employers can get away with giving workers raises that amount to substantial wage cuts on an inflation-adjusted basis.
Say inflation is rising at a 4 percent annual rate, and you get a 2 percent raise. You’ve just received a real wage cut. If there’s no inflation, and your wage is cut by 1 percent, you’ve also gotten a wage cut — but you’ve lost less money than in the case of high inflation. What’s odd is that workers tend to view the bigger real wage cuts as fairer.
This makes sense, the authors say, when you factor in money illusion.
Where We Are Now
At the moment, consumer sentiment surveys are skewing lower than they have in periods that were similar in economic growth and employment. Neale Mahoney and Ryan Cummings, two economists at Stanford, think inflation, and lingering dissatisfaction with price levels, may well be the cause.
Looking back at past periods of high inflation, they have done some rough calculations that show that the negative effects of inflation on consumer sentiment erode 50 percent each year. In other words, they have a half life of about one year.
Professor Mahoney updated the research at my request. He found that in the three years through March, inflation rose 17.9 percent. According to his model — and, crucially, assuming the rate of inflation drops immediately to the Fed’s forecast of 2.5 percent annually — there would be an eight percentage point increase in consumer sentiment by November. There happens to be a national election then.
Mr. Mahoney and Mr. Cummings both served in the Biden administration. If they are right — and, if inflation really drops quickly and stays low — the improvement in the national mood could tilt the outcome of the election.
But inflation has defied economists’ prediction efforts over the past few years. I make no assumptions.
Certainly, I hope inflation will fall and it will be safe to live an ordinary life without thinking about money illusion. But it will take a long while for me to unsee the shrinking dollar.
