Viewpoints

State labor markets were somewhat improved in August. Four states reported a statistically significant increase in jobs—California gained 39,400 and New Mexico Eight states saw statistically significant drops in their unemployment rate, though none was larger than .2 percentage points. The highest unemployment rates were in DC (5.7%), Connecticut (5.1%), Oregon (5.1%), California (5.1%), and Michigan (5.0%). Nebraska, New Hampshire, Hawaii, Vermont, North Dakota, and South Dakota had unemployment rates under 3.0%, while South Dakota’s 2.0% was the lowest in the nation.

Puerto Rico’s unemployment rate increased to 6.1%, reflecting a .7% increase in the island’s labor force (July saw a .8% rise), while the island’s job count was up 1,000.

10-year Treasury yields averaged 4.2% in the 12 months ending February 2026. They now hover near 5%, a significant increase. Besides higher oil prices, several explanations are plausible. Real rates have risen associated with the sustained healthy economic growth and higher expected rates of return on investment, particularly reflecting the booming AI buildout that is involving more debt financing. Inflationary expectations have remained generally well-anchored, but market-based measures have risen a few tenths of a percent. And the persistence of budget deficits and projections of ever-rising government debt-to-GDP may be exerting pressure on yields.

This note focuses on oil prices and yields. As a temporary negative supply shock to the economy, the higher oil prices are supposed to hurt economic activity which may be associated with lower real rates and are not supposed to impact intermediate and longer-run inflationary expectations. But Chart 1 shows convincingly that short-run movements in WTI oil spot prices (measured in 21-day changes in dollar-per barrel) and 10-year Treasuries (21-day percentage point changes) have been very closely correlated since end of February 2026 when the bombing in Iran commenced. Chart 2 shows that the levels of the Treasury yields and oil prices.

WTI rose dramatically from $65/barrel end-of February to the high-$90s end-of-March, bounced around and rose to $108 in May and plummeted to $70 in early July during the temporary ceasefire and then ratcheted up during the summer to its current above $102. Treasury bond yields rose and fell and rose again with these fluctuations.

At the recent Jackson Hole annual Kansas City barbecue, Fed Chairman Warsh mentioned that if the Fed had paid more attention to the surge in the M2 money supply in 2021, it might have raised the federal funds rate sooner, which, in turn, might have moderated the sharp increase in consumer price inflation that ensued. Wow! The ghost of Milton Friedman, may his memory be a blessing, must have been talking to Warsh while he was at Stanford’s Hoover Institution. The Fed could do worse than paying more attention to the behavior of the M2 money supply. It could do better, though, by paying more attention to behavior of the sum of the monetary base (reserves of depository institutions held at the Fed plus currency) plus securities and loans on the books of depository institutions (broad thin-air credit). But where Fed Chairman does not quite get it is his continued emphasis on using the federal funds interest rate as the Fed’s operating instrument. If the ghosts of Milton Friedman and Robert Laurent (also, may his memory be a blessing) would have had more séance time with Warsh, they might have been able to convince him to abandon using the federal funds interest rate as the Fed’s policy instrument and instead directly set the level of depository institution reserves such that a constant rate of growth in a monetary quantity, be it M2 or thin-air credit, could be achieved. This would require some institutional changes such as the elimination of interest payments on reserves and the re-introduction of reserve requirements. (See, my August 25, 2026 commentary “A Modest Monetary Policy Proposal for Fed Chairman Warsh to Consider” for a discussion of these necessary institutional changes.)

Let’s compare the relationship between percentage changes in the M2 money supply and thin-air credit with goods/services price inflation. Plotted in Chart 1 are the percent changes in the annual averages of the M2 money supply (the blue bars) vs. the percent changes in the annual averages of the Gross Domestic Purchases chain-price index (the red line) starting in 1960. The highest positive correlation between the two series occurs when percent changes in M2 are advanced (lead) by two years. The correlation coefficient is 0.48. Although a correlation coefficient of 0.48 is a long way from the maximum possible value of 1.00, it’s not bad for government work.

