Viewpoints

The Federal Reserve Bank of Philadelphia's state coincident indexes in May showed some dispersion. Five states had no gains, or losses, in May (Michigan, Arizona, Hawaii, Montana, and Arkansas), while West Virginia, Rhode Island, Massachusetts, and Maryland were all up by more than 1 percent. The relative strength of the Northeast was also evident at the 3-month horizon, with Massachusetts, Maryland, West Virginia, and Rhode Island rising more than 3 percent. While 12 states—none in the Northeast—had increased of less than 1 percent. Over the last 12 months, every state had gains of at least 3 percent, but 6 (including California and New York) were up more than 10 percent, with West Virginia's 15.2 percent far and away the highest.

As is chronically the case, the independently estimated national figures of growth over the last 3 (1.3 percent) and 6 (6.0 percent) months look substantively weaker than the state figures.

It remains the case that Connecticut, Hawaii, Louisiana, and Michigan are the only states that have not yet matched their pre-pandemic highs in this series.

Recession risks are high, in my view, because of the "income" consequences of the Fed's inflation fight. The math is very straightforward: A significant reduction in price inflation means less nominal revenue or sales, weak or negative operating profits, and less labor income. Consequently, the subsequent drop in national income growth would be sharp, rivaling some of the most significant declines on record.

The Fed aims to bring consumer price inflation back to 2%, down from the current rate of over 8%, a drop of 600 basis points. Slicing 600 basis points off the headline and roughly 400 basis points from the current reading of the core index would cause an uneven distribution of price changes, with prices for many consumer goods posting significant declines.

Commodities or consumer goods prices rose 10% in 2021. Given the stickiness in service sector prices, inflation for consumer goods would have to show no change or decline a few hundred basis points if the Fed successfully gets overall core prices back to a 2% rate. That would result in a sharp fall in revenue growth for a vast part of the retail sector.

Yet, the consumer price inflation fall would extend much further. Producer prices for finished goods and intermediate materials are cyclically aligned with consumer prices but are much more volatile. In 2021, producer prices for core materials and supplies rose 23%, 4x the core consumer price index and the most significant increase since the mid-1970s. If the Fed kills consumer price inflation, a record deceleration in prices for materials and supplies is in store.

The most significant reversal in materials prices occurred during the Great Financial Recession. In mid-2008, these prices were up 12% and one year later off 8%. If material price inflation drops to zero by early next year, it will exceed the price deceleration of 2008-09. As a result, the revenue drop for the materials producers would be substantial, crushing profits.

In 2021, with significant and broad consumer and producer inflation along with large wage gains, national income, 80% of which is accounted for by operating profits and employee compensation, rose 12%, 200 basis points faster than GDP.

If the Fed takes three-fourths of consumer price inflation out of the economy and all of the producer price inflation, the drop in nominal income would be sharp, especially when the hit to labor occurs.

Aggregate income would rise marginally, no more than 4%, and down from the current rate of 11%. That 700 basis points deceleration of nominal income growth would match the drop during the Great Financial Recession. Yet, in this case, it would still be marginally positive. Depending on how quickly firms cut back on labor and other costs, the fall in operating profits would be sharp, off at least 20%.

The Fed's inflation fight is in its early innings, and the biggest hit to company revenues, profits, and margins is months or even quarters away. Still, the process has started with reports of cuts in advertising and hiring freezes.

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

Senate Banking Chairman Senator Brown: This confirmation hearing will now come to order. Welcome Dr. Kasriel.

Mr. Kasriel: Before this hearing proceeds, may I submit a correction for the record. The only Dr. Kasriel I am aware of is my deceased second cousin, Robert Kasriel, who earned a doctorate in mathematics and went on to have a brilliant career teaching that subject at Georgia Tech. I never turned in a final draft of my PhD dissertation in which I investigated an obscure Federal Reserve policy called “even-keel policy”. I was attracted to this policy because I was and still am a sailor. We sailors try to keep our craft on a relatively even keel. My research concluded that there was no discernible difference between periods in which the Fed was pursuing an even-keel policy and periods when it was not. So, I do not hold a PhD, but rather an ABD, all but dissertation. That said, I do believe that my stay at a Holiday Inn Express does qualify me for consideration to serve on the Federal Reserve Board of Governors.

