Joseph G. Carson

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 Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
 

Federal Reserve Chairman Jerome Powell has played down the current runup in inflation, arguing it is associated with the reopening of the economy. And as the low inflation readings of one year ago drop out, the twelve-month calculation (i.e., the so-called base effect) of reported inflation is likely to move up in the coming months.

Yet, Mr. Powell's "base effect" inflation argument is nonsense. For the "base effect" argument to be correct, the twelve-month reading of reported inflation should be markedly lower when the economy was closed than what occurred before the pandemic. But that's not the case.

Last week, the Bureau of Economic Analysis reported that the twelve-month change ending in March 2021 in the core personal consumption index (the Fed's preferred price index) was 1.83%. That compares to the 1.87% reading for the year ending in February 2020 and 1.7% for the year before that.

The 1.83% reading for twelve months ending March 2021 essentially matches the average inflation rate of the two prior years. And that 12 month period includes the three months (April to June) when the economy was closed, and GDP plunged a record 31% annualized. How could there be a "base effect" on reported inflation when the base year has the same inflation rate as it did before the pandemic?

Mr. Powell's "base effect" inflation argument has not been questioned or challenged by analysts or reporters. Regardless of that, investors need to ignore the Fed's rhetoric and treat upcoming price increases as "new" inflation.

As nonsensical as the explanation for the uptick in inflation, so too is the remedy. Demand has always been the primary force behind broad inflation cycles. Yet, Mr. Powell argues that product price inflation will ease once manufacturers increase output and eliminate "supply bottlenecks," and home inflation will slow once builders build more homes.

It's hard to see how more supply (or growth) will slow inflation anytime soon. Federal Home Loan Mortgage Company (Freddie Mac) estimates that the US needs almost 4 million new homes to meet demand. That could take two to three years. Also, it's hard to see how increasing product output will solve the inflation problem. The supply-side argument solution; fight inflation with more demand and more commodity inflation.

The Fed's mantra has always been "inflation is everywhere and always a monetary phenomenon." But nowhere in Mr. Powell's statements or comments do you find any monetary policy role for increased inflation or any responsibility for containment. Investors forewarned.

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Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics. Federal Reserve Chairman Jerome Powell has played down the current runup in inflation, arguing it is associated with the reopening [...]

The Fed's "Base-Effect" Inflation Argument Is Nonsense

Sticky services prices behind sticky overall PCE inflation

Flash April PMIs point to slower growth in the US but a pickup in Europe and Japan

Outlook strengthens for US while it weakens for other major economies

Crude petroleum prices are having a big impact on inflation expectations

Inflation surprising to upside in the US; by contrast to the downside in the euro area

 Gross Domestic Income is catching up with GDP

FOMC expects GDP growth above trend over the next three years

US core CPI inflation has begun to reaccelerate

Fiscal-policy aided factory building in the U.S. provided an unusually large boost to growth last year

US consumers much more optimistic than those in the Euro area and the UK

  Job openings take a step down in 2024

Fed's super core services inflation measure pushing up core rate

Blue Chip forecasters expect significant monetary easing this year except in Japan

Euro area economy stagnating while US grows above trend

Chinese and Japanese equity markets are diverging markedly

Chinese population declines in 2023 for second consecutive year

Outlook for US GDP growth on the rise; declining in euro area, Japan and China

There are still 1.4 job openings for every unemployed person in the US

US PCE inflation over the past six months has slowed to the Fed's 2% target

FOMC think rate hikes are done and looks for 75bps of decline in 2024

Weaker economic data surprises pushing down US interest rates

Recent disinflation has been widespread across Europe and North America

Recent decline in US inflation expectations helping to lower interest rates

China is losing its luster as foreign direct investment heads out

Blue Chip forecasters think Fed will be tighter for longer

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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.

