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Inflation and Making Ends Meet: Increasing Real Household Incomes
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Inflation and Making Ends Meet: Increasing Real Household Incomes

A temporary bump in inflation limited to a few items obscures the fact that policies such as the Bipartisan Infrastructure Framework (BIF) and the $3.5 trillion budget resolution would boost incomes for Americans.

The U.S. Capitol Building is seen as the sun sets and a heavy thunderstorm forms over Washington, D.C., on July 26, 2021. (Getty/Samuel Corum)
The U.S. Capitol Building is seen as the sun sets and a heavy thunderstorm forms over Washington, D.C., on July 26, 2021. (Getty/Samuel Corum)

Inflation—changes in prices—has repeatedly made headlines in recent months. But several key points are important to keep in mind in this situation. First, inflation has only a limited and temporary effect on people’s wallets. Price spikes are temporary and isolated in a few key areas such as vacation rentals, airline tickets and used cars. Prices for more important items such as health care have been flat or declining.

Second, income growth has offset much of the bump in prices. Wages have grown, especially for low-wage workers. Congress also passed President Joe Biden’s American Rescue Plan in March, which provided extra financial help to low-income and middle-income Americans with relief checks; expanded and prepaid child tax credits; and expanded unemployment insurance benefits.

Finally, Congress’ work is not done yet. The Bipartisan Infrastructure Framework (BIF) and the $3.5 trillion budget resolution that would enact many of President Biden’s key proposals would make key investments in a strong and equitable economic recovery. These measures would boost employment and wages while also keeping future inflation threats in check due to faster productivity growth resulting from necessary investments.

The current discussion over inflation often ignores that much of what is happening with prices does not actually affect people as much as is commonly asserted. All evidence suggests that current price increases are temporary and are driven by a few isolated goods and services, such as used cars and airplane tickets, that play a disproportionate role in influencing overall price jumps. Moreover, consumers can and do avoid many of the costlier items and substitute them with less expensive alternatives. Those substitutions—which reduce the effect of price increases in people’s experienced inflation—are not fully reflected in the reported inflation measures.

Wages, especially for lower-wage workers, have risen substantially in recent months, while the government has provided extended unemployment benefits and relief checks. These boosts to people’s incomes have provided some insulation against higher prices to those who may be economically most vulnerable. The key lesson then is not to stall the economic recovery but instead to further shore up wages and incomes for low-income and middle-income families. The bottom line? Inflation matters a lot less for most Americans than some of the breathless reporting over the past few months suggests.

What really matters is the combination of income and expenses to ensure that people can make ends meet. Current policies, such as President Biden’s American Rescue Plan, as well as several of his executive orders (for instance, a requirement that all federal contractors will need to pay a minimum wage of at least $15 per hour) are important first steps to boosting incomes of hard-working Americans. But, families need more, especially since legislative efforts will expire and executive actions only impact some subset of workers.

Congress and the administration are currently considering the BIF and additional investments in transportation and other physical infrastructure under a $3.5 trillion budget resolution proposal.

If adopted, these measures will produce sustained improvements in inflation-adjusted incomes for families at all income levels. Low- and middle-income Americans would especially see meaningful gains from faster employment and wage growth. Moreover, these investments would not trigger inflation. On the contrary, these investments could reduce future inflationary pressure as they lay the foundation for faster productivity growth over the coming years and decades. Faster productivity growth means that workers and companies will be able to produce more and higher quality goods and services with the same amount of resources. Making better use of limited resources—the definition of efficiency or productivity growth—means that companies do not need to raise prices as much to cover their costs. Inflation continues to stay in check even as economic growth accelerates.

Three considerations are key to understanding inflation in the current environment. The data summarized in this piece show that current price bumps are temporary and will gradually dissipated. Moreover, a few isolated price jumps for airline fares, vacation rentals, and used cars play an outsize role in driving overall inflation higher. Policy measures already put in place and proposed by the Biden administration will both buffer households’ finances against higher prices and help lower prices for items such as prescription drugs. Fears of accelerated, broad inflation are overstated.

Inflation is likely temporary driven by pent up demand and supply bottlenecks

The monthly headline numbers report the changes in consumer prices overall—based on consumer price index for urban consumers (CPI-U)—and for individual groups of goods and services such as gasoline and medical services. Consumer prices were 5.3 percent higher in June 2021 than in June 2020 and core consumer price inflation—price changes that exclude often volatile food and energy price swings—rose by 4.5 percent over the past twelve months through June 2021.