Senator Brown: Let the record show that the nominee is a mere “Mister” rather than a “Doctor”. Mr. Kasriel, I am intrigued by the written statement you submitted to this committee outlining your approach to conducting monetary policy entitled “Fed, First Do No Harm”. Could you briefly explain your thesis, not the one on Fed even-keel policy, but the one in your written statement to this committee?

Mr. Kasriel: Mr. Chairman, I am a great admirer of the writings of the late Professor Milton Friedman. Friedman argued that economies are complex, ever-changing “organisms” of which economists do not have sufficient knowledge to regulate with any meaningful precision at a macro level. There are lags, the lengths of which can vary and are unknown with, again, any meaningful precision, between when a central bank policy action is taken and when the full effect of such action on a targeted variable will occur. Moreover, economies are subject to relatively unpredictable “shocks” such as the Covid pandemic of 2020 and the Russian army’s invasion of Ukraine on February 24, 2022. Both of these shocks had significant effects on the course of the US and global economies, the magnitudes and durations of which are not known. Friedman argued, and I believe history has borne out his argument, that the Fed often takes well-intentioned policy actions to mitigate an actual or perceived undesirable macroeconomic process only to find that these policy actions result in other undesirable macroeconomic processes. A case in point was the Fed’s flooding the US economy with liquidity when the Covid pandemic hit the US economy in March 2020. The Fed rightfully feared that Covid-induced partial shutdown of the US economy could result in massive credit defaults in the private sector and the “freezing up” of the private credit markets. The Fed’s actions prevented these consequences, but the Fed did not withdraw this liquidity in a timely manner, which has fueled the high inflation we now are experiencing. In essence, Friedman argued that well-intentioned Fed monetary policy actions tend to increase the amplitudes of business cycles. That is, Fed monetary policy actions tend to turn business expansions into booms and business slowdowns into more severe recessions. The upshot of this is that the Fed should operate monetary policy such that it first does no harm to the macroeconomy.

Ranking Member, Senator Toomey: Mr. Kasriel, are you suggesting that the Fed should keep the federal funds rate at its so-called “neutral” level?

Mr. Kasriel: Senator Toomey, that might be a good policy if the Fed actually knew at what level of the federal funds rate represented neutral. I would submit that the neutral level of the federal funds rate is not a constant through time. For example, when businesses perceive that capital investments will be more profitable, there will be an increased demand for credit. All else the same, the level of interest rates ought to rise. Even if the Fed were aware of this, it does not know by how much interest rates should rise. Demographics can play a role in determining the neutral level of the federal funds rate. As a population ages, households’ demand for credit will ebb as they previously have borrowed to purchase a house and durable goods. All else the same, as a population ages, the neutral level of the federal funds rate would decline. Again, would the Fed know by how much the neutral level of the federal funds rate had fallen? Will all else be the same?

Senator Toomey, the Fed currently talks about hiking the federal funds rate “somewhat” above its neutral level in order to rein in inflation and achieve a “softish” landing. I would ask the Fed to specify what it perceives the neutral level of the federal funds rate to be under current conditions. As of June 24, 2022, the 30-day federal funds futures market contract 12 months out closed at a federal funds rate of 3.50%. Should we consider this to be the neutral level of the federal funds rate?

I don’t pretend to know what is the neutral level of the federal funds rate. But I do know that historically, the federal funds rate tends to be above the consumer price inflation rate. Plotted in Chart 1, which I submitted to the committee, is the percentage-point spread between annual averages of the federal funds rate and the year-over-year percent change in the All-Items Consumer Price Index (the blue bars). From 1955 through 2019, the median spread was 1.24 percentage points. In 2021, the CPI inflation rate was 4.70% and the federal funds averaged 0.08%, which yielded a spread of minus 4.62 percentage points. Let’s fantasize that the CPI inflation rate slows to 3% by the end of June 2023. Based on the long-run median percentage point spread between the federal funds rate and the CPI inflation rate, the federal funds rate would be 4.24% (3% plus 1.24 percentage points). This is a higher federal funds rate than the 3.50% that was priced into the federal funds futures contract 12 months from now as of June 24, 2022. The red line in Chart 1 represents the year-over-year percent change in annual average All-Items CPI. Notice, senators, when the percentage point spread between the federal funds rate and the inflation rate is negative, the inflation rate tends to be moving higher.

