Introducing

Joseph G. Carson

Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein.   Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees.   He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.

Publications by Joseph G. Carson

• USA| Nov 13 2024

  The Viability of the New Administration's Fiscal Policy Will Be Determined by the Bond Market

  The new administration intends to pursue an unconventional fiscal strategy. A key aspect of the strategy involves reducing or abolishing non-defense government agencies in order to create fiscal space to make the current tax law permanent, lower taxes even more, and generate extra revenue through an extensive and significant tariff program.

  The success of the fiscal policy of the new administration will depend on the reaction of the bond market, which has historically influenced policy changes. Three decades ago, Bill Clinton pledged a stimulus package if he won the election, but upon taking office, he had to shift towards a "financial market strategy" instead. Stimulus spending was abandoned in favor of a deficit reduction plan to prevent long-term interest rates from increasing. Given the imbalance in the federal budget is much larger today, it is crucial for policy decisions to take into account the bond market's reaction, raising the question whether policymakers will heed the advice as they did in 1993.

  The odds are in favor of the opposite happening, as the new administration is not inclined to give in to the pressures of the bond market. If bond yields jump sharply, the administration might urge the Fed to intervene, potentially worsening the situation.

  The Federal Budget

  In the fiscal year 2024, total federal spending reached $6.75 trillion, resulting in a budget deficit of $1.83 trillion. Currently, defense budget and social programs are deemed off-limits, as are interest payments. This shifts the attention towards cutting expenses in non-defense discretionary spending.

  During the fiscal year 2024, non-defense discretionary spending amounted to approximately $950 billion. Although non-defense spending had stayed stable in nominal values between 2010 and 2019, it surged in 2020 as a result of economic recovery initiatives through additional legislation. Nevertheless, there is a pattern of downward trend in non-defense expenditure even prior to the upcoming Congressional term, with forecasts indicating a decline to 2.5% of GDP over the next ten years as per the Congressional Budget Office. The smallest proportion of such outlays in the past five decades was 3.1%.

  Although additional spending cuts may still occur, the meager budget share allocated to these programs indicates that the extent of budget savings is significantly smaller than advertised. Below are some more reasons why significantly cutting non-defense discretionary spending will pose political challenges.

  With a budget of $238 billion, the Department of Education provides support to almost 100,000 public schools through its programs.

  With a budget of $106 billion, the Department of Commerce supports research and development in emerging technologies such as artificial intelligence.

  With a budget of $460 billion, the Department of Agriculture funds many projects in rural communities, including housing, community facilities, and utilities.

  With a budget of $275 billion, the Department of Transportation makes billions of dollars in grants to improve and upgrade all types transportation systems.

  Non-defense federal spending plays a critical role in the economy by offering assistance to businesses of different scales and types, along with state and local governments and individuals. This does not imply approval of the Federal budget or its spending preferences, but rather recognizing essential elements concerning federal spending and its economic influence.

  Furthermore, handling the distributional effects of significantly reducing non=-defense spending will pose significant controversy and implementation challenges. For example, states in the northeast pay more in federal taxes than they receive in federal spending, while various states in the south, as well as a few in the mid-west and southwest, receive more assistance than they contribute in taxes. This raises the question of whether politicians from states receiving the most aid will support legislation that significantly reduces the assistance provided to their constituents. Every state listed that gets more in federal assistance than they pay in taxes voted for the new administration.

  Extending the 2017 tax cuts adds another layer of complexity to the new administrations fiscal plan. The Congressional Budget Office projects that prolonging these tax cuts could result in a $4.6 trillion increase in the deficit over the next ten years. To counterbalance this, Congress would need to enact spending cuts averaging more than $450 billion a year, affecting almost half of non-defense spending. Moreover, there are discussions about proposing further reductions in federal taxes.

  Implementing a comprehensive and substantial tariff program could lead to increased revenue. However, the effectiveness of this strategy is uncertain, as it relies on the assumption that foreign trade partners will not retaliate. Additionally, foreign entities play a crucial role in aiding the US in meeting its federal borrowing needs, hence implementing a tariff strategy is like informing your creditor that you intend to cease transactions with them but expect them not to demand repayment of your loans.

  The tariff plan could potentially create complications for both the economy and the bond market. Significant risks include the possibility of higher consumer inflation, which may raise the expenses of social programs (such as inflation indexation) and widen the budget deficit. Additionally, it could lead to higher interest rates, affecting policy rates accordingly.