It is important—especially in the current tumultuous time—to understand what the CPI-U measures and also what it does not measure. It is meant to capture how inflation affects people’s day-to-day lives, which is a combination of both higher prices and changes in households’ behavior as they often avoid buying more expensive products. The Bureau of Labor Statistics (BLS) takes consumption data for the average household at a given point in time from the most recent household spending data. This basket of goods and services that the average household consumes is assumed to stay fixed for a few years. Each good or service that households buy receives a relative weight based on this spending data. More important items, such as owner-occupied housing receive a greater weight in calculating inflation than less important items, such as breakfast cereal. The BLS then looks at how the prices of all goods and services a household buys change from month to month. It then creates a weighted average of those prices based on the respective importance of each item—its weight—in the consumption spending data. This weighted average is used to arrive at one measure of inflation.

Three issues arise from calculating inflation this way. First, the BLS reports price changes from month to month as well as price changes over the course of the past 12 months. During the pandemic—which has lasted more than twelve months—the data shine a spotlight on rather volatile up and down movements. It is important to take a somewhat longer picture to put these movements in context. Some current price increases, for instance, are just corrections of sharp price drops at the start of the pandemic. This includes transportation related items (including gasoline, car prices, and car insurance), for example. Second, sharp price jumps for a few goods and services can have a relatively large effect on the overall inflation measure. This happens when prices for most goods or services show little movement, while others—such as those for airline tickets and used cars—jump a lot. Yet, what truly matters to everyday people is fact that prices for the vast majority of items that they need and regularly buy go up—not whether a few items see outsize increases. Third, the CPI-U does not fully reflect behavioral changes. The inflation that people experience is not just a result of higher prices but also of people’s reaction to this sticker shock. People may, for example, decide to drive to their destination rather than take a plane if tickets are too high. This kind of substitution effect happens with some regularity, but it is not fully reflected in the data.

A more detailed look at inflation data based on price data from the BLS suggests that the price increases are likely temporary. It is true that the overall price increase was the largest since July 2008. But that also means that a little over a decade ago the United States also experienced sharply higher prices and that past inflation spike subsided very quickly as did similar price increases since the 1980s.

Moreover, the fact that the pandemic has lasted more than a year and wrought a lot of economic uncertainty makes it difficult to interpret recent price changes as a change in trend inflation. Year-over-year changes typically reduce the influence of short-term fluctuations, but that is not the case when the past 12 months have been characterized by historically unprecedented economic turmoil. Put differently, longer-term time trends that compare the current situation to prices before the pandemic provide a more useful context. Consider, for example, what has happened with gasoline prices, which have been especially volatile. Calculations based on data from the BLS show that during the first three months of the pandemic, between January and May 2020, gasoline prices dropped precipitously. As a result, gas prices were 33.8 percent lower than they were in May 2020 than in May 2019, as calculations based on the same data show. More recently, gas prices have jumped in 2021 and were 45.1 percent higher in June 2021 than in June 2020. Because of this up and down movement, gas prices were only 6.5 percent higher in June 2021. To put this in perspective, calculations based on the same price data from the BLS show that gasoline price increases of this magnitude over a period of 17 months have occurred 270 times from 1967—when the BLS started to collect prices for gasoline—to 2019, before the pandemic started. Most recently this happened in 2018, 2011, and 2007. The current spike in gasoline prices is in large part a recovery from very low prices at the start of the pandemic and might be blunted by increased oil production. It is also overshadowed by seasonal gasoline price increases at the start of the summer holiday season that typically dissipate later in the year, as calculations on additional data from the Energy Information Administration (EIA) show. (see Figure 1)

Two temporary factors play a substantial role in determining prices right now. One factor is a resurgence in demand for goods and services that people could not or did not need to buy during the pandemic. The other factor are lingering supply chain bottlenecks that are often related to the global pandemic, as production for raw materials and intermediate products was also affected. Lumber prices, semiconductors, and petroleum, for example, have all sharply grown amid global supply obstacles.