There is little to get excited about in the ASEAN-4 cyclical picture. Westbourne Research is underweight Indonesia across asset classes and has become distinctly more pessimistic about its cyclical and structural growth prospects. It is also underweight Malaysian equities and remains ambivalent about the Philippine and Thai stock markets. On sovereign bonds and currencies, positioning is either neutral or underweight.

Figure 1 shows the business-cycle assessment for the big four. As expected, economic activity slowed modestly in Indonesia and the Philippines in the second quarter. More concerning is Indonesia, where the corporate profit cycle has deteriorated sharply, moving from upswing to downturn, while both investment and credit remain in downswing. The positives are recovering broad-money growth and a falling real cost of capital, despite Bank Indonesia raising policy rates by 100bp since January 2026. In the Philippines, the only material change is the inflation signal, which has turned positive.

The latest round of inflation releases will help determine what central banks do next. A larger question lies behind the monthly numbers. Has inflation once again become more responsive to economic pressure? For much of the decade after the global financial crisis, falling unemployment generated surprisingly little inflation. That apparent flattening of the Phillips curve, the relationship between economic slack and inflation, encouraged policymakers to believe that economies could run hot at relatively little cost. Evidence since 2020 suggests that assumption is now less secure.

This argument complements, rather than overturns, the analysis in The age of abundance is over. That article argued that today’s inflation overshoot largely reflects scarcer labour, energy and productive capacity, none of which higher interest rates can directly replace. The evidence considered here makes a separate point. Even if supply constraints explain much of the current level of inflation, additional demand may now pass into prices more readily than it did in the 2010s. The source of inflation and its sensitivity to demand are related questions, but they are not the same question.

The evidence from the United States The US provides the clearest example. Comparing a real-time measure of economic tightness with inflation one year later reveals a marked break after 2020. Before then, a one-standard-deviation rise in the tightness measure was associated with an increase of about 0.4 percentage points in subsequent inflation. Since 2020, the estimated response has been roughly four times as large, at about 1.7 percentage points (Figure 1). Put simply, inflation now appears to react more strongly when demand presses against the economy’s capacity.

In recent months the maritime supply chain of oil and petroleum, especially via the Middle East, has come under immense strain. The ongoing disruptions to sensitive maritime chokepoints make the economics around it increasingly precarious. The Strait of Hormuz has been heavily restricted since March 2, 2026 and as of August 30, 2026 remains effectively closed. According to the EIA, prior to the conflict roughly a fifth of global oil consumption and LNG trade flowed through this chokepoint. There was a partial opening that lasted from June 17, 2026 to July 14, 2026. More recently on July 20, 2026 Yemen’s Houthi movement declared a naval blockade and maritime embargo on Bab el Mandeb strait. Together, the two disruptions have exposed the limited scope for rerouting and increased the risk of a more persistent energy-price shock. In this piece, we examine their impact on tanker shipping routes and Saudi Arabia’s oil trade, using IMF PortWatch data available in Haver’s TRANSPRT Database.

A closer look at chokepoints: Limitations of rerouting

In the month following the closure of Strait of Hormuz, tanker trade volume through Hormuz collapsed to 22.8 thousand tons from 1.97 million tons over the previous 30 days. This difference in lost volume was not absorbed by the aggregate of the remaining chokepoints – Suez Canal (Egypt), Bab el Mandeb (Yemen) and Cape of Good Hope (South Africa) – as the net volume through the alternate corridor remained nearly steady and has actually begun to fall off in the latest month (Figure 1 Blue line).

There were some significant gains made during the partial reopening from June 17 to July 14, where Hormuz tanker volume regained 29.5 percent of its original value. However, the Houthi blockade (July 20) triggered a second, compounding decline, this time visible on all three lines (Figure 1). Hormuz dropped again, and the alternate corridor (which had shown slight gains at that time) dropped as well. These were not two independent shocks; the second disruption hit the very route ships had been relying on to cope with the first.

