High Inflation Means More Aggressive Monetary Policy
The title of our last article (published in August) was “Coming off the Boil,” and the U.S. economy did just that. U.S. GDP growth slowed from a hot 6.7 percent in the second quarter to 2 percent in the third, the weakest quarter since recovery from the pandemic began a year and a half ago. Inflation, however, is still boiling. While the Fed has announced that it will begin to reduce its bond purchases this month, it has placed a higher bar for raising interest rates, suggesting it won’t do so for a year or more. Market pricing, by contrast, has recently brought forward the timetable for rate hikes by around six months in response to inflation that has turned out to be higher and more persistent than had been expected.
We believe the markets have this one right, and thus expect the Fed to begin raising rates by the middle of next year. While the unique character of the current business cycle makes forecasts even more unpredictable than usual, there are good reasons to believe that high inflation is going to be with us at least through next spring, and that it is likely to settle above the Fed’s 2 percent target. While this suggests that monetary tightening will be faster and more aggressive than current Fed rhetoric suggests, the economy is not positioned for a recession anytime soon—barring a major negative shock.
As extreme as the slowing in the economy was last quarter, it does not portend further weakness going forward. Consumer spending—the largest contributor to the slowdown by far—was bound to slow significantly from the fiscal-induced surge in the spring. It was exacerbated by yet another re-emergence of COVID infections that hampered the rebound in services spending. Supply bottlenecks also depressed third-quarter activity, with a plunge in auto production alone accounting for a whopping 1.4 percentage points of drag on GDP. And restrictions on foreign travel to the U.S. depressed tourism.
With the notable exception of supply bottlenecks, these factors have begun to reverse, and the economy is already bouncing back. Infections have plunged since early September, which has allowed the recovery in consumer spending on activities outside the home to accelerate again. Meanwhile, the U.S. administration has lifted restrictions on foreign travel to the U.S. and producers are beginning to rebuild unusually lean inventories.
The pickup in demand will add to the already substantial pressures on inflation. While the initial surge was concentrated in a narrow set of COVID-related categories, inflation has since broadened to areas like housing costs, which tend to have more inertia. Supply shortages, meanwhile, are persisting for longer than expected: October data revealed that delivery delays for goods shipments have extended even further. Finally, a surge in energy prices has intensified inflation pressures.
Policymakers have been at pains to point out that temporary effects associated with the pandemic are behind the surge in inflation and that was largely true initially. But there are now clear signs that this inflation surge has legs. While attention has focused on consumer prices, pipeline inflation pressures for goods—where the inflation problem is concentrated—have surged by even more. Prices that producers pay for final goods are up 14 percent from a year ago, and those for intermediate goods more than 25 percent. When producers pay more for inputs, it puts pressure on their profit margins and incentivizes them to raise prices, suggesting more inflation is ahead.
It is not only goods that producers are paying more for; labor market tightness is generating a surge in labor costs. While gains in payroll employment have at times been underwhelming, record job openings and quit rates are clear indications that labor demand is exceeding supply. The jump in employee compensation is the proof in the pudding: The October employment report showed that average hourly earnings have risen nearly 5 percent over the past year. The Employment Cost Index—the broadest measure of labor costs that includes bonuses and benefits—rose at an annual rate of 5.3 percent in the third quarter, the fastest pace recorded since this index began 25 years ago.
High inflation is likely to persist well into next year and could well settle at 3 percent or even higher. The biggest moves in inflation have occurred when labor markets and commodity prices are moving in the same direction, and that is what is happening now. Moreover, there are also indications that some of the structural factors underlying the lack of inflation pressures over the past few decades are beginning to unwind:
1. Bargaining power has shifted toward workers. While labor force participation has rebounded smartly for so-called prime-age workers (age 25-54), it has remained near pandemic lows for older workers, many of whom have apparently retired. Along with the significant declines in birth rates and immigration, this suggests that growth in the labor force will remain weak for years. Meanwhile, many workers in low-skill, low-paying jobs are now demanding higher pay to return to their jobs after being laid off during the pandemic. Finally, the end of extra unemployment benefits and the re-opening of schools did not generate the increase in labor force participation that had been expected.
2. China is unlikely to be the supplier of cheap goods to the rest of the world that it has been. Policymakers there have shifted focus from maintaining extremely strong economic growth to structural reforms in regulation, credit and energy that are collectively slowing growth in output.
The persistence of higher inflation doesn’t necessarily spell bad news for the economy or financial markets. Economic recoveries are usually hampered by severe damage to household and business balance sheets incurred by recessions, but that didn’t happen this time around. On the contrary, both are healthier than they’ve been for many years, buttressed by massive policy stimulus. And while both fiscal and monetary policy are turning less stimulative, neither is likely to become truly restrictive for at least another year or more. Fiscal stimulus has already faded, but additional packages are forthcoming. And while the market is pricing in more rate hikes than what the Fed seems to be currently planning, Fed funds futures imply a policy rate barely above 1 percent by the end of 2023, far from what would be considered restrictive. In any case, it is hard to see the economy decline when cyclicals like autos and inventories are already at extraordinarily low levels and supply constraints are holding back output in the face of strong demand.
So what does all this mean going forward? Following a bit of a pickup in the current quarter, we will most likely transition gradually to more modest growth—say, 2 to 3 percent—as is typical in mid-cycle following the post-recession surge. As for the financial markets, stocks tend to hold up well when the Fed transitions from a super-easy to neutral policy stance. While bond yields remain low relative to growth and inflation, it may take a significant stock correction before they move significantly higher. With the Fed continuing to buy bonds and investors holding large percentages of their portfolios in stocks, U.S. Treasuries remain an effective hedge, even at 10-year yields of around 1.5 percent.