Viewpoints: October 2022

The Federal Reserve Bank of Philadelphia's state coincident indexes in September were again somewhat softer than earlier, and somewhat dispersed. 11 states report declines from August to September, with Montana down .59 percent. On the plus side, both Hawaii and New Jersey clocked increases above 1 percent and New York was just shy at .99 (the Northeast was strong, with Massachusetts and Maryland both comparable to New York, and Pennsylvania at .59 percent). At the three-month horizon, six states declined, with West Virginia and Montana, as in the initial August report, both off by more than one percent. Hawaii and Indiana both had increases above 2 percent. Over the past 12 months, Massachusetts's index was up more than 9 1/2 percent, and 25 other states had increase of at least 5 percent. Four states (Arizona, Wisconsin, Oklahoma, and Mississippi) had increases of less than 3 percent over this period.

As always seems to be the case, the independently estimated national figures of growth over the last 3 (1.02 percent) and 12 (4.98 percent) months look weaker than the state figures would imply.

Connecticut and Hawaii remain under-by very small margins--their pre-pandemic peaks in this series.

The resiliency of the corporate sector has been one of the surprises in 2022. Despite a volatile and uneven economy and a series of interest rate hikes from the Federal Reserve, the corporate sector has maintained record profitability and near-record profit margins. The high-profit margins may be the biggest surprise as it confirms that cost increases have been passed along and not absorbed. That dynamic makes the Fed's job of slowing inflation much more difficult, as it shows an "acceptance" of price increases.

In 2021, real operating profit margins for nonfinancial companies stood at 15.7%, the highest level since the mid-1960s. Surprisingly, companies simultaneously passed along the higher costs of materials, supplies, and labor and lifted margins in the process. And the spread of 275 basis points between final prices and total unit costs was the second widest since the 1960s.

Real operating margins have remained relatively high in the first half of 2022. At 15.5%, real profit margins for nonfinancial companies are still 300 basis points above the levels that were in place before the pandemic.

Q3 data on profit margins are not yet available. But, the price and wage data suggest margins held up if not expanded. To be sure, core consumer prices of 6.4% annualized and core producer finished goods prices of 7% were 100 to 175 basis points over the increase in wages for non-supervisory private workers. Firms' total unit costs were probably lifted somewhat due to rising finance costs.

High-profit margins help to explain why job growth has continued to be so strong this year. Companies added over 1 million workers in the third quarter, about the same number as in the prior quarter. That robust pace of hiring is not something that one would expect if companies, in the aggregate, were experiencing intense downward pressure on margins from rising costs.

Policymakers will never publicly admit this, but the Fed wants an environment where companies cannot pass along cost increases into final prices. That would lead to a decline in margins, a typical outcome during slower growth periods or recessions, eventually forcing cost cuts, including layoffs, less demand, and slower inflation.

Policymakers place a lot of emphasis on inflation expectations, but that is a "soft-data" measure of what people would like to see or expect versus what they are doing or accepting, as is captured in the "hard data" measure of companies' profit margins. Near-record high-profit margins indicate the Fed's job of fighting inflation is far from over, raising the risk that official rates have to go much higher than is shown in policymakers' dot plots or future prices.

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

To quote Mark Twain, "The report of my death was an exaggeration." I just have not had anything to say that tickled my fancy as I have watched the Fed drive the US economy toward a recession, which I think will commence in Q1:2023, as it tries to compensate for the policy error it committed in 2020-2021. Although I believe a 2023 recession is inevitable, I also believe that it will be a relatively mild one because the latest data available suggest that the balance sheets of households, nonfinancial corporations and commercial banks are in good shape. Admittedly, the latest data available are somewhat dated, being Q2:2022 for households and nonfinancial corporations and Q1:2022 for commercial banks.

Let's start with households. Plotted in Chart 1 are quarterly values of domestic deposits plus money market funds held by households as a percent of the dollar amount of household loans outstanding. As of Q2:2022, household deposit/money market fund assets were 101.0% of the amount of their outstanding loans. In Q4:2007, the peak in the business cycle before entering the Great Recession, this ratio was only 57.0%. Thus, households are cash rich as we slip into the next recession.

Investors should be cautious of a policy pause or pivot as it might bring short-term gain at the expense of long-term pain. No one is better than Mr. Volcker at knowing that quick pivots or reversals in the fight against inflation don't end well. Mr. Volcker abandoned his inflation fight in early 1980 following the sharp plunge in the economy (at the time, it was the sharpest one-quarter drop in GDP in the post-war period) associated with the imposition of credit controls.

After lifting official rates by more than 1000 basis points over several months, Volcker dropped them equally fast, only to resume his inflation fight later in the year. Volcker eventually raised official rates to higher highs in the next two years, underscoring the critical point of inflation cycles; that they do not die quickly or easily.

Nowadays, there is nothing on the horizon that would trigger an economic decline equal to that of the 1980's drop. But that's not the critical point. Killing inflation cycles require a significant reset of economic and financial conditions following a fundamental tightening of monetary policy. The sharp two-day rally in equities this week based on the slightest hint of a policy pause shows investors' risk-taking appetite is alive and well. If that is still alive, so is the economy's growth and inflation appetite.

Yet, it is hard to deny that things are lining up for Fed Powell to pause at some point. For example, prices paid diffusion indices from the Institute of Supply Management for manufacturing and the service sector provides a snapshot of cost pressures. Both price measures fell to their lowest levels in roughly two years in September.

Yet, it is worth noting that diffusion indexes track the breadth of increases (or decreases) and do not distinguish the magnitude of change. So while cost pressures have subsided, they have not disappeared completely. Also, the service sector's price index at 68% remains elevated, which has to do with two things: services use fewer commodities than manufacturing, and labor is a more significant part of their cost. Since the inflation cycle is increasingly becoming a service sector phenomenon, rising labor costs remain the biggest wild card for the inflation cycle.

The number of job openings stood at 10 million in August, off 1.1 million from July, but still far above pre-pandemic levels. And, with 1.7 job openings for every unemployed worker, companies, especially in the service sector, will need to pay up to attract labor.

Tightness in the labor markets will not be an obstacle for Fed Powell to pause after the Fed follows through on hiking rates at the next two meetings, as suggested in the latest policymakers' projections. Yet, it does create the risk of a pickup of inflation and higher official rates later. That's because, without sufficient slack in the labor markets, companies would still face the same labor cost conditions as they do today, raising the prospect of an extended inflation cycle.

Inflation cycles are not linear, nor do they end in a day, week, or month. It takes time to stop and reverse. Policymakers say they must maintain restrictive policy rates for some time to kill inflation. Yet, will politics and investors let them?

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