Viewpoints: 2021

Rapidly rising case numbers, fuelled by the Omicron variant, have once again dampened hopes that the COVID pandemic would shortly come to an end. In the meantime, lingering supply-side bottlenecks, still-high inflation and fading policy support are further derailing expectations for global growth next year. Against this backdrop of gloom is there anything about the global economic scene at present to be positive about?

In the spirit of the current holiday season we'd suggest the answer is yes. In what follows we offer five specific reasons to be a little more cheerful about the outlook than some of the more gloomy commentators might suggest.

1. The Omicron variant does not (yet) to appear to be as harmful as prior strains

The first reason concerns the Omicron variant. To be sure the emergence of that variant is clearly inflicting some damage to global economic activity via stricter social distancing measures, ebbing mobility and heightened consumer fear. However, although Omicron case numbers in South Africa have surged in recent weeks, there has not yet been as much follow-through (yet) into hospitalizations relative to previous strains. What's more there has even less follow-through so far from hospitalizations to fatalities (see chart below). The same is true incidentally from an analysis of other countries that have seen a surge in Omicron cases (e.g. the UK).

It's still far too soon to draw strong conclusions from this but at face value – and at present - this suggests that this strain of the virus, while more contagious, may not be as harmful as previous strains.

Figure 1: South Africa has seen far few hospitalisations and fatalities from Omicron relative to prior strains

Estimates of state real GDP growth varied fairly substantially in 2021:Q3. 13 states saw outright declines; these were mainly commodity (energy and agriculture) intensive ones, but oddly New Hampshire—pretty far from either camp—was the weakest state in the nation, with a 3.3% rate of decline (the Granite State had a massive collapse in government output).

In general, states bordering salt water were stronger than the nation, though that should be taken as more of a curiosity than something of analytical value (aside from New Hampshire, Alaska and Louisiana had negative growth rate). Hawaii's 6.0% rate of growth was the highest in the nation, Delaware was second at 4.7%, DC's figure was 3.9%, and Massachusetts, New Jersey, and Florida all had 3.7% growth rates. By industry, commodity production was generally weak, as was construction, manufacturing, and trade (wholesale and retail). Other sectors generally rose (New Hampshire's strange government decline was almost unique, North Dakota and North Carolina were the only other states not to see increases in government output, and the drops there were much smaller.

It is almost December 23rd and that means that Festivus is nearly upon us. (Actually, Festivus is floating holiday that can be observed whenever one chooses to.) It is traditional on Festivus to air one's grievances. And this Festivus, I got a lot of problems with you people. My problems with you mainly concern inflation – the cause of it rather than the description of it. Related to this is the incorrect, in my opinion, assumption made by the media and many economists that increased government spending causes higher inflation. In addition I have a problem with the media reporting that the headline number of an economic release was higher/lower than economists expected.

The faster rise in consumer prices began to be noticed in the spring of this year. Rather than discussing the cause, economists and the media tended to describe the faster increases in various consumer price indices. For example, the rate of consumer price inflation was increasing because used car prices were racing ahead. And if were not increases in used car prices one month resulting in an increase in a consumer price index, it might be restaurant meals the next month. This reminds me of President Calvin Coolidge's "analysis" of unemployment, to wit, "[w]hen more and more people are thrown out of work, unemployment results." I suspect Cal wished he had been silent on this one. But this was the initial "analysis" of rising consumer price inflation this past spring. Inflation went up because the price of this or that item in a price index went up. This is merely a description of an increase in price inflation.

Then soon we had new definitions of "core" inflation such as all items excluding the prices of food, energy and used cars. In other words, if we exclude items with rising prices, higher inflation rates vanish. In December 2021 energy prices have fallen, which likely will moderate the rate of increase in consumer price indices. I wonder if a new "core" definition will be trotted out, this one including energy prices but excluding shelter costs.