  The new administration has expressed interest in influencing the Federal Reserve's interest rate decisions and has even proposed replacing the Fed Chair before his term expires in 2026. Unlike other government agencies that report directly to the President, the Federal Reserve is an independent agency accountable to Congress. Altering the Fed's independence would require legislative action, potentially causing disruption in the financial markets. The odds of changing the status of the Fed is minimal, but that does not mean the new administration will not publicly expressing its views, which pose challenges for the Fed and confusion (volatility) in the financial markets.

  The new administration faces a specific challenge when it comes to dealing with the bond market, particularly due to the fact that it is commencing with an excessively large budget deficit that is forecasted to grow over the next decade. The sheer size of the bond market renders it impervious to being swayed solely through rhetoric or public persuasion. Irrespective of the new administration's declarations or viewpoints, the bond market will express its position on fiscal policy. Three decades ago, the Clinton administration changed direction when the bond market rejected a stimulative fiscal plan. If the new administration's fiscal strategy indicates larger budget deficits and increased inflation, the bond market's rejection will be more significant than that of 1993.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Sep 19 2024

  What Constitutes Tight Financial Conditions? Using Interest Rates Alone Is No Longer Relevant

  The Fed raised official rates by 500 basis points from 2022 to 2023, the most significant increase over forty years, and there was no recession. The Treasury yield curve inverted for almost two years, and there was no recession. Is it time to rethink what constitutes tight financial conditions? Merely measuring financial conditions based on interest rate levels is insufficient nowadays when monetary and fiscal policies add trillions to the economy via asset purchases and budget deficits.

  The traditional perspective on stringent financial conditions involves official rates higher than reported inflation, an economy expanding below its capacity, an unemployment rate significantly exceeding estimated full employment, and stagnant real and financial asset values, with the possibility of notable declines in either or both.

  Yet today's economic and financial picture is the exact opposite—the economy is growing above trend, the unemployment rate is close to the full employment mark, and asset prices are at record levels.

  Given these economic and financial outcomes, it becomes clear that a reassessment of our monetary and fiscal policies is necessary to better understand and explain tight financial conditions. This could explain why the current economic and financial situation differs significantly from past years.

  Firstly, it's crucial to note that the Federal Reserve's balance sheet remains substantial, at close to $7 trillion. This is approximately $4 trillion higher than its level four years ago. While the Fed's balance sheet is no longer expanding and is gradually shrinking, its impact on financial markets should not be underestimated. The additional $4 trillion of Fed security holdings equates to $4 trillion of liquidity for private investors seeking other investment opportunities.

  Second, the US budget deficit is running at about $1.9 trillion. Not every dollar of government spending shows up in GDP, but what does not goes into the hands of people and businesses, and their spending does show up. Also, when the government runs a deficit, it means that people and businesses are not being taxed to an equal amount for the level of government spending. So, the bottom line is that budget deficits enable people's and businesses' cash flow to be higher than otherwise would be the case.

  The Fed's balance sheet and the Federal government deficit together amount to over 30% of nominal GDP, which is enormous. The only times it was larger were during the pandemic years.

  Using interest rate levels as the traditional method to gauge tight financial conditions is no longer relevant. The current unprecedented stimulus from monetary policy, achieved through asset purchases, and from fiscal policy, due to a relatively large budget deficit, makes it difficult to determine what defines tight financial conditions. It is challenging to ascertain if financial conditions are tight until the combined stimulus falls below pre-pandemic levels (or well below 20% of Nominal GDP).

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Aug 29 2024

  Another BLS Blunder: Basing Inflation Measurement on Theory and Not Logic or Reason

  The ratio of the home price to median household income has nearly doubled since 2000. It's counterfactual to think that would have occurred if the BLS (Bureau of Labor Statistics) had not changed in 1999 its survey of owner-occupied housing to measure implicit owner-rents. Unbeknownst to many, the change has led to a significant undercount of housing and overall CPI inflation for decades.

  In 1999, BLS made a significant change by 'simplifying the housing survey' to measure owners-rents in the CPI. It no longer tracked two types of housing units, owners and renters, with different characteristics and, in many cases, various locations. BLS argued that this change was necessary because it could no longer find an adequate sample of owner-occupied units for rent. BLS stated that the change was made to ensure the accuracy of the data, but the actual outcome was an understatement of housing inflation and overall inflation.

  During the housing boom of the early 2000s, a crucial period that underscored the importance of accurate inflation data, I debated with BLS at an annual economic conference in 2004. Our research found that the rental survey underestimated actual or experienced inflation by several hundred basis points each year in the owner-occupied housing market. My main point was that the owner and rental markets were two distinct housing markets with different vacancy rates, and the latter was a primary determinant of rent changes.

