The amazing strength of the American economy, despite the recession, has economists scrambling for explanations. Consumer resilience is much cited. So is price cutting. Who can resist a bargain, even in hard times? Less noticed, but crucial, is the boost that came from a declining inflation rate.
Consumer spending, price cutting and lower inflation are interrelated, of course. But focusing on inflation produces a forecast of what might happen next to the economy that is different from the standard fare. Most forecasters are bullish: The recession, the 10th since World War II, is on its way out. Period. Focusing on inflation would also lead people to be bullish, but with less certainty.
First, the positives. Inflation as measured by the Consumer Price Index fell precipitously to an annual rate of 1.1 percent in January from 3.2 last June. Rarely has inflation fallen that much, so quickly. Wages went in the opposite direction. Despite the recession, companies kept giving raises. "There was still enough pressure in the system from the very low unemployment of the boom years to keep wages rising," said Jared Bernstein, a senior economist at the Economic Policy Institute.
The raises were smaller, but tens of millions who escaped layoff received them. And the rapidly falling inflation rate gave those modest raises an extra kick. "Real" wages -- actual purchasing power, or wages adjusted for inflation -- rose in the fourth quarter by a greater percentage than in any quarter since the boom years of the 1990s.
No wonder that consumer spending has been so much greater than anyone had expected. Bernstein estimates that real compensation was US$91 billion higher than it would have been if the inflation rate had not declined since June. That US$91 billion, fully spent, explains much of the economic growth that appeared so unexpectedly in the fourth quarter, after the economy contracted in the third quarter.
Business was also helped by lower inflation. Most of the decline came from the sharp drop in energy prices. Energy is a big cost of production, and this lower cost gave companies more leeway to keep down the prices they charge consumers. Given their druthers, corporate America would have preferred mildly rising inflation and rising prices, while holding down labor costs by foot-dragging on raises. But in a world that produces so much more than people are willing to buy -- even avid consumers -- price cutting became the only option. And lower production costs made that easier.
There were other contributions to the surprising economic strength. Tax rebates helped. Mortgage refinancing, made possible by falling interest rates, freed cash for family spending. Mild winter weather aided home construction. Rising labor productivity -- maintaining production levels with fewer paid hours of work -- lowered costs. Government spending rose, particularly for the military, adding unexpectedly to economic growth.