Inflation trends and impacts

Inflation has been a significant challenge for the economy over the past two years, with the headline consumer price index (CPI) reaching a record high of 9% in June 2022—the highest level since 1982.

Consumers have felt the pinch as prices surge across a broad spectrum of goods and services. Financial institutions’ margins are being squeezed, and policymakers are navigating a delicate balance to control inflation.

Initially, neither policymakers nor professional forecasters anticipated the rapid rise of inflation, which began in April 2021. At that time, the economy was grappling with a pandemic-induced recession, and the unemployment rate stood at 6.1%.

To support businesses and households affected by the pandemic, the federal government implemented expansionary fiscal policies. At the same time, the Federal Reserve employed its available tools to stimulate the economy and achieve maximum employment, one of its mandates alongside price stability.

Several factors contributed to the inflationary pressures. These include stronger and faster demand recovery, a shift in consumer demand from services to goods, supply chain disruptions, a tight labor market, and the war in Ukraine. A hindsight analysis of these factors explains the rise in prices.

A recent study by former Fed Chair Ben Bernanke and French economist Olivier Blanchard highlights the role of easy fiscal and monetary policies, the accumulation of excess savings during the pandemic, and the reopening of previously locked-down economies in driving strong demand for goods with limited supply. This primarily accounts for the high prices of commodities, including durable goods such as vehicles, energy, and food that were observed early on.

However, the effects of these price shocks have since diminished.

According to the analysis, inflation explained by the tight labor market conditions will persist unless there’s a better balance in labor demand and supply. This assessment aligns with Federal Reserve Chairman Jerome Powell’s remarks in his speech on inflation and the labor market at the Hutchins Center on Fiscal and Monetary Policy. 

“Core services other than housing may be the most important category for understanding the future evolution of core inflation,” he said in the November 2022 speech. “Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”

Recent labor market reports from the U.S. Bureau of Labor Statistics (BLS) indicate a slight easing of conditions. The number of job openings per unemployed person decreased from 2 to 1.6 in May. The June payroll employment report showed that the economy added 209,000 jobs with a downward revision of more than 100,000 jobs in the previous two months. This suggests a moderation in hiring demand.

Average hourly earnings also declined over a 12-month period from a peak of 6% in March 2022 to 4.4% in June. This indicates progress toward a balanced labor market that can prevent a wage-price spiral.

The headline CPI also decreased over the past 12 months to 3% in June 2023 mainly due to declines in prices for energy, food, and durable goods. However, core inflation, which excludes volatile energy and food prices, remained at 4.8% compared to a year ago. That’s well above the Fed’s target of 2%. 

In the most recent CPI report, housing prices, which account for 40% of the weight for core inflation, contributed to more than 70% of the monthly increase. Even so, the lagged nature of housing price indicators means they don’t accurately reflect current market conditions.

Other indicators that track current rent prices all suggest a decline in the CPI housing index in the coming months.

This progress in controlling inflation represents a significant achievement for the Federal Reserve, which must carefully walk a tightrope to bring inflation down without breaking the economy.

The Federal Open Market Committee acknowledged the lag between monetary policy and its effects on economic activity and inflation when it paused rate hikes in June. However, the summary of economic projections released at the time revealed that committee members’ median projections of the fed funds rate anticipate a 50 basis point increase from current levels by year-end.

Considering the encouraging labor market and inflation reports from June, the committee should reassess the need for further rate hikes in their upcoming meeting. 

NEXT: Consumers feel the pinch

Consumers feel the pinch

According to analysis from Moody’s Analytics in September 2022, the average American household needed to spend an additional $445 per month to buy the same goods and services compared to a year earlier. This represents approximately 8% of the median household income of $70,000 per year, resulting in a significant erosion of purchasing power by inflation.

The impact is even more pronounced for households below the median income level. These households allocate a large portion of their income to essential items such as food, energy, rent, health care, and child care.

When the prices of these necessities increase, it further strains the already fragile financial well-being of these individuals and families.

Consequently, individuals are tapping into their savings and relying more on credit cards to meet their basic needs. This partly explains the significant decrease in the personal savings rate, which has halved compared to pre-pandemic levels.

Moreover, total outstanding credit card loans, which declined during the pandemic as people used stimulus money to pay them down, are now on the rise.

Impact on credit unions

Inflation has mixed implications for credit unions, necessitating effective risk management practices to mitigate the negative effects.

High interest rates caused by inflation can increase the interest income credit unions earn on new loans and other interest-earning assets. Credit unions, driven by their mission to serve members, consistently offer more affordable interest rates on loans compared to for-profit financial institutions.

CUNA’s analysis of credit report data from Equifax reveals that credit unions raise rates on auto and mortgage loans at a slower pace and to a lesser extent after the Federal Reserve begins tightening monetary policy. This translates into substantial savings for members, particularly those with lower credit scores, over the life of the loan.

Consumers will find credit unions a better partner for their financial needs as they search for affordable rates in this high interest rate environment.

However, inflation can also prompt members to seek higher returns for their deposits to protect their savings. This increases the cost of funds, impacting credit unions’ lending capabilities. Additionally, inflation leads to higher expenses, such as employee wages and operating costs, thereby reducing net income.

Members who face challenges with the high cost of living may struggle to keep up with their loan payments. This reduces asset quality and interest income.

As a result, credit unions may need to increase loan loss provisions, which further erodes net earnings. Fortunately, recent data on credit union delinquency rates indicates that members are paying their loans on time relative to borrowers at other financial institutions.

Mortgage delinquency rates remain low, as many members secured affordable interest rates during the pandemic. Delinquency rates for auto loans and credit cards have gradually increased from their low levels during the pandemic. But they still remain below or close to pre-pandemic levels.

Rising interest rates also introduce risk to financial institutions, as their assets and liabilities don’t reprice equally. High levels of interest rate risk increase liquidity risk and reduce the value of fixed-income investment portfolios, leading to capital erosion. For this reason, NCUA identifies interest rate risk as a supervisory priority in 2023.

The failure of Silicon Valley, Signature, and First Republic banks was partly caused by interest rate risk, as they held a large share of long-term bonds in their investment portfolios, which declined in value. These institutions also held a large share of uninsured deposits that led to bank runs and their subsequent failure.

Credit unions, however, have lower exposure to the kind of risk that caused the failure of these banks. As of December 2022, the median credit union had only 5% of its assets in long-term debt securities, and 95% of deposits as percentage of assets were insured.

Focus on risk management

Inflation has presented significant challenges to the economy in recent years, affecting consumers and financial institutions alike. The Federal Reserve raised short-term interest rates by 500 basis points within 15 months to tame inflation. This introduces risk to financial institutions.

Effective risk management practices will be essential for credit unions to navigate these challenges successfully and continue serving their members in a changing economic landscape.

DAWIT KEBEDE is a senior economist at Credit Union National Association. Contact him at dkebede@cuna.coop.