Inflation Story Far From Over
The labor market’s steady recovery since 2009 showed signs of tightness, with the ratio of job openings vs. unemployed reaching a disparity of 5 million in 2017. As the labor market continues to rebalance post COVID-19, employers now face the challenge of continuing higher labor costs.
US Federal Reserve (Fed) Chair Jerome Powell signaled that a policy rate cut might be in order in the September Federal Open Market Committee (FOMC) meeting, if the committee sees more “good data.”
We have become accustomed to that phrase and interpret it to mean that inflation needs to continue trending toward 2%. The core PCE (Personal Consumption Expenditures) — the Fed’s preferred measure of inflation — averaged 1.58% from the end of 2009 to 2019 and is currently at 2.63%. If the inflation measure was, on average, 42 basis points (bp) below the target for a decade, resulting in interest rates below the “neutral rate,” then it makes sense that rates remain above the neutral rate for a period of time. But with inflation only 63 bp above this target, the current policy rate of 300 bp above neutral seems excessive. We have long advocated for the Fed to begin easing. The challenge now is how fast this easing should occur.
Investment bank strategists and economists have revised their forecasts, suggesting the Fed will aggressively ease the policy rate, with one prediction indicating a 150 bp cut before year-end. While anything is possible, such a drastic cut appears to be an overreaction. We are not in panic mode. Measured cuts seem appropriate, and three 25 bp cuts at each meeting (September, November and December) should suffice. The plan might need adjustment if the labor market begins to deteriorate significantly.
The labor market has been supported by several factors. The steady recovery since 2009 showed signs of tightness, with job postings to total unemployed turning negative in 2017. This ratio reached a disparity of 5 million, indicating there were 5 million more job openings than unemployed individuals. Enhanced unemployment benefits from COVID-19 allowed many to leave the job market, and as the economy reopened, labor shortages emerged in various sectors, driving up wages. As the labor market continues to rebalance, employers now face the challenge of continuing to afford higher labor costs. Many businesses have indicated that these new costs are unsustainable, potentially leading to reduced output, less product availability, and slower growth. This suggests that the inflation story is far from over but may reverse. With rising costs, consumers, businesses, and governments are likely to pull back, affecting economic growth.
Another variable that could impact growth is the potential election outcome. Regulation, trade, and immigration policies will play significant roles. Raising tariffs, while politically appealing, could increase prices and potentially inflation. Historically, tariffs have had mixed effects on economic growth. They can protect domestic industries, generate revenue, reduce trade deficits, safeguard national security, and encourage domestic production. Conversely, tariffs can increase consumer prices, instigate trade wars, cause inefficiencies and resource misallocation, disrupt global supply chains, and lead to corruption.
The US economy, being highly complex, requires careful study to determine the most effective policies. Attempting to revive industries from a generation ago might be overly nostalgic and misguided. Instead, focusing on bringing highly skilled, complex industries could be critical for the long-term strength of our economy. It will be important for any administration to remain nimble and flexible in its approach to tariffs and other economic policies.
In summary, while a gradual easing of the Fed’s policy rate seems appropriate given current inflation levels, careful monitoring of the labor market and broader economic conditions will be crucial. The interplay of domestic policies and global economic factors will continue to shape the economic landscape in the coming months.