How Fast Are Labor Costs Rising?  Faster Than You Think

Ken Matheny

**The US economy is stronger than suggested by the “soft” 1.6% increase in GDP in the first quarter, while a sharp upturn of inflation puts Fed rate cuts on hold for at least several months.**

**Look to final sales to private domestic purchasers, not GDP, for a better indication of the economy’s underlying strength.**
The initial (“advance”) report of the national accounts for the first quarter of 2024 should be interpreted carefully.  Looking beyond the headline figures, the economy’s underlying growth momentum was notably stronger than the disappointing figure of 1.6% quarterly GDP growth in the first quarter.  GDP growth was held down by declines in components that tend to be more volatile  --- inventories and net exports --- in contrast to solid growth in other components, including consumer spending and private investment.  Personal consumption expenditures (PCE) posted solid growth (of 2.9%).  Business fixed investment also rose 2.9%, while residential investment jumped 13.9%, continuing a recovery that began in the second half of 2024.

A more telling indicator of the US economy’s underlying strength is final sales to private domestic purchasers, which rose at a solid 3.1% annual rate in the first quarter, virtually identical to increases in the third and fourth quarters of 2023 of 3.0% and 3.3%, respectively.  This is a clear if preliminary indication that the economy retains solid momentum for growth.

Together, declines in inventory investment and net exports subtracted 1.2 percentage points from GDP growth in the first quarter, but those components are not likely to continue to subtract large amounts from GDP growth on an ongoing basis, even though quarterly swings could be significant (in either direction) from time to time.  The level of inventory investment ($35 billion in the first quarter) is broadly sustainable, suggesting that repeated large declines are not the most likely outcome.  Net exports have been in a sideways waffle since the second half of 2022.  Future large declines are possible if foreign demand were to collapse or the dollar were to appreciate sharply, but neither of those outcomes appear to be highly likely at this juncture.  In short, the 3.1% growth in final sales to domestic purchasers is a better indicator of underlying strength in demand than the smaller 1.6% increase in GDP in the first quarter.

Of course, GDP and other estimates are subject to revision, so the picture of first-quarter growth could be altered in coming months.

**Inflation surged in the first quarter, nearly eliminating any prospect for a Fed rate cut prior to this fall.**
Another major component in today’s report on the national accounts was a disturbing increase in consumer inflation.  The price index for personal consumption expenditures (PCE) rose at a 3.4% annual rate in the first quarter, the largest increase since the first quarter of 2023.  Meanwhile, the core PCE price index rose at an even higher 3.7% annual rate in the first quarter, far above the increase of 2.0% in the final two quarters of last year.  This is a direct challenge to any hope that the Federal Reserve will begin to lower interest rates in coming months.  As of the first quarter, the annual (four-quarter) increase in the core PCE price index was 2.9%.  It is likely that tomorrow’s report on monthly PCE will show annual (12-month) inflation at or slightly above February’s 2.8% reading.

The Federal Open Market Committee (FOMC) will almost certainly not begin to seriously contemplate rate cuts without clear indications that inflation is easing and well on track to fall to 2% over time.  The latest inflation figures suggest that progress on bringing inflation down has stalled.  It will take more than one or two “good” monthly inflation reports to convince policymakers that it is appropriate to begin cutting interest rates.  This makes any rate cut prior to this fall a low probability outcome and adds to the risk that there might not be any Fed rate cut in 2024.

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First-Quarter 2024 National Accounts

Charles Steindel

The Federal Reserve Bank of Philadelphia’s state coincident indexes in March showed some moderate variance. Four states were down slightly from February. The largest increase was Arizona’s .8 percent; three other states (Iowa, Delaware, and Vermont) had gains of at least .5 percent. Over the three months since December, Massachusetts was up 1.9 percent, while 8 other states (scattered across the nation) rose more than 1 percent. Over the last 12 months, Massachusetts again led, with an increase of 4.9 percent, while New York’s 3.6 percent was a fairly distant second. 5 states were down over the period, with Montana’s slump continuing, with a loss of 3 percent.

The independently estimated national figures of growth over the last 3 months (.75 percent) may be a touch higher than the state estimates would have suggested, but the 12-month figure (2.9) percent) looks to be roughly in line with the state numbers.

State Coincident Indexes in March 2024

Viewpoints: May 2021

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The Fed's "Base-Effect" Inflation Argument Is Nonsense