In my opinion, the concept of "core" inflation has done a lot to discredit economists. Fed Chairman Arthur Burns is responsible for its inception. In 1973, the global economy suffered two negative supply shocks – the failure of anchovies to show up off the coast of Peru, which indirectly caused a sharp increase in animal protein prices, and OPEC's decision to cut oil production. Chairman Burns asserted that the increases in food and energy prices were not caused by his management of monetary policy. He was right about food prices; not so much about energy prices. In August 1971 the Nixon administration discarded the 1944 Bretton Woods international monetary arrangement whereby the US dollar was fixed to gold at a price of $35 an ounce and other foreign currencies were tied to the US dollar at fixed rates. So, an era of floating exchange rates was entered into after August 1971. Leading up to and after the 1971 Nixon "shock", Burns oversaw an explosion in the growth of thin-air credit (the blue bars in Chart 1). The foreign exchange value of the US dollar collapsed after the Nixon "shock", as illustrated in Chart 1 by the decline in the US dollar vs. the German D-mark (the red line). What does this have to do with the price of oil? OPEC was receiving US dollars for its sales of oil, US dollars that were declining in terms of purchasing power. In an attempt to restore the purchasing power for the US dollars it was receiving for its oil sales, OPEC raised the US dollar price of their oil by cutting production. And, oh yes, there was the matter of a war between Israel on one side, Egypt and Syria on the other side in October 1973, after which OPEC imposed an embargo on oil sales to countries viewed as Israeli allies. Whether the Yom Kippur War was the real reason for the OPEC embargo or just convenient cover for the action could be debated, as I am sure it will be in comments to this epistle. Why not? ‘Tis the season to air one's grievances.

Having erred in calling the inflation surge transitory, the Fed appears to be making another error in assessing the labor market. The official statement following the December 14-15 FOMC meeting stated that "the Committee expects it will be appropriate to maintain this target range (i.e., on official rates) until labor market conditions have reached levels consistent with the Committee assessments of maximum employment.

What is maximum employment? Maximum employment is a level of employment and joblessness that strikes a healthy balance between demand and supply of labor, resulting in moderate wage increases. The current employment situation is anything but balanced.

November's unemployment rate of 4.2% is 1.8 percentage points below March. The last time the jobless rate starting at 6% fell as much as it did since March was 1950---over 70 years ago. Yet, after that record fall, there are 11 million job openings, 4 million more than the unemployed. Moreover, a record number of small businesses can't find qualified workers, and a record number are planning wage increases.

Average hourly earnings have increased 5.9% in the past year. Workers are demanding more, and companies are rushing to meet those demands by hiking wages and bonuses and promising more.

Labor markets have far passed the point of demand and supply balance. And by not recognizing the tightness of labor markets, the Fed is fueling a faster wage cycle and a different source of inflation.

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

Significant and persistent increases in labor costs could be the next big surprise in the inflation cycle. My research found that the most reliable signal on the labor market is the monthly change in the civilian unemployment rate. Since the spring, the record drop in the civilian unemployment rate indicates that the labor markets have far passed the point of demand and supply balance. That will force companies to continue increasing pay to maintain workers and attract new ones.

November's unemployment rate of 4.2% is 1.8 percentage points below March. Over that period, the jobless rate recorded monthly declines of 0.4 percentage points or more three times. Monthly drops in the jobless rate of 0.4 percentage points or more are rare. It's even rarer to occur when the jobless rate is at or below 6%. It happened four times in the past 50 years, and three of those occurred since March. Also, the last time the jobless rate starting at 6% fell as much as it did in 2021 was 1950---over 70 years ago.

Press reports indicate that companies plan the most significant wage increases in 2022 in over a decade. Yet, with job openings at 11 million and exceeding the number of unemployed by 4 million, the odds are high that wage costs will surprise as much on the upside as commodity and freight costs did in 2021.

A few months ago, large companies, such as Walmart, Costco, and Amazon, announced pay increases and significant pay incentives for workers to stay with the firm in 2022. At those announcements, the jobless rate was around 5%; there is even more pressure now, with the jobless rate approaching 4%. The most severe pressure is likely to be felt in smaller companies (100 or fewer workers) since losing a handful of workers will force others to work longer hours, demanding more pay in the process.

Average hourly earnings have increased 5.9% in the past year but still, trail inflation by 100 basis points. Workers want more. Wage increases have not exceeded consumer price inflation for an extended period since the late 1990s. But, the balance of power between labor and employers has shifted, and faster wage increases are in store for 2022.

So far, the current inflation cycle has been more significant and broader than expected. Despite its scale and persistency, many are forecasting an end to the inflation cycle, citing stable to lower oil prices and easing freight and shipping costs. Yet, that optimistic view contradicts the lessons learned from the 1970s inflation cycles and the political trade-off at the Fed of fighting inflation at the expense of jobs and wages.