  BLS countered, stating, "There is no clear theoretical relationship between the homeowner vacancy rate and owners' equivalent rent." I emphasized that the practical relationship states otherwise. When housing prices are rising rapidly, and there is a short supply of housing units, why would owner-rents track the rental market and not the owner-housing market? Different markets yield different inflation.

  This practical relationship, often overlooked, is crucial to understanding the actual inflation rates in the owner housing market. During the housing boom of the early 2000s, owners' rents increased between 2% and 3% per year, as they were linked statistically to rents of primary residences, while house prices rose at double-digit rates. Even today, owners' rents are not tracking house price inflation.

  Many factors are behind house price inflation. Yet, if consumer price inflation tracked actual house price inflation versus a "hypothetical measure," it is hard to argue against the view the fact that overall inflation would not be higher, as official and market interest rates would be as well, resulting in a median house price much below current levels.

  The change in the housing rent survey is a much more significant BLS blunder than the recent controversy over the overstatement of payroll job growth, as it affects reported inflation, inflation adjustments to entitlement programs, and, in some cases, workers' wages and official and market interest rates.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Aug 15 2024

  Growth Cycles Are "Murdered By The Fed": Why Hasn't Fed Rate Hikes Murdered The Current Cycle?

  History shows that US growth cycles don't die of old age but are "murdered by the Federal Reserve." Then why has the most significant, in terms of scale, Fed tightening cycle of the past forty years not "murdered" the current growth cycle? The question is complex and challenging to answer, involving many factors. Still, monetary and fiscal policy roles are central to the current growth cycle, making this a compelling study area for analysts and policymakers.

  Monetary Policy

  The Fed's 500 basis point tightening cycle from 2022 to 2023 stands out as the most significant in scale over the past forty years, surpassing the previous four cycles, which ranged from 175 to 350 basis points. Notably, three of the prior tightening cycles ended in recession, with the 1994-95 cycle being the exception. This time, the economy avoided recession and experienced a growth of over three percent following the Fed's cessation of official rate hikes.

  So, has the role of monetary policy in impacting growth cycles changed, or is the policy stance not restrictive to "murder" a growth cycle? The latter.

  First, history shows that restrictive monetary policy occurs when official rates are well above the inflation rate. The Fed hiking cycle started with official rates near zero, far below the inflation rate. It wasn't until the middle of 2023, more than a year after the Fed started hiking rates, that official rates matched and then began to exceed what is reported nowadays as consumer inflation.

  Yet, it is worth noting that a recent study by economists at Harvard and the IMF found that if inflation was still measured the "old way" (i.e., which included financing costs), reported inflation would have been in the mid-to-high teens. Monetary policy may not be restrictive if actual or experienced inflation is higher than reported. The Harvard and IMF study did not include house prices in its findings as the old CPI did. If house prices replace owners' rents, which are not actual prices, the current reported inflation is still far below actual or experienced inflation.

  Economists have developed numerous rules or indicators, such as the Sahm rule and yield curve, to gauge the risk of recession associated with a restrictive monetary policy. However, the housing starts rule stands out for its consistent reliability. It has always succeeded in signaling a tight monetary policy and an impending recession. A substantial decline in housing starts has consistently preceded every recession, and so far, housing starts have not shown a decline associated with stringent monetary conditions. This underscores the importance of considering multiple indicators in economic analysis.

  The new tool of quantitative easing is another factor that needs to be considered in the overall stance of monetary policy. Based on the 'stock effect' of quantitative easing, which former Fed Chair Ben Bernanke said is more powerful than the flow effect, QE has offset a significant chunk of official rate hikes, as the Fed balance sheet is still twice the size it was before the pandemic. This underscores the complexity of analyzing the current stance of monetary policy, as the scale of QE needs to be considered.

  Fiscal Policy

  Fiscal policy is another critical factor when analyzing the current economic cycle. Every dollar the federal government spends goes into someone's pocket, whether a consumer or a business.

  The federal government is running a deficit of 6% of nominal GDP. Deficits of that magnitude are rare, occurring during the depth of the recession and never during an economic growth cycle.

  When the federal government runs a deficit, it's comparable to when the consumer borrows money to spend beyond its income. Yet, federal government spending is not sensitive to interest rates as it merely borrows more to fund the excess expenditures.

  The stance of fiscal policy will only change in two ways: first, if there is legislative action to reduce the pace of spending, or second, if there is a change in tax law requiring consumers and businesses to pay more in taxes to fund the higher spending. Given the 2024 elections are three months away, Congress will not pass any significant spending or tax legislation. And with a new administration taking office in early 2025, it is unlikely that there will be any fiscal restraint anytime soon. The earliest there could be a significant change in fiscal policy stance is when the 2017 tax cuts expire at the end of 2025.

