Viewpoints: 2022

The Federal Reserve Bank of Philadelphia’s state coincident indexes in October softened, with only 23 states reporting gains from September, one (California) unchanged, and 26 seeing declines. Maryland’s index fell more than 1 percent, while number 1 Hawaii was up only .77 percent, which is fairly modest for a leader. At the three-month horizon, eleven states were down, with Maine and Montana off by more than 1 percent and West Virginia just short of that (.99 percent). On the upside, Hawaii and Alaska saw increases of more than 2 percent. Over the past 12 months, Massachusetts’s index was up nearly 9 percent, and 18 other states had increase of at least 5 percent Both Mississippi and Oklahoma had increases of less than 2 percent over this period. In all cases noted (growth at the top, numbers growing slowly and rapidly) the October results were less robust than September’s initial numbers.

Yet again, the independently estimated national figures of growth over the last 3 (.69 percent) and 12 (4.60 percent) months look weaker than the state figures would imply. These results were also lower than in the initial September report.

Hawaii has surpassed its pre-pandemic peak in this series; Connecticut is still short, by the smallest of margins. Connecticut’s index dropped in October, but its revised September reading was 121.49. The state’s peak was 121.50 in March 2020.

State labor market results in October were softer than in the last couple of years, though not very weak. Seven states had statistically significant increases in payrolls, with Colorado’s .8 percent gain the largest in those terms. California picked up more than 50,000 jobs, and Texas slightly short of that. Over the last 12 months, every state (and DC) saw a gain in payrolls, thought the increases in Alaska, DC, Mississippi, and Wyoming were not deemed to be statistically significant. Florida and Texas were the only states to see gains of at least 5.0 percent (California’s absolute increase was a hair larger than Texas’s.

A full 24 states experienced statistically significant increases in their unemployment rates from September to October (Pennsylvania’s fell .1 percentage point to 4.0 percent), but in the vast majority of cases these were, in absolute terms, fairly modest. Only Maryland’s .5 percentage point rise (from 4.0 to 4.5 percent) would normally be considered large. Unemployment rates remain fairly low across the nation DC’s rate is the highest tin the nation, at 4.8 percent, while Illinois and Nevada are both at 4.6 percent. Seven states have rates of 2.4 percent or lower.

Puerto Rico’s job count was little-changed, and for a second straight month there was insufficient information to compute the unemployment rate on the island.

One of the worst courses I took in undergraduate school was an introduction to management “science”. The only thing I remember from that class is that if one has responsibility for some outcome, one should have the authority to influence that outcome. As we approach the midterm elections, the Republicans are holding the Democrats responsible for the higher inflation that has been experienced in the past two years. The Republicans claim that the high inflation is primarily due to the rapid growth in federal government spending implemented by President Biden and his fellow congressional Democrats, forgetting that a sizeable increase in government spending occurred on the watch of President Biden’s Republican predecessor. Perhaps President Nixon was correct when he exclaimed that we are all Keynesians now.

I will argue, however, that Federal Reserve monetary policy is primarily responsible for the behavior of inflation, not federal government spending. If this is true and the executive and its political party are going to be held responsible for the rate of inflation, then it follows from Management 101 that the executive branch should have the authority to manage monetary policy, not the semi-autonomous Federal Reserve. My wife did not coin the term “econtrarian” to describe me for nothing.

Let’s go through the verbal argument as to why monetary policy, not fiscal policy has the primary influence on the behavior of the inflation rate. If the government increases spending, from where does the funding of this new spending come? It comes from either an increase in taxes or an increase in securities issuance, i.e., borrowing. If taxes are increased, some entities, on net, must decrease their current spending. (There is the possibility that entities could deplete their cash holdings to make their increased tax payments, but generally this would be de minimis.) So, an increase in taxes to fund an increase in government spending would result in approximately a net zero increase in aggregate spending in the economy. The government would spend more; the private sector would spend less. Thus, a tax-financed increase in government spending would not lead to a net increase in aggregate demand, which, in turn, would not put upward pressure on the rate of inflation. The same result would obtain if the increase in government spending were financed by an increase in securities issuance to the nonbank public. To pay for the new issues of government debt purchased, just as was the case for increased taxes due, the nonbank public would have to cut back on their current spending. Thus, a securities-financed increase in government spending would not lead to a net increase in aggregate demand, which, in turn, would not put upward pressure on the rate of inflation. If foreign entities were to purchase the increased amount of government securities, they would have to cut back on their purchases of US exports because there has been no increase in their US dollar holdings. Foreign entities would purchase more US bonds and fewer US-produced Buicks. In sum, there is no logical reason to expect a tax-financed or a securities-financed increase in government spending to lead to a net increase in aggregate spending or an increase in the inflation rate. (Perhaps I am the lone non-Keynesian left.)

Let’s look at some data. Plotted is Chart 1 are the year-over-year percent changes in the annual average of calendar year nominal U.S. government expenditures and the year-over-year percent changes in the annual average All-Items CPI from 1960 through 2021. The growth in U.S. government expenditures is lagged by two years because this yielded the highest correlation coefficient between the two series, 0.51 (shown in the little box in the upper left corner of the chart). Lagging changes in government spending by two years means that the inflation rate this year is associated with the change in government spending two years prior. Remember, if the two series moved in perfect tandem, the correlation coefficient would have a value of 1.00. So, there does appear to be some positive relationship between changes in government spending and the inflation rate.

When policymakers started to raise official rates in the spring, the official projections showed an official peak rate of 2.8% at the end of 2023. With inflation running much faster at the time, I argued that the peak rate could be as much as 100 basis points higher than what the Fed was telegraphing. We were all wrong.

Four consecutive seventy-five basis points increases and three hundred and seventy-five basis points in eight months look like a substantial increase in official rates. But the starting point was zero, and much more is still needed to reverse inflation risks.

Price increases lead to revenue and profit increases for companies, while wage increases trigger income gains for workers. So when the price cycle broadens and wages increase, it takes more and more rate hikes to break the cycle because higher profits and income offsets the higher borrowing costs.

In October, core consumer prices were up 6.7% from one year ago, while average wages for non-supervisory workers increased by 5.9%. Price increases are 260 basis points above last year's gain, while wage increases are roughly the same. At 4%, the fed funds rate is still far below the price and wage gains, so there is more ground to cover before the policy is even neutral, let alone restrictive.

Businesses and consumers do not borrow at the fed funds rate. But the federal funds rate is the benchmark for all borrowing costs, so for market rates to be at levels that restrict borrowing, the Fed needs to lift rates to prohibitive levels. The fed funds moved above price and wage gains in the past three cyclical inflation cycles (the 1980s, 1990s, and 2000s).

So we all were wrong. Fast and broad price and wage gains require higher official rates.

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.