Viewpoints

Policymakers are learning in "real-time" the staying stimulative power of the Fed's quantitative securities purchases (QSP) and the scale of official interest rates required to neutralize its effects. How else can anyone explain 800,000 new jobs (60,000 in the interest-sensitive construction industry) created over the July-to-September period and estimated GDP growth of nearly 5% for Q3 after over 500 basis points in official rate hikes in the past 18 months?

Former Fed Chair Ben Bernanke, the mastermind behind this new policy tool, argues that QSP helps to lower long-term yields, and the effects are long-lasting. How long? No one knows, but one way to track the QSP effect is by looking at the spread between long-term yields and Fed funds.

The Fed has been raising the Fed funds rates since March 2022. For half of those 18 months, the yield of the 10-year Treasury has run well below the Fed funds rate and still is well below. During every Fed tightening cycle of the past 35 years, the 10-year Treasury yield ran equal to or slightly above the Fed funds rate, especially when the economy was strong, and the Fed still was leaning towards more rate hikes.

Most of the focus of QSP is its direct impact on the Treasury yields. However, it also involves direct cash transfer (liquidity) into the financial markets and the economy as the Fed buys securities from investors. The Fed added $5 trillion to QSP over two years, which boosted asset prices and directly and indirectly consumer investment and spending behavior.

Mr. Bernanke also argues that for QSP to be effective, the economy's nominal "neutral interest rate" (observed after the fact) must be between 2% and 3%. Suppose the "neutral interest rate" is twice that, or 5% to 6%, close to the current target on fed funds, and is rising as is the case nowadays.

Does the stimulative power of QSP increase as the economy's nominal "neutral interest rate" increases, especially when the scale of QSP is still enormous? Mr. Bernanke never contemplated this scenario or how to exit QSP when policymakers needed to shift the stance of monetary policy to the restrictive side.

We are in uncharted territory because never before has there been a period of a rise in the economy's nominal "neutral interest rate" and enormous QSP. At the end of September 2023, the Fed's security holdings stood at $7.44 trillion, roughly $1 trillion below its peak, but still stood nearly $ 4 trillion above the level when the Fed started its latest QSP program in 2020.

Does the stimulative power of $4 trillion of QSP outweigh the adverse effects of an estimated $100 billion increase in household net interest costs? The economy's growth performance says it does, but financial conditions models say the opposite. Why? Financial conditions models omit QSP.

State personal income growth ranged from annual rates of 6.1 percent in DC and New York to -2.7 percent in Maine. The drop in Maine related to a one-off large decline in transfers; Arkansas, number 49 with a meager .4 percent growth rate, was weak in all major categories.

In general, states in that grew notably faster than the national average were in the Northeast and Far West, and slow-growing states in the middle of the nation. There were exceptions: Kentucky grew at a 5.8 percent clip and Kansas 5.0 percent, while South Carolina (another state affected by a drop in transfers) grew at only a 1.4 percent rate.

The range of the annual rate of growth for net earnings (employee compensation plus noncorporate business earnings—a measure likely more closely related than overall person income to current economic activity—was also wide, with Florida’s 7.1 percent tops, and North Dakota at the bottom at -.8 percent.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in were soft. 17 states reported declines from July, with West Virginia down nearly 1 percent. The largest increase was.7 percent in neighboring Maryland.in the rate of growth. Over the 3 months ending August 7 states had declines, with West Virginia’s -1.4 percent being the largest. Maryland had the largest gain, at 3 percent. The results look somewhat better at the 12-month horizon, with Massachusetts up 7.8 percent and Maryland’s index rising 7.7 percent. Virginia was the other state with an increase higher than 5 percent. 4 states had increases of less than 1 percent, with New Jersey’s a mere .25 percent.

The independently estimated national figures of growth over the last 3 months (.6 percent) and 12 months (3.2 percent) both look to be roughly in line with what the state figures suggest.

State labor markets were generally lackluster in August. Only 5 states saw statistically significant increases in payroll, while 3 had declines. North Carolina picked up 17,500 jobs while Missouri lost 13,700. Montana a .7 percent increase; Hawaii a .8 percent loss.

10 states had statistically significant increases in unemployment from July to August, with New Jersey and Wisconsin both up .3 percentage points. North Dakota and South Carolina had significant .1 percentage point drops. Nevada continues to have the highest rate of any state in the nation, at 5.4 percent. Nevada, and DC had unemployment rates at least one point higher than the national average of 3.8 percent. Alabama, Arkansas, Florida, Hawaii, Kansas, Maine, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Hampshire, both Dakotas, Oklahoma, Rhode Island, Utah, Vermont, and Virginia, were all at least a point lower, with Maryland at 1.7 percent.

