There are no shortcuts to affordability

As 2025 comes to a close, affordability is the lens through which all policymakers are being judged. That’s true for the Fed, too. After reducing its policy rate last week, Fed Chair Powell was asked how this step to support the labor market made sense, given that inflation was people’s number one concern. Powell’s reply:

So we hear loud and clear how people are experiencing really costs. It’s really high costs. And a lot of that is not the current rate of inflation. A lot of that is just embedded higher cost, due to higher inflation in 2022 and ‘23. So that’s what’s going on.

And so the best thing we can do is restore inflation to its 2 percent goal. And our policy is intended to do that. But also have a strong economy where real wages are going up and earning money. And they’re -- we’re going to need to have some years where real compensation is higher -- you know, it’s positive, significantly positive, so wages -- nominal wages are higher than inflation for people to start feeling good about affordability -- the affordability issue. And -- you know, so we’re working hard on that.

We want to -- we’re trying to keep inflation under control but also support the labor market and strong wages so that people are earning enough money and feeling economically healthy again.

Affordability is about more than prices; it’s about wages, too. The Fed’s rate cuts ensure the labor market doesn’t unravel and wage growth doesn’t collapse. Powell hit on another underappreciated aspect of affordability: the need for “some years” of real wage gains. It takes time to make up for past inflation, and to rebuild confidence in the staying power of the gains.

Americans remain downbeat about their finances.

Asking Americans about their finances has been a sobering exercise in recent years. The long-running Michigan Survey opens with the following question:

We are interested in how people are getting along financially these days. Would you say that you (and your family living there) are better off or worse off financially than you were a year ago?

It’s a straightforward question, but the answer can be as complex as people’s financial lives. It’s one of five questions in the Index of Consumer Sentiment. The picture is quite bleak now.

In the fourth quarter, only 21% of people (green line) said they were better off than a year ago. That’s only slightly above the series’ low in the Great Recession. Even more notable than the current low is the dramatic slide since the start of the pandemic. More than half of people at the end of 2019 said they were better off, close to the series high. It is hard to overstate how much of a shock the pandemic was. The decline in the better-off share occurred in a series of steps: during the first year of the pandemic in 2020, during 2022 when inflation surged, and since the middle of 2024. The decline stretches across multiple administrations and is ongoing.

Historically, recessions (gray areas) are times when the share of people who are better off drops sharply. There are good reasons for the Fed to take recession risks seriously. A recession might lower inflation, but it’s not the way to improve people’s finances.

Currently, 50% of people say they are worse off than a year ago (blue line). That nearly matches the recent peak at the end of 2022, and is rivaled only by the worst of the Great Recession. Even more disconcertingly, we have been stuck in a cycle of worsening finances. Since mid-2022, in each quarter at least 40% of people said they were worse off than the year before.

Finally, the share of people (29%) who say their finances are about the same as a year ago is near its pre-pandemic level (27%). Overall, the shift in how people view their finances over the past six years has been decidedly downbeat: fewer people are better off, more people are worse off.

It’s about income and prices.

The survey asks a follow-up question, “Why do you say so?” which confirms that for most families, income and prices drive their assessment of their finances.

The fall in the share of people saying they are better off financially is mirrored by a fall in the share citing higher income (green line) as the reason. Higher assets and lower debt are much less frequently mentioned, noting that one person can cite multiple reasons for their change in finances.

Similarly, the jump in the share saying they are worse off financially is mirrored by a jump in the share citing higher prices (gray line) as the reason. The percentage citing lower income as a reason for being worse off has risen recently, but it is still close to the historical average. Lower assets and higher debt are relatively small factors.

With income and prices both critical to family finances, it underscores why both sides of the Fed’s dual mandate are important. Policies that sharply lower inflation at the expense of income growth would not be an improvement. By the same token, high inflation can undermine the benefits of solid income growth.

It will take “some years.”

Income and prices being the primary reasons for judging family finances is not surprising, but it may seem surprising that people’s assessments remain so downbeat. Recall that the question asks about changes in finances over the past year. Year-over-year inflation peaked in 2022, and various measures of wages and income have been rising faster than inflation since 2023. Isn’t that an improvement? There are many possible explanations for the apparent excess pessimism. I have written about it previously, the pandemic, media coverage, etc. kyla scanlon, who coined the term vibecession, wrote a thoughtful piece on it recently.

One thing I keep coming back to is a woman I spoke with a few years ago who said that her family “may look better on paper,” but it “feels like that could easily slip away.” So, they do not feel financially better off. Given the abrupt changes in life with the pandemic and the turbulence of the last six years, that concern makes sense. Also, in the discussions of higher prices, it’s clear that people aren’t just comparing to last year. What would it take for people to feel better off? Some years of consistent improvement. That’s another way to frame the emphasis on the price level rather than the one-year change in prices. The Fed may let ‘bygones be bygones’ in their inflation-targeting approach to monetary policy, but that does not appear to be the case for families judging their finances.

The percentage of people who say they are better off financially in the past year closely tracks the change in real wages over the past five years (left chart). The one-year changes in real wages (right chart) are more volatile and cannot account for the trends in reports of people being better off. Despite the recent rebound in annual real wage growth, the increase over the past five years remains close to the lows after the Great Recession.

The five-year window illustrates how people may use longer time horizons to assess how well they are doing. The main point is that it takes time for people to shift their views. It’s useful to unpack the changes in real wages (blue) into their components: changes in nominal wages (purple) and prices (red). Real wages are up 3% over the five years through September (left chart), reflecting a 26% increase in nominal wages and a 23% increase in prices. The five-year increase in real wages has not improved much in recent years, even though the one-year price increase (right chart) is now much less than in 2022. Wage growth has also slowed. The real wage gains in the past two years have been solid, but the declines in 2021 and 2022 largely outweigh them.

The intuition that Powell laid out of “some years” of real compensation gains corresponds with people’s assessments of their finances. A similar exercise using median household income or weekly earnings, rather than hourly wages, also finds that five-year changes in economic conditions are better than one-year changes for understanding shifts in people’s views of their finances.

In closing.

There are no shortcuts to affordability.

We need years of income and wages rising faster than prices to undo the damage done during the pandemic. It’s more than restoring the ability to pay—the level of real compensation is already above pre-pandemic levels. It’s about improvements large enough to inspire confidence. It’s about consistency, too. The pandemic set off a series of shocks that destabilized people’s daily lives and the global economy. The challenge for policymakers now is to support stable, sustainable growth. No quick fixes or gimmicks. We need “some years” of good policy.