Both of these factors should play a diminishing role in the future. People will eventually have caught up on their spending; decide to postpone purchases of some expensive items; and substitute less expensive items for more expensive ones in other instances. This may decrease the current high demand on items such as used cars and home furnishings. In addition, over the coming months, the restoration of supply chains and a return to more regular economic activity should increase the supply of goods and services that are currently scarce. This should also further decrease price pressures in areas such as travel, gasoline, and used cars, where they have been especially pronounced.

Prices spikes for a few items has taken on an outsize importance

The data further indicate that current inflation spikes are isolated in a few areas that now play an outsize role in driving the overall price increases. For example, core inflation as compared to overall inflation captures close to 80 percent of the inflation that the average American household experiences in a given month. It reflects price changes of 55 detailed spending categories, including furniture, medical services, prescription drugs, clothing, rent, and owner-occupied housing. Only 24 of these categories have seen a price increase of more than 3 percent, while prices in eight categories actually fell. The remaining 23 categories had inflation of less than 3 percent over the course of the past year. Put differently, most spending categories saw no or modest inflation even during the tumultuous period of the pandemic.

Most of the large increase in core inflation came in goods and services that play a relatively modest role for consumer spending. For instance, our calculations based on BLS data show a sharp increase in used car prices contributed 41.9 percent to the rise of core inflation in June. Price increases for hotels and motels added another 8.2 percent and airline fares added yet another 2.4 percent of the total jump in core inflation during the past 12 months. These three items account for less than one-fourth—23.4 percent to be exact—of total core consumer spending items but amounted to 52.5 percent of the core price increase in June 2021. Put differently, for most of their spending, consumers experienced much less and possibly no inflation.

This is further underscored by price data for key items that many households cannot easily do without. For example, health care services, prescription drugs, rent, owner-occupied housing, furniture, and clothing amounted to 57.3 percent of core consumer spending items in May 2021 but contributed only 13.4 percent to the core price bump in June 2021. Yet, these items—such as health care and housing—are also items that households cannot easily go without, delay, or substitute. The fact that prices have risen only modestly or not at all in these categories means there is less pressure on average Americans’ wallets.

In comparison, households often offset their spending on relatively more expensive items if they can. Many consumers will avoid buying more expensive items, reducing their overall importance in the typical household’s spending. They will also postpone purchases—attempting to avoid prices that are temporarily high—or they will switch from goods and services that they find too expensive to less expensive substitute. Calculations based on data from the BLS show that adjusting for these behavioral changes generates an overall year-over-year inflation measure that is 0.3 percentage points lower than the CPI-U.

Many consumers likely adapted their spending in recent months, especially with respect to leisure activities and possibly with respect to used cars. For instance, a consumer looking to buy a five-year-old used car may decide that a seven-year-old used car will suffice. From June 2020 to June 2021, the commonly used CPI-U for private transportation—which includes new cars, used cars, as well as airline travel—was higher than the measure that accounts for behavioral changes. Specifically, this column calculates the average of the year-over-year change in the CPI-U and the price measure that accounts for behavioral changes, known as the chained CPI-U. This column then averages across all 12-month periods that ended in a month from June 2020 to June 2021 to eliminate seasonal fluctuations. This average was 0.7 percentage points higher for the CPI-U than for the chained CPI-U. People are substituting less costly items for more costly ones in this recovery and, as a result, the inflation they experience is lower than the headline numbers suggest.

More investments in the economy will boost incomes and reduce future inflationary pressures

Ultimately, income gains matter a lot more to people’s lives than temporary, isolated price spikes. A key indicator of people’s overall welfare is the combination of income and expenses. Sustained improvements in inflation-adjusted incomes should be a key goal for policymakers.

In this regard, the trends seen in the last few decades have been discouraging. From 1979 to 2018, real, inflation-adjusted pay for American workers has grown by less than 0.6 percent. From 2000 to 2019, hourly wages for the bottom 10 percent of wage earners have risen by 0.5 percent each year. For the median (50th percentile), growth in hourly wage has been only 0.4 percent. In comparison, those wage earners in the top 10 percent of the wage distribution have seen annual wage growth of 1 percent. Working class and middle-income wage earners need to see much faster wage gains in line with overall productivity growth.

