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Transcript

Hi, Paul Krugman here. Different city, different country, still not home. Unfortunately, couldn’t manage to do this one in a cafe, but we have been sitting in cafes a fair bit.

I just want to weigh in on a really kind of alarming report on consumer confidence that came out today. This is the long-running University of Michigan survey of consumer sentiment. It is kind of time hallowed. I don’t know that it’s necessarily the gold standard — there are other surveys — but this is the one that people really do focus on most.

The numbers are terrible, people. We’re hitting a record low on consumer sentiment which fits in with the general picture. We know that people are very upset about prices; they’re very upset about economic management; they just don’t feel that there’s anyone making any sense who’s in charge of things; which is all true.

I mean we can argue that objectively things are not as bad as all that. We have consumer sentiment that’s worse than at the depths of the financial crisis. We have consumer sentiment that is worse than during the stagflation circa 1980. And it’s hard to say that that’s really justified. But OK, the customer is always right. If people are feeling this down then we need to take that seriously.

But that is actually not the big issue. The really big issue is inflation expectations.

Now why do we focus on that? Inflation for a short period of time is not good but it’s tolerable. If we have a year of elevated inflation — even if you do something stupid, if you impose tariffs and raise consumer prices, or you start a war and mishandle it and you drive up oil prices that is not good. But it only turns into a really, really serious problem if it gets “entrenched” in the economy.

That is usually the term that people at the Federal Reserve use. And what they mean is this. If you think about how wages and prices are set, think about the process of inflation. Not all prices are set at the same time. There’s a kind of a leapfrogging in which each individual company, each individual employer is setting prices based both on inflation in the past and on inflation that they expect in the future. They’re looking over their shoulders at what they think competitors are going to be charging. They’re looking over their shoulders at what they think is going to happen to their costs.

And they need to do that because for many prices, it’s impractical and costly and disruptive to change them too frequently. So you set prices for a year in advance, something like that. You set prices for a while, which means that a lot of what’s happening to prices now is determined by what people think is going to be happening to prices in the future.

We don’t have great measures of what’s in the minds of people who are setting prices, but we have pretty good, or at least consistent over time, measures of what consumers expect. And, you know, we’re all living in the same society. So that’s telling you something about where we are in terms of expected inflation.

If you have a spike in inflation, if inflation comes and goes, but it doesn’t get built into expectations of higher inflation for a long time, then okay, you ride through it. Maybe people vote the bums out, but you ride through it.

If it gets built into expectations, then it’s a much a much more difficult situation. Then you have to somehow wring those expectations of high inflation out of the economy because if you don’t, inflation will just feed on itself. Prices will rise because everybody expects prices to rise and those expectations will be confirmed and it just goes on.

So if you want to return to an acceptably low rate of inflation and if people are expecting a high rate of inflation, then while there may be other ways, normally what we do is we put the economy through a wringer. which is what happened at the beginning of the 1980s.

After the inflation of the 1970s, inflation was eventually brought under control, but that would happen through years of extremely high punishing unemployment. Some people looking at inflation four years ago, looking at the inflation of 2021-2022 predicted that we’d have to do the same thing, that having seen a burst of inflation after decades of low inflation, that we were going to have to go through something like the end of the 70s stagflation, that we’d have to go through a severe recession with high unemployment for years to get inflation back down.

Something I called right — we all get things wrong, but something I called right — was that I said no, that that’s not going to happen, that it’s a false analogy. And the reason I said it was a false analogy was because medium-term expected inflation had not gone up very much.

Now, we go for medium term because we know that for short-term inflation, well, people’s expectations about that bounce around a lot, often driven by fluctuations in gasoline prices. But medium-term expectations are normally more stable, so if they rise that’s an indicator that you are starting to get entrenched inflation and things will be really bad.

In 2022 — sorry, let’s go back to 1980 — medium-term inflation expectations as measured by the Michigan survey were about nine percent — expected inflation over the next five to ten years was 9%. That was really bad. That said that people had basically internalized the inflation of the 70s and expected it to continue indefinitely.

This meant that actually getting inflation back down to tolerable levels was very costly and very painful.

In 2022, well, expected inflation over the next five years had crept up by a fraction of a percentage point, but it was still quite low. People were not at all building in anything like the expected inflation that prevailed before the great painful disinflation of the 1980s.

And so I was quite confident that the dire predictions about what it would take to bring that inflation back down were wrong.

Well, guess what? Especially in the last two months, expected inflation over the next five years has gone up a lot. It’s 3.9 percent in the latest Michigan release. That is, it’s not 1980 but it’s really bad. It’s the worst we’ve seen on that number since the early 1980s. It is saying that the person on the street is starting to believe after the tariff shock and now the Iran shock that we’re in a higher inflation environment. And we have to suspect that people making decisions about prices are thinking the same way.

They’re going to start building those expectations into pricing. So we’re starting to get the thing that everyone in the economics biz fears, which is entrenched inflation.

And if that’s happening, then the costs of the policy failures, the policy foolishness of the past year and a half are going to be a lot bigger than anyone is now reckoning. This is going to be an extremely painful situation that we have.

It looks, at least according to these preliminary indications, as if Donald Trump has managed to create the kind of environment that we had at the end of the 1970s stagflation, which means that this is going to be really, really ugly and that we are going to be paying the price for these misadventures for years to come.

Happy thought. Have a nice day.

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