  So, when the next recession occurs, it will still be "Made in Washington." However, for now, the combined monetary and fiscal stance policies are too stimulative for a recession to occur and are likely to become even more so if the Fed decides to ease in September.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Jun 18 2024

  OER Is A "Fake" Price: So Why Is In the CPI; It's Political

  The owner's equivalent rent (OER) index has received a lot of press lately because it's primarily responsible for keeping reported inflation well above the Fed's 2% target. Yet, if asked, many analysts and even policymakers probably need to learn why OER exists.

  OER is a concept unique to how housing units are accounted for in GDP statistics. In GDP, rental units and owner-occupied units are considered the same. To maintain this equivalence, an imputed estimate shows how much money owner-occupied units would have spent if they were renting to match the money tenants paid for housing. This process, which creates an artificial expenditure in consumer spending, necessitates the creation of a price measure or a deflator. That's because the government needs to estimate the imputed 'real' value of money owners spend for rent when calculating Real GDP.

  OER is a 'fake price, a unique concept involving zero transactions. No one actually pays OER, and as a result, it does not generate any economic activity such as sales, income, or jobs. Therefore, official rate increases do not affect the demand associated with OER. However, despite its unique nature, it has accounted for a significant part of the increase in consumer price inflation in the last three years. For instance, the increase in shelter costs contributed to more than a third of the 3.4% rise in consumer prices in the past twelve months.

  OER is suitable for GDP accounting, but why does the CPI use OER to measure housing costs? It's political because if housing costs were calculated based on house prices and borrowing costs, reported inflation would be much higher nowadays and would have run markedly higher for the past fifty years.

  BLS and the Fed should be humble enough to admit that, but they won't.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| May 31 2024

  People's Inflation vs. Policymakers' Inflation: What Accounts For the Big Disconnect?

  What accounts for the big disconnect between people's inflation and policymakers' inflation? People consider the total costs of things; based on that measure, inflation remains relatively high. Policymakers view inflation differently, creating a disconnect. Analysts should call out the disconnection and help the Fed avoid another policy blunder.

  Inflation Based on Total Costs

  People's inflation views are based on the total costs of things; yet, nowadays, inflation measurement is based on list prices/cash transactions ( and excludes financing costs), which makes little sense as fewer and fewer cash transactions occur.

  When it comes to measuring inflation, it's crucial to take into account the total costs of goods and services, which includes financing costs. These costs are not only significant in individuals' purchasing decisions but also have a direct or indirect impact on their inflation expectations.

  The influence of financing costs on inflation measures is particularly evident in the case of high-value items like vehicles. Here, financing plays a substantial role in determining the total cost of an item. With the prevalence of credit used to finance almost all consumer expenditures, incorporating financing costs in inflation measures could provide a more accurate reflection of people's perception of the cost of goods. A recent study by economists from Harvard and the IMF demonstrated that reported inflation would be significantly higher if current measurements included financing costs.

  The PCE measurement method, meanwhile, which policymakers focus on, is notably disconnected from the inflation experienced by the public. It only captures a little over half of what people actually pay. This disconnect is attributed to various factors, such as the exclusion of financing costs and the use of a non-price measure for owners' housing.

  Additionally, roughly a third of the index includes administered prices for government-subsidized items (such as health care) or items people never pay for. The PCE index, a hybrid of market and non-market prices, is inherently ambiguous, and for it to track people's inflation would be more a matter of luck than design.

  Analysts should call out the disconnect between people's and policymakers' inflation as it raises the possibility of a major policy blunder. That's because policymakers consider the current stance of monetary policy restrictive, wrongly comparing the official rate level to an inflation measure disconnected from people's inflation. However, comparing official rates to people's inflation, which includes financing costs, monetary policy remains easy—which is what the financial markets have been saying for some time.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| May 20 2024

  The Politics of Inflation & The Fed

  What is inflation? That should be easy to answer. Inflation should be what people pay for things. However, politics and policy got involved, making things complex and confusing. The government told one generation of consumers that a specific set of goods and services was inflation, and for the next generation, inflation was something different. One generation of policymakers followed one price index, even with its imperfections, and the next generation followed something different, even though it had more imperfections.

  Years ago, I created a broad price index, which included consumer, producer, and asset prices because all prices send signals that matter. A broadly defined transaction-based price index could serve as a valuable indicator of economy-wide inflation and end the politics of the numbers. The current reading of 4.5% is 100 basis points over the prior year reading.