Personal incomes growth again varied widely across the states in 2022:Q1, with large differences in both the growth of transfer payments (reflecting idiosyncratic impacts of the wide-down of COVID relief) and net earnings The fastest rate of growth was South Dakota’s 8.5 percent, while the lowest was Hawaii’s 1.3 percent. Growth was fastest in the Great Plains and New England; slowest in the Southwest. The distribution of net earnings was somewhat different. The Plains—aided by sharp increases in farm income--and New England remain the strongest regions there, but the weakest was the Mideast. In the Mideast overall personal income grew at the national average of 4.8 percent. The drop in transfers was less marked than the national average, and the growth of property income was larger. In the Southwest, net earnings growth was greater than the national average, but property income rose less rapidly and transfers fell more.

In other industry detail, the boom in incomes generated in leisure and hospitality was over in the first quarter, with Nevada the only state seeing especially marked gains.

State payrolls were not as strong in May as in recent months. Only 7 states had statistically significant increases, while 3 report declines. Texas had the largest gain (74,200) while West Virginia jobs rose 1.3 percent. On the other side, Alaska shed 4,400 jo15 bs (1.4 percent), Wyoming lost 2,800 (1.0 percent) and Michigan payrolls fell 14,600. Over the last year, Alaska and Wyoming were the only localities that did not show statistically significant job growth (Alaska's point estimate edged down). Both California and Texas had job growth exceeding three-quarters of a million in that period, and Nevada had a 7.1 percent increase. Aside from Alaska and Wyoming, Wisconsin was the only state with job growth under 2 percent.

16 states saw statistically significant drops in their unemployment rate in their unemployment rates in May, with a number (California, Iowa, Missouri, and Rhode Island) reporting declines of .3 percentage points. The range of unemployment rates across the nation continues to narrow. Nebraska continues to have a 1.9 percent rate; the highs continue to be DC (5.7 percent) and New Mexico (5.1 percent), but in both cases May's number was lower than April's.

Puerto Rico's recovery is ongoing, with a small (likely statistically insignificant) increase in payrolls, and the unemployment rate moving down to 6.2 percent.

The latest June survey of Blue Chip professional forecasters is an uncomfortable read. Further downward revisions to growth expectations for 2022 have been accompanied by further upward revisions to inflation forecasts. That’s an unpleasant combination, suggesting stagflation risks are high and rising. That many policymakers moreover are now more actively engineering a tighter monetary policy in order to check inflation leaves global growth forecasts subject to further downward revision. The still-large - and growing - disconnect between forecasts for consumer spending growth and real household income growth in the meantime offers a stark reminder that the growth portion of the stagflation equation are subject to intense downward pressure at present. In other words, global recession risks are rising sharply.

These conclusions are reinforced in the charts below.

The evolution of consensus GDP growth forecasts for 2022 is shown in figure 1 below. These have been revised sharply lower over the last several months and most notably in large economies such as China, the US and the Euro Area. Their synchronized nature moreover hints that these revisions can be traced to global, not domestic, factors.

Figure 1: The evolution of Blue Chip forecasts for GDP growth in 2022

Peak inflation is not a meaningful statistic. In some ways, it is similar to peak growth or peak earnings. Indeed, it provides no context to the reduction in speed or the duration of the cycle. It is hollow. The Fed made a mistake in thinking that the spike in inflation was supply-side driven and, therefore, temporary. It would be equally wrong to conclude that peak inflation signals a quick end to the inflation cycle.

There is a lot of talk of peak inflation as it somehow creates the impression that with inflation coming off its highs, the Federal Reserve has less need to tighten. Yet, peak inflation implies inherent linearity to inflation, which is not the case. Inflation cycles are non-linear. To be sure, inflation cycles rotate, move up and down, and broaden over time.

The thinking behind peak inflation is similar to the supply-side driven view of the current inflation cycle. Supply-driven inflation, according to some, is temporary as it will fall on its own accord once the unique factors disappear or dissipate in intensity. Yet, the error in that analysis is that it overlooks or ignores the spreading effect of inflation. In other words, as certain costs rise, it forces different prices up over time.

