Viewpoints

The August report on consumer prices should end the discussion of peak inflation, deflation risks, and the quick end to the Fed tightening cycle. But it won't. The happy prophecy of this inflation cycle ending without a lousy outcome fails to learn from past episodes.

Lessons from past cycles show that inflation cycles are not static or linear; they rotate and broaden. Some items post significant increases in any given month, others smaller ones, and a few none at all. Months later, the composition of inflation could be completely reversed, with items that were not rising at the outset beginning to run faster than others.

Earlier this year, rapid price increases in a few items were mainly responsible for the acceleration in inflation. For example, at the end of Q1, gasoline prices increased 48% from a year ago, used cars 35%, airline fares 24%, and new cars 13%. These price spikes reflected supply shortages and the rebound in demand from the idle days of the pandemic. Much of that inflation has reversed, but the more significant broad inflation cycle lives on.

The Bureau of Labor Statistics (BLS) provides special aggregate price series that remove the noise from these factors, the spike in food prices, and the controversial shelter index. In August, BLS estimated that CPI less food, energy, shelter, and used car and truck prices rose 0.5% in the month and now stands at a new cycle high of 6.3% in the past year. The annual increase is the largest since 1982.

Inflation cycles are complex, with many interconnected parts. Consequently, taming or reversing the inflation cycle is not as simply slowing or ending the price increases for those items that spiked early on. The drop in consumer goods or commodities, especially energy, is good, but inflation in the service sector is much more difficult to eradicate with monetary policy. That's because it is linked directly to labor costs, and labor nowadays is in short supply.

Investors are waking up to the view that the Fed has much more tightening before it can confidently conclude the inflation cycle is over. Policy rates of 4% or higher are possible, given the changing nature of the inflation cycle. And because of that, I am reminded of what a former colleague and Wall Street strategist, Bob Farell, claimed bear markets have three stages, "sharp down, reflexive rebound and drawn-out fundamental downtrend." The last stage can last a while and be ugly.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

At the start of the third quarter, there were 10 million job openings in the private sector, and seventy-five percent were in the service sector. The imbalance in the labor markets, especially for service workers, creates a nightmare scenario for the Federal Reserve. That's because as it attempts to slow demand, dampen wage growth, and cool inflation, its monetary tools are much less effective in dealing with the less interest-rate sensitive service sector.

Up to now, the hottest inflation issue was commodities, even excluding food and energy prices. But the composition of the inflation cycle is quickly shifting towards consumer services, making it more difficult to reverse without a dramatic drop in demand due to a prolonged period of higher interest rates.

Core inflation in consumer commodities stands at 6.8%, well off its double-digit highs from earlier than in the year. Yet, prices for core consumer services at 5.6%, the fast annual gain in roughly 25 years, are still accelerating. And core consumer services have nearly three times the weight of core consumer commodities.

Thus, solving the inflation problem requires a fundamental change in service sector growth dynamics. And that cannot occur without a dramatic shift in the demand and price of service sector labor.

Before the pandemic, the private sector service job growth was 1.5 to 2 million per year. So reducing the 7.5 million job openings in the service sector by half would take two years. But that would not mitigate wage pressures, the most significant source of service sector inflation.

The average wages for the private sector non-supervisory service sector workers are up 6.2% in the past year. Excluding the spike in wages in the early months after the pandemic, service sector wages are running at their fastest pace since the early 1980s. And, they are running roughly 100 basis points above the gains in the goods-producing industries.

Private service sector labor and price dynamics are the Fed's most significant hurdles in its inflation fight. Creating slack in the labor market for service workers will require a much official rate and in place for an extended period than it would if inflation was only a goods sector phenomenon.

So Fed Powell's warning that "a lengthy period of very restrictive monetary policy" will be needed to stem the inflation cycle is something investors should not ignore, as it signals a volatile market environment.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Energy is playing a critical role in the cost of living crisis that presently engulfs the world economy. Hardly a day goes by in the UK, for example, without a newspaper carrying headlines that concern spiraling fuel prices and how this is magnifying inflation tensions on the one hand and draining household purchasing power on the other. The latest raft of European inflation releases certainly attest to the outsized role that energy prices have played in driving consumer price inflation to recent highs. The consumer price of energy, for example, specifically accounted for between 40 and 45% of the respective y/y gains in the UK and Eurozone consumer price index in July (see figures 1 and 2 below). Nearly half of Europe's inflation problem, in other words, can be traced to energy.

The Federal Reserve Bank of Philadelphia's state coincident indexes in July were modestly dispersed, but arguably less so than in recent months. Only three states (Indiana, West Virginia, and Montana) are reported to have declined. Thirty states had increases between .25 and .75 percent. At the top, New Mexico, Massachusetts, and Nevada had gains higher than one percent. At the 3-month horizon Montana and Arkansas again saw drops, but only three others had gains of less than ½ of one percent, while 11 others had increases of less than one percent. Massachusetts was again the only state with an increase of more than three percent, and 8 others were above two percent. Over the last 12 months, it was again the case that every state had gains of at least 3 percent, with three (West Virginia, Massachusetts, and California) up more than 10 percent,

As always seems to be the case, the independently estimated national figures of growth over the last 3 (1,1 percent) and 12 (5.6 percent) months look substantively weaker than the state figures.

Connecticut and Hawaii are now the only states that have not yet passed their pre-pandemic peaks in this series.

The recent rally in equities, bonds, and the narrowing credit spreads has been impressive. It hinges on the view that the Fed's war against inflation is over, or almost so, and a new economic and profit cycle will begin soon. Yet, the downcycle in prices and the fallout in the economy and company profits has not started yet.

For investors looking beyond the economic slowdown, it is mathematically impossible for the Fed to lower inflation to 2%, from the current 8% to 9% range, without triggering a sharp decline in operating profits.

