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Yahoo U: When is an economy overheating?

Yahoo Finance’s Brian Cheung explains overheating in the economy in this week’s Yahoo U.

Video Transcript

AKIKO FUJITA: The core Personal Consumption Expenditure index, PCE, jumped 3.1% last month, renewing fears that the economy is overheating. But what does overheating actually mean? And how do you define that? Our very own Brian Cheung here with this week's lesson in Yahoo U. Brian.

BRIAN CHEUNG: Well, Akiko, class is in session. And you're right, everyone is talking about overheating. But before we get into that, we need to understand that economic expansions don't live forever. And in fact, Janet Yellen, the current treasury secretary, former Fed chair, once said that it's a myth that expansions die of old age, which implies that they were murdered.

So what are the main culprits in the death of an economic expansion? Well, let's take a look at who dunnit, our line up here, if you will, of your three culprits. So first, you might have a financial bubble that explodes, think of housing in 2008, or an external shock, something that has nothing to do with the economy itself, something outside, kind of like a global pandemic, which we learned the hard way. And then lastly, overheating, when an expansion slips into runaway prices, and this is the one that we're going to explore.

Now in an economic expansion, you generally expect to see these three things. So people are getting jobs because employers are hiring, so that means unemployment is going down. You also have economic growth, right. So in a measured real GDP, you'll see growth happening on a quarterly basis. And then it's also normal in an expansion to see some inflation, prices notching up a little bit.

But this last indicator is where most people start to worry about things catching on fire, about overheating. And the story usually goes a little something like this. So if the economy is healthy, people will be going out. They'll be buying things, shopping. And demand is high, so producers will start to raise prices.

And then the people working for those companies will say something like, well, hey, I want a raise if you're going to raise these prices. But these employees are consumers too. So if they have more money, they might go out and buy more stuff, and then all of a sudden you can see how the loop goes.

Now, if you're going to do a few of these loops, that's a good thing, right. People are consuming. People are making more money. But if you do 4, 5, 6, 10, 15 of these loops, all of a sudden you're at the store buying the same pair of pants for $50 that you bought for $40 last year, and you're wondering what the heck happened.

Now it's a bit oversimplified, but that so-called wage-price spiral happened in the 1970s, which contributed to that double-digit year-over-year inflation during that period of time. And Paul Volcker, who was the Fed chair at the time, pumped the brakes, drew back on the money supply, and that sent the economy into a recession, which wasn't pleasant, but it did have the effect of taming inflation. Again, this is personal consumption expenditures index that you're looking at, year-over-year change.

And right now we're trying to figure out if the COVID crisis is going to lead to the same. And the PCE print this morning, which is that not-- actually not reflected on this chart yet, clocked in at above 3%. That is the highest that we've seen in a while, which begs the question, are we about to enter that spiral? And it really depends.

So let's revisit this spiral, which can break in many places. So for example, input costs have, in many cases, become cheaper in the 2020s than they were in the 1970s because of globalization. So they may not be as sensitive to raising prices. There's a break in linkage there.

Then employers have also been dodging higher wages. You can get creative. You can offer other types of comp, one-time signing bonuses, benefits, free lunch, free iPhones I've seen in some cases. So that's going to be a break in that part of the cycle.

And then lastly, making higher wages doesn't necessarily mean you're going to spend more. If you put money into that bank and opt to save it instead, then you're not going to go out and buy stuff. So that could break the link right there. So it's not necessarily a done deal that will spiral out of control, but this is not to say that we're completely out of the woods yet either.

So you remember how I said that there were three culprits and we just talked about overheating? Well, imagine if all three of these culprits teamed up to make some sort of, like, legion of doom. Overheating can come alongside inflating asset bubbles, which may become more sensitive to a macro shock. So when we talk about overheating, it isn't exclusive to just inflation.

But of course, who's to say if we're facing that yet? And a common view among economists is that we don't have enough data yet to assess whether or not we're overheating, no matter what side of the debate that you're on. And the question is with inflationary pressures rising, which we've seen in these readings, is it temporary? Is it because of supply chain chokeups like we've seen in lumber, like we've seen in used cars?

Or is it because of a wage-price spiral that could be something more emblematic of a more serious secular trend? That indeed remains to be seen. And it depends on what your definition of overheating is. But hopefully that gives you a little bit of a primer on the general definition from an inflationary standpoint. And that wraps up this week's Yahoo U. Class is dismissed.

ZACK GUZMAN: Yeah. And Brian, everybody knows every good detective wears shades. I was waiting for the "Knives Out" accent, your Daniel Craig impression there. But when we talk about--

BRIAN CHEUNG: I was going for NCIS, you know?

ZACK GUZMAN: [LAUGHS] That also works. In the relationship between unemployment and inflation, and a lot of people will bring up the Phillips curve and talk about where the Fed's going to be since they got those two mandates, right, price stability and the job market, so when you look at that, I mean, where does it put the Fed, given the fact that they've been pretty clear they're fine running hotter than 2%, which we're already seeing in the data now?

BRIAN CHEUNG: And Zack, this is such an important question because of that wage-price spiral that I showed you. There was a school of thought within traditional economics and the Federal Reserve itself where there was an unemployment rate at which point so many people will be employed that that spiral could really get out of control, where there would be inflation. They called it a NAIRU, which is a kind of an estimate for what level the headline unemployment rate would be before you start to see inflationary pressures.

That was their guiding star on when to start raising or lowering rates. They were looking at where the economy was relative to that estimate. And what they found was that the recovery that we saw post-2008 got to an unemployment rate well below where they thought that level was without seeing any sort of inflationary pressures. I showed you that chart of PCE over the last few decades. You could see that we haven't really seen above 3% or 4% inflation in many decades.

So the dynamics have definitely changed. And to your point, that's a big reason why the school of thought is now we don't really know exactly how the Phillips curve, which is the interaction between unemployment and inflation, really works in 2021, that it may have been the case there was a more rigid dynamic between those two in the 1970s, but maybe not so much today, which presents a very interesting conundrum and economic question for scholars that are researching this type of thing.

AKIKO FUJITA: Brian Cheung, always coming through with the answers on Yahoo U. Thanks so much for that.