Haver Analytics
Haver Analytics

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

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • Pent-up demand and record monetary and fiscal stimulus drove' inflation's first act. Inflation's second act will revolve around higher house prices, partly driven by record financial wealth and higher wages. Inflation's second act may not run as hot as the first, but it will only be broken with a monetary response.

    Statistically, reported inflation has been decelerating, but actual inflation, especially core inflation, has risen again. House price inflation, which is not part of the official price index, has rebounded over the past five months and stands nearly 5% higher than year-ago levels, according to the Cass-Shiller home price index.

    The government measure of consumer prices does not include house prices but instead uses an imputed rent measure as a substitute or proxy. But that is not a measure of inflation. For one, it's not an actual price; secondly, no homeowners have ever experienced or paid that inflation. To be accurate and timely, inflation measurement must use transactional prices that people confront in the marketplace. One of the reasons the spike in core inflation in recent years was not as disorderly as previous periods of similar inflation was because two-thirds of households, or homeowners, never felt or experienced it.

    House price inflation could run hot for many months. Household's direct holdings of equities relative to real estate stand at close to their highest level recorded during the tech boom. Back then, there was massive portfolio reshuffling away from equities and toward tangible assets, and it should happen again, especially given the sharp drop in borrowing costs in recent months.

    The second act of the inflation cycle will also include significant wage increases. In Q4, UPS workers won the most lucrative wage and benefits package in history, lifting wages immediately by roughly 10%. UAW won an 11% wage increase in year one and additional gains over the contract's life. That triggered a flurry of wage increases at non-union companies; for example, Volkswagen raised pay by 11% at its Tennessee plant, Nissan increased wages by 10%, Honda an 11% increase, Toyota by 9%, Tesla hiked wages by 9% at its battery plant, and Hyundai said it would lift wages by 25% over a series of years. Also, Congress recently approved a 5.2% pay increase for federal workers, the most significant annual increase in forty years.

    The large and broad wage increases indicate at least a 5% increase in the employment cost index (ECI) in 2024. Since the ECI series started in 1983, there have been only three years in which the annual increase topped 5%, the last being 1990. 2024 should be the fourth; at some point during the year, the Fed will realize a 5% increase in employee costs is inconsistent with a 2% inflation target.

    Inflation's second act may not run as hot as the first, but it will be hard to break without a monetary policy response.

  • At the outset of 2023, most forecasters, even some policymakers, thought a mild recession was in store for the economy. Yet, the economy expanded at an annualized rate of 3% during the first three quarters and looks to grow somewhat slower in the fourth quarter. What happened? Here are five reasons why the economy beat the odds and did not fall into a recession in 2023.

    First, the inverted Treasury yield curve was "artificial." The inversion of the yield curve in the fourth quarter of 2022 was one of the most cited reasons for the recession occurring in 2023, especially with the Fed telegraphing more official rate hikes. But yield curve inversion was a direct result of another Fed policy tool.

    Before the Federal Reserve started raising official rates in March 2022, it embarked on the most extensive quantitative easing (QE) program in history, purchasing approximately $4.5 trillion of debt securities in 24 months. The primary purpose of QE is to keep long-term interest rates (one side of the yield curve measure) lower than otherwise would be the case. Some analysts estimated QE was the equivalent of 150 to 250 basis points of Fed easing. Even today, the Fed's balance sheet is approximately $3.5 trillion above when they started QE in March 2020.

    Second, monetary policy was not restrictive. Monetary policy influences the growth of nominal spending. At the end of Q3 2023, nominal GDP growth of 6.3% of the past year was still 100 basis points over the fed funds rate level. There has never been a recession in the past 50 years in which the level of federal funds did not equal or exceed the growth in nominal GDP.

    Third, interest-sensitive sectors grew in 2023. The goods and structures sectors expanded each quarter in 2023, hitting a new record high in Q3, with an annualized growth rate of 6.9% and 3% in the past twelve months. If the economy were to enter or be in a recession, it would be most visible in these two sectors as they have consistently contracted during recession periods.

