This Week in Summary 12/2/2022

Dec 1, 2022 | Bubble Monitor, No Bull Economics

Bubble Monitor Chart
Bubble Monitor Chart

Summary & Analysis of Powell’s 11/30/22 Speech on Inflation & the Labor Market

Powell’s recent speech spoke of a moderation in rate hikes which was very well received by the market (as evidenced by our Bubble Monitor dashboard). While he acknowledged that there are some nascent signs of inflation moderation, a sustained downward trend is required for these indices to have credibility. Powell points to a labor shortage as the main culprit for inflation while rightly acknowledging that the Fed has no tools to increase the labor supply. Instead, his plan is to pressure demand lower via higher interest rates until it reaches parity with a depressed level of supply (to bring prices down). While the Fed is moving in the right direction, we believe it is high time for our economic leaders to acknowledge that: (1) a policy to curb inflation by driving job losses is actually very hurtful; (2) a policy to prevent inflation by curbing excessive money creation (i.e. $6 trillion in covid stimulus printed out of thin air) is far preferable; and (3) pro-business government policies provide the best bet that the private markets can find pricing equilibrium all on their own. Please read a concise nobull summary of this speech below.          

The report must begin by acknowledging the reality that inflation remains far too high. My colleagues and I are acutely aware that high inflation is imposing significant hardship, straining budgets, and shrinking what paychecks will buy. This is especially painful for those least able to meet the higher costs of essentials like food, housing, and transportation.

We currently estimate that 12-month personal consumption expenditures (PCE) inflation through October ran at 6%. While October inflation data (5%) received so far showed a welcome surprise to the downside, these are a single month’s data, following upside surprise revisions over the previous 2 months. It will take substantially more evidence to give comfort that inflation is declining.

While the inflation forecasts of private-sector forecasters and FOMC participants broadly show a significant decline over the next year, previous forecasts have been predicting just such a decline for 1+ year, while inflation has moved stubbornly sideways.

We need to raise interest rates to a level that is sufficiently restrictive to return inflation to 2%. There is considerable uncertainty about what rate will be sufficient, although there is no doubt that we have made substantial progress, raising our target range for the federal funds rate by 3.75% since March. It seems to me likely that the ultimate level of rates will need to be somewhat higher.

Slowing demand growth should allow supply to catch up with demand and restore the balance that will yield stable prices over time. Restoring that balance is likely to require a sustained period of below-trend growth.

There are 3 components of core PCE inflation, core goods, housing services, and core services less housing (the largest component).

PCE Inflation Graph
PCE Inflation Graph

Early in the pandemic, goods prices began rising rapidly, as abnormally strong demand was met by pandemic-hampered supply. Reports from businesses and many indicators suggest that supply chain issues are now easing. Both fuel and nonfuel import prices have fallen in recent months, and indicators of prices paid by manufacturers have moved down. While 12-month core goods inflation remains elevated at 4.6%, it has fallen nearly -3% from earlier in the year.

Housing services inflation now stands at +7.1% over the past 12 months. Housing inflation tends to lag other prices because of the slow rate at which the stock of rental leases turns over. Measures of 12-month inflation in new leases rose to nearly 20% during the pandemic but have been falling sharply since about midyear.

Market Rents and PCE Housing Services Inflation Graph
Market Rents and PCE Housing Services Inflation Graph

The core services other than housing spending category (covering a wide range of services from health care & education to haircuts and hospitality) are the largest of the 3 categories, constituting 50%+ of the core PCE index. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.

In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2% inflation over time. A significant and persistent labor supply shortfall opened up during the pandemic (a 3.5MM employee shortfall reflecting a decline in the labor participation rate) and it appears unlikely that these excess retirements will unwind. The labor shortage also reflects slower growth in the working-age population with a plunge in net immigration and a surge in deaths accounting for about 1.5MM missing workers. While job openings have fallen by about 1.5 million this year, they still exceed available workers by 4MM. Policies to support labor supply are not the domain of the Fed. Our tools work principally on demand.

Jobs-worker Gap Graph
Jobs-worker Gap Graph

In conclusion, as the full effects of the Fed’s rapid tightening so far are yet to be felt, it makes sense to moderate the pace of rate increases starting in December. However, it is likely that restoring price stability will require holding policy at a restrictive level for some time.

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