In the last twelve months, nominal GDP has increased by 9.3%, with the price component rising 7.5% and the output component rising 1.6%. And what happens on the output side also occurs on the income side since nominal GDP and Income are mirror images.

In the past year, nominal income has been up an estimated 10%, a bit more than the reported 9.3% gain in GDP, with employee compensation rising 10% and operating profits less than 3%.

The Fed does not directly target GDP prices. Still, consumer prices make up the lion's share of GDP prices, so lowering consumer price inflation to 2%, down from 8% to 9%, would result in a dramatic drop of about 500 to 600 basis points in Nominal GDP growth, with a parallel downward move in nominal income.

In the last 30 years, nominal GDP growth has dropped that much three times (1989-90. 2000-01, and 2007-09), excluding the pandemic non-economic recession. Each of the three sharp declines in nominal GDP resulted in an official economic recession, with 2007-09 being the worst one of the post-war period at that time. Aggregate operating profits posted negative numbers before and sometimes during the recessions.

What makes the current situation unique is that the Fed is fighting inflation against a backdrop of a labor shortage. How does the Fed squash inflation when labor costs are rising? And for investors, the more significant issue is what happens to companies operating profits if Fed lowers inflation and nominal output and income growth slow accordingly, and employee compensation slows only half as much. That points to a sharper decline in operating profits far more significant than analysts and strategists expect.

The scenario that could be a win-win for investors is if the Fed raises official rates, inflation slows, and real output increases. That would result in a smaller decline in operating profits. In my view, the odds of that occurring are very low as it has never happened before.

Some may disagree, citing the 1994/95 slowdown. Back then, the Fed was trying to stop inflation from accelerating. This time the Fed is trying to lower a significant and broad inflation cycle, the biggest in 40 years. The economic and financial consequences are much different when inflation has accelerated. Price increases have already inflated income and profit figures, so unwinding inflation creates more harm and dislocation than trying to stop it from occurring in the first place.

Yet, investors disagree and are betting that ending inflation cycles do not trigger the economic harm, profit, and job declines of past cycles. It is hard to fight the tape, but it's even riskier to defy economic common sense.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

State labor market results in June were generally strong. While 20 states had statistically significant increases in payrolls—led by Hawaii's 1.3 percent increase—2 saw significant declines. The outliers were Kentucky and Tennessee, and one suspects the flooding in that part of the nation played a role. Elsewhere, gains were more uniform. After Hawaii, the largest increases were .9 percent in Missouri and Arkansas. The largest absolute gain was California's 84,800. Over the last year all states had at least point increases in payrolls, though in a handful the gains weren't statistically significant. Alaska, Kansas, Vermont, and Wisconsin were the only states with increases less than 1 ½ percent. Texas's 5.8 percent gain (736,700) was the largest, though the absolute increase in California was very slightly larger.

Fourteen states, plus DC, saw declines in their unemployment rates in July, led by a .4 percentage point drop in New Mexico. Indiana, Montana, and Nebraska had statistically significant modest increases. DC's rate in July was 5.2 percent, and Minnesota's was 1.8 percent. The other 49 states had rates in the 2.0 to 4.5 percent range.

Puerto Rico's labor market also showed some improvement. The island gained 7,500 jobs (.8 percent) in July, and the unemployment rate fell to 5.9 percent—another record low for this series, which starts in 1976, and the first time the rate has been under 6 percent. However, the drop in the unemployment rate from June to July was an artifact of a decline in the labor force, as resident employment declined.

The Bureau of Labor Statistics (BLS) publishes two estimates of job growth each month: one based on a survey of households and the other based on a survey of firms. The increasing disparity in recent months has created confusion over the size of job gains, as the payroll survey shows robust gains, while household employment is down one month and up the next. Some analysts and portfolio managers have used the household employment data to support their view that the economy is in recession. They're wrong.

The two surveys are not strictly comparable. But BLS publishes a household employment figure adjusted to payroll survey concepts. And, when modified, the household series shows solid gains, even outpacing the payroll's whopping increase in July.

To estimate the household employment series equivalent to the payroll series BLS removes from the initial estimate of household employment agricultural workers, unpaid family workers, paid private household workers, and workers on unpaid leave and adds multiple jobholders.

In July, the household series adjusted for payroll concepts rose 611,000, far above the published gain of 179,000 for household employment and above the 528,000 payroll gain. The series also shows that household employment rose by 131,000 in June, whereas the regular series shows a decline of 315,000. Since the start of the year, the adjusted household series has outpaced payroll jobs by 216,000.

In the end, the divergence runs the opposite, with household employment outpacing payrolls, and the jobless rate at 3.5%, a 50-year low, confirms that strength. The labor market data says the economy is not in recession.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

Was the recent rise in inflation caused by supply constraints or excess demand? The answer is vitally important for monetary policy. The Federal Reserve can’t do much about supply-chain issues, but it can influence the pace of demand. There is no question that supply chain issues are hampering firms’ ability to supply enough goods and services, which is driving up prices. But much of the supply issues in goods markets have occurred BECAUSE there is too much demand. The combination of expansionary monetary and fiscal policy during and after the lockdowns fueled demand beyond levels that firms could comfortably satisfy. So although there is ample evidence of supply constraints pushing up inflation, the actual root cause was too much demand – which is something the Fed can address.

A look at retail sales gives a clear picture of the excessive amount of spending that has occurred in 2021 and 2022 (Figure 1). Prior to the pandemic, consumer demand for goods was running at a pace that was close to its long-term trend. We can view this trend line as the steady state growth rate – the pace that spending can grow without generating supply-chain issues and ultimately inflation. In other words, the trend line in the chart represents the maximum amount of retail sales that will not generate demand-led inflation pressures.