  Inflation & Measurement

  Measuring inflation is a complex task, particularly regarding achieving real-time accuracy. However, there are some fundamental truths about inflation measurement. A price measure should capture the purchase price of a good or service that most households commonly consume or buy. A price index should not include any items that could lead to ambiguity or biases.

  The Consumer Price Index (CPI), initially called a "buyer's index," was created to measure the purchase price paid by the consumer (i.e., households) for a fixed basket of goods. Yet, the politics of inflation got involved, and it is no longer a "pure" price index based on what people pay.

  In the late 1970s, there was a lively debate over the construction of housing cost components in the CPI. Government statisticians and many in the academic world argued that it overstated housing and general inflation and recommended a change in the measurement. A panel of experts recommended the measurement of owner-housing costs shift towards a "rental equivalence," which purportedly measures the consumption of housing, not the investment part.

  Congress approved the change because they felt a lower price index would help reverse the ever-rising budget deficit and federal debt as it should slow the rise in the inflation-indexation of social payments and lessen the impact on federal revenue through the inflation escalation of federal income tax brackets.

  Rental equivalence is not observable since there is no cash outlay. Here's an example to better understand rental equivalence. Suppose a homeowner has an outside garden. Instead of consuming the garden's produce, the homeowner decides to sell it. So, one way to determine the inflation rate of homegrown food is to sell rather than eat it. However, if there is no sale how do you measure the inflation rate of homegrown food? It's arbitrary.

  Today, the controversy over rental equivalence has resurfaced for different reasons. Some argue that it alone keeps reported inflation higher than it is and should be overlooked because reported inflation statistics are losing credibility. One of the reasons cited for changing housing costs in 1980 was that many people felt that the old way of measurement was "seriously flawed" and that to maintain "public confidence," the index must be changed. The politics of inflation never dies; only the actors change.

  The Fed entered the politics of inflation two times. First, former Fed Chairman Alan Greenspan created a controversy in the mid-1990s when he argued that the CPI overstated inflation and the inflation rate should be reduced by one percentage point when used to index federal entitlements. That caused a massive scramble in Congress with a formal commission (Boskin) announcing the study of the CPI, which ended in a series of recommendations for methods to reduce the CPI and gave little attention to changes that might increase the index.

  The second political-inflation decision by the Fed was selecting its price target as a policy tool. The old generation of Fed policymakers always viewed the CPI as the primary measure of consumer inflation in the US. Yet, the new generation of Fed policymakers chose the personal consumption deflator (PCE) as its primary price target.

  The Fed defended its choice by arguing that CPI gave too much weight to housing, and the PCE measure allowed for product substitution due to price changes. However, the Fed failed to say anything about the PCE imperfections.

  For example, the PCE is not a direct measure of consumer price inflation since 30% of it included administered prices for Medicaid and Medicare. Also, the Fed failed to mention that the PCE does not capture product substitution because detailed spending data for most goods and services does not exist in real-time but is available with a lag of one to five years. Nonetheless, choosing the PCE over the CPI was a convenient, if not political, way of producing a lower price index and, most importantly, making it easier for the Fed to say it achieved its targeted inflation rate.

  Years ago, I created a broad price index after the former Fed Chairman asked the question, "Where do we draw the line on what prices matter?... Certainly the prices of goods and services now produced matter...But what about futures prices or more on future goods and services, like equities, real estate, and other earning assets? Are stability of these prices essential to the stability of the economy?”

  Greenspan's remarks of 1996 proved prescient. The recessions of 2001 (tech bubble) and 2007-09 (housing bubble) were caused by the sharp reversal in asset price inflation.

  Recent history shows the rising importance of asset inflation, making a solid case for a broad price index. My version of a broad price index included: • Consumer and producer prices (excluding food and energy prices at lower processing stages to avoid double counting). • New and existing house prices. • Equity prices.

  The weighting scheme is consistent with the consumer, business, and housing sector shares in GDP, and the equity share was equal to the consumer saving rate. A current reading of the broad price index pegs economy-wide inflation at 4.5%, 100 basis points over the rate recorded one year earlier. The fast gain in asset prices has principally driven the acceleration, a sharp reversal from the previous twelve months.

  Because price measurement is not what it used to be, nor what people think it is, the current version of prices is losing credibility. A recent paper by economists at Harvard and the IMF argues that the failure to include consumer borrowing costs as the old version did may help explain the disconnect between reported and experienced inflation nowadays.