Because wage growth has been slow for many American workers, high costs for necessary items—such as health care, childcare, housing and education—are often out of reach. Families are often financially strapped, caught between stagnant incomes and high and frequently rising costs. They cannot put enough money away for emergencies, such as layoffs and chronic health issues. The pandemic made evident on a mass scale what had been true for many years: Many families are financially fragile and do not have the means to face a relatively small financial emergency. Boosting wages and, thus, incomes for American families is key to improving financial security.

A main policy goal should be to increase incomes—both in the short run and in the long run—while helping to boost productivity growth.

The American Rescue Plan was a good start in boosting people’s incomes

The American Rescue Plan signed into law in March of this year gave robust support for the economy, providing health infrastructures to combat the pandemic and offering quick relief to the tens of millions of Americans suffering from hunger, poverty, eviction, foreclosure, and a lack of health care. It also substantially contributed to faster economic growth in 2021 and the acceleration in employment and wages, especially in some low-wage industries such as restaurants.

The federal government also provided money for states to expand unemployment insurance benefits to those looking for a job, relief checks to low-income and middle-income families to deal with the ongoing fallout from the pandemic and extra tax benefits to parents. These progressive boosts to people’s incomes provide a widely shared, albeit temporary financial security blanket amid still widespread unemployment and isolated price increases. The policy challenge now is to extend those income gains by strengthening employment and wage gains for years to come.

Congress should pass additional measures to expand income growth and accelerate productivity growth

Additional policy steps should focus on strengthening and extending the current economic recovery. Millions of people are still looking for a job and cannot find one. Policy also needs to support wage increases for low-income and middle-income earners.

Congress and the administration should invest in U.S. competitiveness to bolster productivity growth that will both support higher wages and ensure even fewer longer-term inflationary pressures.

Current discussions by Congress and the administration are centering around the BIF and additional investments in transportation and other physical infrastructure under Congress’ $3.5 trillion budget resolution, that would enact many of President Biden’s key proposals. A recent analysis shows that, if enacted, these measures would have a salutary effect on incomes, especially for lower- and middle-income Americans. The benefits to American families would include restoring the labor market to full employment and faster wage growth. All this would happen while also expanding productive capacity so that the economy does not overheat. Passing the currently proposed measures—the BIF and the $3.5 trillion budget resolution—would further allay fears of increased inflation. The macroeconomic analysis of the effect of these measures on the economy over time takes into account the “high multiplier” of infrastructure spending on growth. The results of these computations also highlight the positive effect of making health care more affordable, expanding the Earned Income Tax Credit, and paid family and medical leave. These policies, among other benefits, have strong employment effects, encouraging paid work and increasing labor force participation. They also make people more productive, since people have to worry less about their health and the well-being of their families. Other investments—such as universal Pre-K and boosting community colleges—are likely to also enhance long-term productivity. Enhancements to long-term productivity will support higher pay increases in the future. Additionally, the administration’s explicit focus on increasing wages—especially at the bottom of the pay scale—and on enhancing labor power, if successful, are likely to increase the share of productivity that actually translates into wages received by workers.

Historically, real wages at the bottom of the pay scale have tended to improve only when the economy is close to full employment. Policymakers have the opportunity now to enact legislation that would seriously reduce the chance of those hardest hit by the pandemic being left behind for years to come.

Conclusion

The overall inflation numbers paint a woefully inadequate picture of the effect of inflation on people’s lives. For most families, inflation is likely a much smaller worry than finding a job with good wages and decent benefits in a healthy environment. Current policies that Congress and the administration are discussing centered around the BIF and a $3.5 trillion budget resolution—which would enact many of President Biden’s key proposals—can have a sustained positive effect in boosting real incomes by Americans, especially low and middle-income earners. Our analysis suggests that Congress and the administration should enact these two measures, as they are likely to expand household incomes, enhance productivity, and economic growth without contributing to inflationary pressures.

Andres Vinelli is the vice president for Economic Policy at the Center for American Progress. Christian E. Weller is a senior fellow at the Center and a professor of public policy in the McCormack Graduate School of Policy and Global Studies at the University of Massachusetts Boston.

The positions of American Progress, and our policy experts, are independent, and the findings and conclusions presented are those of American Progress alone. A full list of supporters is available here. American Progress would like to acknowledge the many generous supporters who make our work possible.

Authors

Andres Vinelli

Vice President, Economic Policy

Christian E. Weller

Senior Fellow

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