Puerto Rico’s unemployment rate was an unchanged 6.2 percent. The island added 3,900 jobs, bringing the number above May’s recent high.

The August report on consumer prices shows that inflation cycles are not linear; inflation patterns rotate, and service sector inflation cycles are hard to break.

In August, headline consumer prices rose 0.6%. That represented the most significant month-over-month increase since June 2022. Also, that broke a 13-month pattern of successively lower headline annual inflation readings, proving that inflation cycles are not linear, up or down.

Second, commodity (or goods) prices rose 1% last month, which accounted for much of the acceleration in the headline. That was only the fourth time in the previous fourteen months that consumer commodity prices increased, illustrating that inflation patterns tend to rotate over time, with some items growing almost every month and others occasionally.

Third, in August, consumer service prices rose 0.4% and 5.9% in the past twelve months. Since the mid-1980s, consumer services inflation cycles have reversed after the federal funds rate exceeded the inflation rate, sometimes substantially. Consumer service inflation is still above the current fed fund rate range of 5.25% to 5.5%. Several analysts argue that the Fed tightening cycle is over. The history "bookie" says the odds of another rate hike are higher than what analysts think.

The US has mandated that light vehicles become much more efficient in coming years in an effort to lower greenhouse gas emissions. For example, light vehicles will be required to average nearly 50 miles per gallon across automaker production by 2026. The requirements are set to become even more stringent thereafter, with the ultimate goal of pushing automakers toward an all-EV fleet in coming decades. However, as a practical matter, there are increasing costs to driving emissions to zero. The improvements in fuel efficiency for many models are reaching diminishing returns, so the benefit to the environment of further gains is minimal. In addition, the country is not ready for an all-EV fleet. As EV production ramps up, the costs of needed raw materials will skyrocket, driving up vehicle prices.

Policymakers could speed up progress toward lowering US gasoline usage and vehicle emissions with existing hybrid technology instead. To do this, policymakers would have to stop rewarding ever-higher miles per gallon for some models and instead focus on eliminating the worst gas-burning vehicles. This would bring down fuel usage in the meantime until the economy is readier for wide-scale EV production.

Diminishing Returns. We have made a lot of progress for many vehicles that now get 33 to 50 miles per gallon. At 33 miles per gallon, it would take huge further gains to save little in terms of gasoline usage.

Chart 1 shows miles per gallon on the horizontal axis and the corresponding gallons used to drive 100 miles on the vertical axis. By basing estimates of fuel efficiency on miles per gallon gauges, the gains seem much bigger than they are. As fuel efficiency rises – measured by miles per gallon – the fuel savings decline.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in July suggest a slowdown in the rate of growth. 8 states saw declines in their indexes from June, with West Virginia and Montana down about .6 percent. No state had a gain larger than Pennsylvania’s 1 percent. Massachusetts and Maryland were again the leaders in growth over the last 3 months, but in both cases the increases were not above 3 percent (Massachusetts’ gain rounded up to 3 percent). 36 states had growth of 1 percent or lower, with 5 experiencing outright declines (Montana was down 1 percent). The 12-month numbers look better, with Massachusetts up a remarkable 7.3 percent, and Maryland rising 6.4 percent. Arkansas and Missouri had increases of less than 1 percent.

The independently estimated national figures of growth over the last 3 months (.60 percent) and 12 months (3.25 percent) both look to be roughly in line with what the state figures suggest.

Only 4 states saw statistically significant increases in payrolls in July. Florida picked up 44,500 jobs, while Vermont had a .9 percent gain. The large increase in Vermont is a bit puzzling, since the disruptions caused by major flooding in that state occurred in mid-month, when the payroll count occurs (leisure and hospitality jobs did fall). Still, Vermont jobs had dropped sharply in June, so the July gain may be mostly normalization, perhaps related to seasonal adjustment issues.

7 states had statistically significant drops in unemployment from June to July, led by Pennsylvania’s .3 percentage point fall. Nevada continues to have the highest rate of any state in the nation, at 5.3 percent. 3 states had significant .1 percentage point gains, though a number of others also experienced point increases, led by New Jersey’s .2 percentage point boost. Nevada, DC, and California all had unemployment rates at least one point higher than the national average of 3.5 percent. Alabama, Maine, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, both Dakotas, Utah, Vermont, and Virginia, were all at least a point lower, with New Hampshire at 1.7 percent.

Puerto Rico’s unemployment rate moved up to 6.2 percent. The job count increase of nearly 5,000 did not reverse all of June’s decline. The recent moves were mainly in the public sector.