Viewpoints: December 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.