  The politics of inflation has resulted in unequal outcomes, as it focuses solely on one type of inflation and ignores and indirectly helps others (asset owners). History has shown that all kinds of inflation matter. So, it's time for monetary policy to ignore politics and focus on all the prices that matter. A broad price index would help improve the Fed's analytical inflation framework.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Apr 30 2024

  How Fast Are Labor Costs Rising? Faster Than You Think

  The widely followed employment cost index (ECI) jumped 1.2% in Q1 2024, faster than the 0.9% increase in Q4 2023, raising fears that labor costs are re-accelerating. As big as the jump in the ECI was in Q1, another labor cost measure (ECEC) shows employee costs are rising even faster.

  The Bureau of Labor Statistics, the government agency in charge of reporting labor market data, provides two crucial measures of employee costs: the employment cost index (ECI) and employer costs for employee compensation (ECEC). Both measures, with a similar scope covering 5500 to 5600 private industry establishments and 23000 occupational observations, play a pivotal role in labor cost analysis. However, it's important to note that the ECI excludes employment shifts among occupations and industries, while the ECEC does not, making the ECEC an equally important comprehensive measure of total current employment costs.

  The two measures are simple to understand: the starting point for both measures is the change in wages, but if people move to higher-paying jobs or shift occupations because of the promise of higher pay, the ECEC measures will grow faster than the ECI. In contrast, if the opposite is true, when the jobless rate is high, job openings are low, and people have to accept lower-paying jobs, the ECI would increase faster than the ECEC.

  In the last several years, the labor market has been characterized by a record number of job openings, which have encouraged people to shift industries and occupations in search of higher pay. The labor cost data confirms this did happen. Private industry wage costs in the ECEC have outpaced the increases in the ECI every year, and the increase in 2023 of 6.9% was the largest on record and 270 basis points over the increase in the ECI.

  The Q1 2024 report for ECEC is due on June 18. Based on the still high number of job openings and low jobless rate, the Q1 rise in the ECEC index should exceed the ECI increase, adding to current fears of higher labor costs feeding into inflation numbers.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Apr 10 2024

  The Fed's "Big" Mistake---- Continuing to Use Its Forward Guidance Framework As A Policy Tool

  The Federal Reserve's persistent use of the 'forward guidance' policy tool, which involves offering forecasts of growth, inflation, and policy rates to influence financial market conditions, is a misguided approach. This tool operates under the assumption that the Fed can accurately predict the future, a notion that is inherently flawed given the unpredictable nature of economic conditions.

  In 2023, policymakers used its forward guidance policy tool to signal an end to its tightening policy cycle, thinking it had or would, in time, arrest the cyclical inflation cycle. At the end of the year, it went further, as it offered forecasts for 2024 that promised three official rate cuts.

  Yet, in hindsight, forward guidance backfired. Promises of no more rate hikes followed by promises of lower official rates triggered a 100-basis drop in long bond interest rates and double-digit increases in equity prices. The dramatic change towards much easier financial conditions has helped produce economic results that the Fed was not expecting in its forward guidance. (Note: Q1 real GDP growth is estimated at 3%, while core consumer prices rose at an annualized rate of 5%, compared to forward guidance growth estimates of 2% and core inflation of 2.4%).

  The challenge for policymakers is how to navigate the modification or discontinuation of the forward guidance policy tool. Forecasts from forward guidance are updated only four times a year, with the next update scheduled for the June meeting. While the Fed chair can provide an informal update at any time, official policy announcements are made at regularly scheduled meetings. A sudden deviation from the last forecast could disrupt the financial markets and undermine the Fed's credibility, if it still has any.

  Yet, the problem with "forward guidance" goes well beyond the announcement dates. Policymakers offer forecasts on growth, inflation, unemployment, and policy rates for two years and a longer-run equilibrium level for each. And, regardless of whether current economic conditions are too hot or soft or inflation is too low or high, the Fed's forward guidance forecasts say, through the magic of monetary policy, growth, unemployment, and inflation will gravitate to trend.

  Like everyone else, the Fed has had difficulty forecasting what the economy will be like in the next year, let alone in two or three years. Yet, unlike other forecasters, policymakers link an official rate path to its forecasts. That linkage makes official policy more predictable. However, it also creates the potential for a significant easings in financial market conditions, similar to what occurred since late 2023, long before policymakers achieved their intended outcomes.