The US has maintained a strong naval presence in the region and has led Operation Prosperity Guardian, a multinational coalition set up in December 2023, which aims to protect commercial shipping in the Red Sea. The challenge is the asymmetry of the threat from the Houthis: cheap drone and missile attacks on tankers and naval escorts are hard to fully deter, so even a partial or a threatened blockade has proven effective.

The employment report confirmed that the labor market is roughly in equilibrium. Now focus shifts to the August inflation data. I think a rate hike is quite likely on the 15th if the August data either match or exceed consensus forecasts.

In times like this, data dependence make sense

The Fed is often criticized for being too “data dependent.” Critics argue that tying policy to upcoming data: (1) makes the Fed backward looking, (2) adds to volatility as markets over-react to each release, and (3) signals the lack of a fundamental framework.

I disagree. After a period of hawkish or dovish news, there is always a period of high data dependence. At that stage incoming data becomes the final straw. In this instance high and rising inflation (chart) has created a strong focus on the August inflation data. After 65 months of above-target inflation, every member of the FOMC wants to hike if inflation does not return to target in a “timely manner.”

Kevin Warsh used his first Jackson Hole address as chairman of the Federal Reserve last week to signal that the next move in US interest rates is more likely to be up than down. He is not alone. The European Central Bank raised rates in June and may go further, and several other central banks have turned hawkish. It is a puzzle. Growth has slowed, unemployment has drifted up, and core inflation across the advanced economies is not far above target. Why is the world's monetary tide turning towards tightening?

The official answer is that they are guarding against a shift in expectations. Supply-driven inflation need not persist; it does so only if firms and households come to expect it, and set wages and prices accordingly. Having misjudged the 2021 shock as transitory, central bankers are unwilling to take that chance a second time. So they are tightening not to reverse the shock, which no rate can do, but to keep expectations anchored.

That, though, is the lesser part of the story. The central banks are treating as a cyclical episode what is in truth a change of regime. For a generation the advanced economies enjoyed abundant supply and abundant capital: globalisation held down the price of goods, a global surplus of saving held down the price of money, and monetary policy had only to manage demand. Both conditions are now reversing, together. Supply has become scarce and costly; so has capital; and the two are related. The consequences are large. Inflation of this kind cannot be brought down by interest rates, only resisted at the cost of a recession. The real cost of capital has risen durably, not cyclically. And investors positioned for the old regime — a central bank that eases into every downturn, government bonds that hedge equities, real rates that subside to their former lows — are positioned for a world that will not return.

Supply has tightened on every front. In the past month alone the United States imposed 50 per cent tariffs on Canadian goods; American forces struck Iranian launchers at the Strait of Hormuz, returning Brent above $90; and a glacier collapse on the Nepal-Tibet border destroyed a regional trade route. Each raised costs, and none can be addressed by a policy rate. To these has been added a contraction in the supply of labour. The administration's immigration enforcement, recently extended to withdraw work authorisation from more than a million people, has reduced the workforce available to construction, agriculture and services, and raised wage costs in those sectors. None of this is a temporary deviation from a stable trend. The real cost of energy has risen for a quarter of a century to a record; reshoring is reconstructing supply chains at higher cost; and demographic change was tightening labour markets before enforcement intensified. The cheap and frictionless supply of the globalisation era has ended.

The data bear this out. Decompose US core inflation into demand- and supply-driven components and the demand-driven part has fallen to around one percentage point, with supply accounting for almost the entire excess over target (Figure 1). Across the G10, core rates are grouped close to target, none much above two and a half per cent (Figure 2). The demand that monetary policy governs has already been contained; wage growth is slowing, and market-based measures of inflation expectations remain near target. What sustains inflation above target is supply.