    Fourth, labor demand outpaced labor supply. In 2023, the labor market was unbalanced, with the number of job openings exceeding the number of unemployed workers. At the end of Q3 2023, there were 9.5 million job openings or 1.5 jobs for every unemployed person.

    Fifth, household liquidity grew in 2023. Based on the current level of equity prices and the rally in bond yields, household direct holdings of equities, debt securities, and deposits are estimated to increase between $10 and $15 trillion in 2023. Fed tightening cycles are supposed to drain liquidity, but that did not happen in 2023.

    Many of these factors are still operative for 2024. The most significant positive factors for 2024 are the need for labor and the growth in household liquidity, as both would support continued growth in consumer spending.

    The wild card is what happens to official and market interest rates in 2024. If the Fed raises official rates again, market rates could quickly reverse the recent decline in yields. That would have a huge and abrupt negative impact on equity prices and household liquidity; people's equity holdings account for 55% of total liquid assets directly held.

    Many factors could trigger a bad outcome in 2024. But those factors need to drain liquidity and trigger contraction in interest-sensitive sectors based on the history of recessions.

  • Monetary policy influences nominal spending in the economy. In the third quarter, nominal GDP grew 8.6% annualized. So far, in 2023, nominal GDP is running at an annualized pace of 6%. That follows a 10.6% gain in 2021 and a 9.1% gain in 2022. The three-year increase, 2021 to 2023, represents the fastest three-year advance in nominal GDP since the mid-1980s.

    The economy's nominal growth performance has two critical messages/implications for policymakers and analysts/portfolio managers regarding Fed policy and market rates.

    First, except for the non-economic slowdown following the pandemic, it has taken a Fed funds rate equal to or above the growth in nominal GDP to engineer a sustained growth slowdown/recession. The target on the Fed Funds rate is still 75 basis points below the growth in nominal GDP.

    Second, many analysts and portfolio managers still expect a return soon to the interest rate pattern of 2008 to 2020. Yet, that interest rate pattern was abnormal, as was the nominal growth path in the economy. Only once did nominal GDP grow more than 5% during those twelve years, which occurred in 2018. The average gain was about 4%.

    The interest rate pattern more applicable to the economy's current growth performance and policymakers' intent to lower inflation is from the mid-1980s to the mid-1990s. At the start of that period, the Fed funds rate, as did the 10-year Treasury yield, exceeded the Nominal GDP growth. Then, in the later part, nominal growth and nominal rates were more in line with one another.

    The longer it takes the Fed to adjust policy to the current growth dynamics, the longer it will be before the economy slows and market rates fall.

  • Critics argue that the current inflation rate is much lower than the published rate. That is true; based on the current methodology, "real-time" consumer inflation is less than the published rate. Thirty-five percent of the prices used to estimate the consumer price index are not for the current month but reflect the prices over several months, according to the Bureau of Labor Statistics. Most of that involves the owner's rent index. Because rents change infrequently, the Bureau of Labor Statistics measures these service prices over six-month spans.

    The owner's rent index is the brainchild of government statisticians and academia, supported by politicians who want a lower, less volatile price index. Yet, the owner's rent index has two "major" problems.

    First, it is not a current price. Rent changes, up or down, would not be captured in the CPI until six months after they occurred. So, given its massive weight in the index, owners' rent would result in reported inflation running below current inflation at the beginning of the rent price cycle and overstate it at the end.

    Second, it is not an actual price. The owner's rent index is supposed to measure or capture inflation experienced by people who own a house. But no homeowner pays that price. Economists and policymakers often talk about demand destruction from higher inflation, but there is no demand destruction here since no one pays the price.

    A "real-time" and more accurate measure of inflation would require a shift back to the inflation methodology pre-1983. That would include house prices and mortgage rates, creating a real-time, more volatile, and higher published inflation rate. So pick your poison---a flawed index or a higher volatile index? Complaints about the current CPI are frequent, but they would only get louder if a shift to a real-time measure of inflation occurred.

  • 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.