  Policymakers spent time "normalizing" official rates, and now they need to "normalize" their policy statement, making it shorter and with fewer promises. Eliminating forward guidance would also be a positive step because even though it implies "it all depends," it still drives market expectations of official rates.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Mar 12 2024

  The Politics of Price Measurement: CPI Is the Sole Measure of Retail Inflation, But the Fed Prefers PCE

  In February, total consumer prices and prices, excluding food and energy, rose 0.4%, resulting in the last twelve-month increases of 3.2% and 3.8%, respectively. The consumer price report is the sole direct measure of retail inflation, capturing what people buy for consumption.

  However, the Fed favors the PCE deflator, which is not a direct measure but rather a blend of CPI prices with administered prices (Medicare and Medicaid). This preference is based on the belief that the PCE captures what people purchase in real time, reflecting the substitution effect of price change.

  But this claim is misleading. Detailed spending data, crucial for accurate measurement, is unavailable in real-time. The choice of the PCE over the CPI for inflation measurement is driven by political considerations, as it tends to produce a lower rate.

  The Bureau of Economic Analysis (BEA), the government agency responsible for estimating and publishing the PCE deflator, faces significant challenges in data collection for various product categories. For instance, while BEA has a small set of product details updated monthly, such as motor vehicles, prescription drugs, gasoline, and tobacco, other categories suffer from a considerable lag.

  For instance, food store sales are supplemented with annual scanner data, resulting in a one-year lag. Similarly, the yearly e-commerce survey report provides additional product details with a one-year lag.

  Detailed consumer expenditures for services are also unavailable when the PCE deflator for a given month is estimated and released. The Census's Quarterly Survey of Services (QSS) is released three months after a quarter ends. However, the QSS provides aggregate spending figures for various service industries and offers few details of how much of it is household spending.

  Without detailed data, the BEA is forced to rely on imperfect product-to-industry ratios, often based on data from the several-year-old 2017 Economic Census, to estimate household product and service spending. This reliance on outdated data is a significant drawback, as it uses spending patterns from years past to explain how current price inflation impacts people's spending decisions. This practice undermines the accuracy and relevance of the PCE deflator, raising concerns about its effectiveness as a current measure of inflation.

  The CPI has been criticized for what it is and isn't (See a recent article by Larry Summers on CPI missing financing costs for consumption). The same should apply to the PCE deflator. The PCE is not what people think it is. Choosing the PCE over the CPI is a convenient way for policymakers to argue that they are close to or hitting their target, even when the only direct measure of consumer price inflation (CPI) runs much higher.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Feb 05 2024

  Asset Inflation Cycles: Modern-Day Form of Inflation

  In the last twenty-five years, asset price cycles have become more dominant in business cycle analysis, and in doing so, asset inflation cycles have become the modern-day form of inflation. Their importance has become so critical that they have become an explicit part of monetary policy via its new tool, quantitative purchases, whose primary purpose is to increase asset prices/values. With the Federal Reserve now a key player, do asset price cycles still exhibit similar boom and bust patterns as was the case in the past? Or can monetary policy permanently elevate asset prices above and beyond economic and financial fundamentals?

  Asset Price Cycles

  Several theories help to explain why asset price cycles have become more significant and more volatile over the past twenty-five years.

  First, monetary policymakers changed its operating framework in the mid-to-late 1990s, just before the asset price tech bubble. Policymakers abandoned the money supply and credit anchors and started to track real official interest (i.e., Fed Funds level less consumer price index). That created an informal price-targeting policy regime, which years later became formal and removed a policy framework that responded to financial conditions and imbalances that could trigger future inflation or economic problems. Ever since the change in its framework, policymakers have refused to use official rates to dampen speculative and significant asset price cycles.

  Second, in the late 1990s, BLS removed the house price signal (i.e., it stopped surveying owner homes for the rent calculation) from its measure of consumer price inflation. That change further broke the link between real estate and consumer price inflation and changed the correlation between real estate and equity prices to positive from negative. So, real and financial asset price cycles became mutually inclusive, which was the opposite of what was usually the case in previous cycles.

  Third, globalization (i.e., the ability to import cheap goods) played a role in the US inflation cycle as it helped dampen goods price inflation. With monetary policy shifted exclusively to reported inflation and less to financial conditions, tame consumer price inflation contributed to investors speculating, and often winning that monetary policy will remain easy regardless of asset inflation.

  Asset price cycles do not generate public outcry as general inflation cycles, even though history shows they can be equally destructive and destabilizing. That could be because asset price upswings can generate substantial wealth gains while general inflation penalizes everyone. Yet, policymakers have a mandate for financial stability, so they must stand up against the crowd even if it's politically unpopular.

  Asset price imbalances or bubbles are hard to detect in real-time and can last long. Yet, one can gain perspective by comparing current market valuations of real and financial assets to past periods of boom and bust.