Supply-side factors, impacting a wide range of agricultural and industrial commodities, sparked the 1970s inflation cycle. That is similar to what sparked the current inflation cycle. But, years of easy money and expansive fiscal policy extended the 1970s inflation cycle.

Fed policy nowadays is more accommodative than the entire decade of the 1970s. At the same time, the federal government appropriated a record $5.6 trillion in spending (roughly 25% of GDP) over the past two years, with the White House hoping Congress will pass another round of stimulus before year-end. In the 1970s, fiscal stimulus was a fraction of that.

With that monetary and fiscal accommodation scale, it makes more sense to look for reasons the inflation cycle will live instead of dying on its own. Surprised by the 2021 inflation cycle, policymakers and many analysts appear to be making the same mistake by ignoring the factors that could sustain the inflation cycle in 2022.

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

The Bureau of Economic Analysis (BEA) is researching the shortcomings of the owner's rent price index it gets from the Bureau of Labor Statistics (BLS) consumer price index as it plans to change its source data for housing services in the GDP accounts. Shifting to a market-based measure of owners' rents in the PCE inflation measure would be an inflation bombshell.

Assuming everything else equal, a market-based measure of owners' rents would permanently lift the PCE inflation, especially during expansions and the dwindling supply of homes for rent, and put an end to the Fed's elusive chase for 2% inflation. The level of official rates would be markedly higher and sit above inflation rather than below. Could a simple change in the measurement of reported inflation end the decades-long bull market in bonds and equities?

Owners Housing Costs

In its May Survey of Current Business, BEA announced that it planned to include a new current dollar estimate for housing services as part of the annual update to the GDP accounts, using data from the American Community Survey. The article stated that the revisions would affect the current dollar estimates and would not affect the deflators for PCE housing services as they planned to continue to use the CPI rental equivalence measure.

BEA has a dual responsibility, providing an accurate estimation, as best possible, of the nominal and real output values. So, I asked a senior official at BEA why they didn't move away from the CPI measure of owners' rent. Using an improper price deflator for owner-housing would over-state the real value of housing services during cyclical upturns and understate PCE inflation.

The senior official responded, "We are currently in the process of researching possible shortcomings of the current rental equivalence price." Saying they are investigating the issue does not mean a change is coming. But in the nearly two decades of researching and writing about how the CPI understates housing inflation, this is the first time a senior official from a government statistical agency (BEA or BLS) stated to me that they were looking into the issue. Progress?

I shared with BEA the research that I presented in 2005 at a panel session, "Housing Costs in the CPI: What Are We Measuring?" at the National Association of Business Economists Annual Meeting in Chicago. The CPI rent index could be statistically explained with a high degree of accuracy by four factors; the vacancy rate in the rental market, the ratio of the vacancy rates in the rental and owners markets, construction cost inflation, and the change in house prices. Of the four, the vacancy rate is the most critical driver of the change in rents.

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Employing the same approach but replacing the vacancy rate of the rental market with that of the owner market help create an estimated implicit rent for owner-occupied housing. The estimated implicit rent index tracked the BLS series, but a significant divergence appeared when BLS stopped sampling the owners market in 1998. And during the housing cycle of the 2000s, the estimated implicit rent ran considerably faster than the official BLS series; in other words, the change in sampling led to an understatement of CPI and PCE inflation from what would have occurred had the change not been made.

BLS, in its presentation, agreed "that the rental-vacancy rates influence rents, but that it is not clear how the owner-vacancy rate influences the cost of shelter services for owners." Common sense would tell you that if the vacancy rate is essential in one market, it is equally significant in the other. And it is the relative shift in vacancy rates that drive different rent patterns. Suppose the vacancy rate is declining in the owner's market while stagnant or rising in the tenant market. In that case, one will expect the rental rate in owner housing to be increasing relative to the tenant market. But for the past two decades, the CPI rent series shows the opposite tenant's rents rise faster than owners even with higher vacancy rates.

A market-based measure of owner-occupied rents would have zero effect on the economy. But there would be spillover effects on the economy and finance as policymakers respond to a permanently higher reported PCE inflation rate. That's because the days of monetary policy trying to achieve a 2% inflation rate would be over and replaced by policymakers attempting to limit the cyclical uptick in inflation. The transition would not be seamless, and the payback in finance could be significant as higher reported inflation increases volatility and risks. Stay tuned.

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