For example, in the 1970s, supply shocks (food and energy) played a massive role in starting the inflation cycle. After that, however, the inflation process spread, and for more than a year, inflation measures without food and energy costs were rising faster than those that included them.

A similar script is starting to play out today. For example, consumer price inflation has accelerated by 400 basis points in the past twelve months. Unique factors, such as energy +30%, used cars +23%, and food +9%, accounted for a lot of the spike. Yet, prices other than food, energy, shelter, and used cars accelerated by 330 basis points, rising 5.8%, the most significant acceleration and fastest increase in this broad price index in over 40 years.

Prices paid indexes are relatively high (low to mid 80%) for manufacturers and non-manufacturers in the May survey from the Institute of Supply Management, and wage costs for the rank and file posted their most significant monthly increase (0.6%) of 2022 in May. So as long as companies are saying costs for materials are increasing and workers' pay is as well, the Fed must conclude the inflation cycle lives on and ignore talk of peak inflation.

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

Bank of England policymakers have been slammed by UK newspapers in recent days for 'being asleep at the wheel'. Spiralling inflation, a 'cost-of-living crisis', a borrowing binge and an overheating labour market are being specifically pinned on lax UK monetary policy. And last week's UK data flow showing a further big jump in inflation, a steeper than expected drop in the unemployment rate and a record high for job vacancies have added more grease to the media's wheels.

But are these criticisms really justified? Well the answer is not quite, and for a number of reasons. The most straightforward reason being that these criticisms are not just being levelled at the BoE. They're also directed at the Fed, the BoC, RBA, ECB, and at many other central banks besides. In other words, many of these issues are globally-rooted and don't have their origins in lax domestic monetary policy.

Global roots

On the other hand, perhaps all of these central banks have been similarly asleep at the wheel during this period? Global monetary policy settings may have been far too loose for too long, particularly during the pandemic period. This could have generated too much money, excessive private sector leverage, and soaring demand. This could have now yielded outsized price pressures, wage price spirals thanks to overheating labour markets and dislodged inflation expectations to boot. If this isn't a wake-up call for policymakers to tighten monetary policy swiftly and aggressively and squeeze these excesses out of the system, then what is?

However, this global narrative and policy prescription doesn't quite hit the nail on the head either. There's no evidence – at the global level – for rampant money supply growth, for excess private sector leverage, or for economic activity more generally that's overheating. Price pressures have been, and still are, emerging due to acute supply side shortages that can mostly be traced to the pandemic or, more recently, to the conflict in Ukraine and China's zero COVID policy. And while a recovery in global demand has admittedly amplified these pressures, it has been fiscal policy – not monetary policy – that's been playing the supporting role.

All things considered, if that analysis is accurate, shouldn't monetary policy now play a bigger role in ameliorating these price pressures and, at the very least, preventing a bad situation from getting worse? This scribe is dubious. If loose and unorthodox monetary policies throughout the post-financial-crisis era failed to generate any consumer price inflation, and isn't really responsible for high inflation levels at present, why on earth should we expect tighter monetary policy to play a restraining role now?

More appropriate policy tools

Fighting the current combination of weak growth and high inflation with higher interest rates will not restore the supply fabric of the world economy not least now that most governments are tightening their fiscal stance at the same time. Surely a far more apt policy response (which admittedly the UK government is leaning toward) would be to use the levers of fiscal policy to alleviate supply-side shortages (e.g. in energy markets), increase an economy's production capacity and shore up the purchasing power of households and companies. By raising the cost of borrowing, tighter monetary policy will impede a supply side investment drive and further derail private sector purchasing power. As such, central banks may well make a bad situation even worse if they were to more actively respond to the pressures facing them from so many opinion formers in the media.

In what follows, we take a look at a few charts accompanied with (mostly) brief commentary reinforcing these messages.

The first chart in figure 1 below shows the strong link between commodity prices and consumer price inflation in the advanced economies over recent years. In short, consumer prices have been rising because input cost pressures have been rising.

Figure 1: Higher commodity costs have pushed up consumer price inflation