  During the tech bubble, the market value of the real estate and equities on household balance sheets to nominal GDP spiked to a record 2.5 times, falling back to below two during the bust (see chart). The housing bubble helped fuel a more significant spike in market valuations to roughly three times GDP, and again, history repeated itself, as it often does in finance, with market valuation falling back to below two.

  The Fed's QE 1 program helped asset prices recover ground lost during the Great Financial Recession, and QE 2 has pushed asset values to GDP to a new record high. Based on Q4 changes in asset prices and GDP, the ratio is estimated at 3.5, just shy of the record high at the end of 2021. If history were to repeat itself, it would take a 35% to 40% decline in both real estate and equity values to match the fall in the Asset/GDP ratio following the tech and housing bubbles. That is not a forecast but an illustration of how far current valuation have deviated from trend. Liquid assets correct sooner and more sharply than real assets so the equity and real estate declines, if they do occur, would not be proportional.

  Can monetary policy permanently increase the nominal values of real and financial assets with its new policy tool (QE)? Monetary policy can make things look better and last longer, and QE has done that. But to permanently increase the earnings power and asset valuations is not something monetary policy can do. Every excessive asset and non-asset price cycle in history eventually broke for one reason or another. The current cycle should be no different.

  Policymakers are debating when to reduce official rates because general inflation has slowed. Reducing official rates would be a significant policy mistake because of the price imbalance in the asset markets. Instead, policymakers should comprehensively review their policies because the economy's performance, evident with the strong job and wage gains in January, says the total stance of monetary policy remains too easy. In doing the review policymakers will learn that their new tool of quantitative purchases offsets a significant chunk of their official rate policy. In the current climate, it makes more sense to accelerate the reduction of the Fed's balance sheet than to lower official rates.

  by:Joseph G. Carson

  |in:Viewpoints
• USA| Jan 18 2024

  QE & The Assetization of the US Economy---It Is Bigger Than The Previous Two Asset Bubbles

  The US has experienced two asset bubbles in the last twenty years, and a third one, bigger than the prior two, has been underway for a few years. Yet, unlike the previous two, which were a function of investor optimism about new technologies and easy credit conditions and the belief that housing prices never fall, the current asset cycle is a function of monetary policy.

  The Federal Reserve's influence in the financial markets has grown substantially since the Great Financial Crisis. The increased influence stems primarily from their new financial tool, quantitative easing (QE), or the purchases of debt securities. QE lowers interest rates (making the future value of equities relative to interest-bearing securities more attractive) and increases the demand for risky assets (mainly equities) by removing the supply of safer debt securities.

  The Fed never fully reversed its first QE program before another adverse event (i.e., the pandemic) triggered a second and even more extensive program. At its peak in 2022, the Fed's holding of debt securities topped $8.5 trillion, up from $3.8 trillion before the pandemic, and currently stands at $7.2 trillion. This has had a ratchet effect, lifting asset values far above fundamental values, and the positive impact remains in play.

  Determining when asset values are running counter to underlying fundamentals is difficult. Yet, one can get perspective by comparing current valuations to past periods.

  Since QE's second program in 2020, the market valuation of tangible and equity assets relative to GDP has increased from 2.5 to 3.3 times. The latest reading is for Q3 2023. Given the surge in equity prices in the fourth quarter, the ratio of assets to GDP could come close to its record high of 3.6 at the end of 2021. By comparison, this ratio peaked at 2.9 during the housing bubble and 2.4 in the tech bubble.

  The prior two asset bubbles were pricked or unwound by market forces. The tech bubble burst when hundreds of new start-ups ran through their capital and failed to become profitable. The housing bubble burst when people had to refinance at higher mortgage rates, and speculators could not unload the homes they bought.

  Critics of QE have always focused on its impact on reported inflation. QE does cause inflation, but not the one that shows up in the CPI or PPI. It is asset inflation, pure and simple. So, the Fed should study the impact of QE on its financial stability mandate, not its inflation and employment mandates.

  Yet, how does an asset bubble burst when a non-market buyer like the Federal Reserve drives it? The 500 basis point increase in official rates would have had a much more significant and sustained negative impact on equity and housing markets if QE did not exist on the scale it does.

  Monetary policy can make things appear better or run longer. Still, even though there is no law of gravity in finance, recent history does show financial euphoria not grounded in solid economic fundamentals is not sustainable. The significant over-valuation of tangible and financial assets poses a substantial risk to the economy, and history says it's not if but when it will unwind.

  by:Joseph G. Carson

  |in:Viewpoints