December 22, 2023
The November Personal Consumption Expenditure Deflator (PCE) should be a pretty clear sign that we have achieved the soft landing the Fed has been looking for. The year-over-year inflation rate in the overall PCE is down to 2.6 percent. The annualized rate for the last six months is 2.0 percent, and for the last three months just 1.4 percent. The same numbers for the core are 3.2 percent, 1.9 percent, and 2.2 percent. And, if we take a core without housing, we get 2.4 percent, 1.1 percent, and 1.4 percent.
We can play with the data in different ways and undoubtedly construct some series that show a higher rate of inflation, but it is pretty hard to look at these data and still think we have a problem with inflation. And it is important to remember that the Fed’s target is a 2.0 percent average rate of inflation.
Chair Powell has been very explicit in saying that, unlike the European Central Bank, the Fed does not see 2.0 percent as a ceiling. He said that he wants inflation to be on average 2.0 percent. That means if it is somewhat lower he would look to raise the inflation rate, and if it is somewhat higher then he would look to lower it, but an inflation rate that is slightly higher, say 2.3 percent or 2.4 percent, is no more of a crisis than the inflation rates that were below 2.0 percent that we saw before the pandemic.
Many people have been wrongly arguing that the inflation rate has to actually hit 2.0 percent for the Fed to achieve its target. That is not the case, unless we think the Fed has changed the target. Given his statements prior to the pandemic, we should certainly consider an inflation rate that is close to, but slightly above, 2.0 percent as being consistent with the Fed having reached its target.
Anyhow, given the most recent data, it is entirely possible that we will actually see PCE inflation below 2.0 percent in the year ahead. As has been widely reported, we know as a virtual certainty that housing inflation will continue to decline through 2024. There are several indexes measuring the rents of housing units that change hands, that show rents have largely stopped rising and in some markets are actually now falling. These indexes lead the CPI and PCE indexes, which measure the rents of all units, by six months to a year.
Furthermore, there are many new units being constructed that will be coming on the market in the next six months, which should put further downward pressure on rents. Insofar as cities can successfully promote conversions of vacant office space to residential units, that will be another factor lowering rents.
We also know the price of many items, starting with new and used cars, that soared due to supply chain problems in the pandemic, will continue to decline in 2024. An analysis from the San Francisco Fed showed that a New York Fed index of supply chain stress leads movements in the price of durable goods by roughly six months. Based on the New York Fed index, we should expect to see the price of not just cars, but also appliances, furniture, and a wide range of other items continue to fall in 2024. (The New York Fed index has shown a modest increase in the last couple of months, but hopefully not enough to have much impact on inflation.)
What About Services and What About Wages?
Jerome Powell has said that the Fed would pay special attention to inflation in non-housing services. This category includes areas like medical care services, transportation services (mostly airfares, car repairs and insurance), restaurants, and college tuition. The trend for inflation in this area is less clear, but it is difficult to envision a scenario where it is fast enough to push the overall inflation rate much above the Fed’s target. The reason is that wage growth has been at a pace that is consistent with the Fed’s target.
In discussing wage growth, it is worth making an important distinction. Excessive wage growth clearly did not cause the burst of inflation we saw in 2021 and 2022. The wage share of income shrank as profit margins rose. However, wage growth did accelerate in response both to extraordinary tightness in the labor market and workers’ efforts to keep up with rising prices.
This acceleration in the pace of wage growth led to the fears many economists raised of the sort of wage-price spiral we saw in the 1970s. That was a story where workers responded to higher inflation by making higher wage demands, which raised costs and pushed inflation higher. The result was the double-digit inflation we saw at the end of the decade in the United States and elsewhere.
That clearly is not happening now. Wage growth has slowed sharply by every measure. According to the Average Hourly Earnings series (AHE), wages increased by 4.0 percent over the last year, and at just a 3.4 percent annual rate over the last three months. This is a sharp slowing from the pace of wage growth we saw in 2021 and 2022, which peaked at over 6.0 percent at the end of 2021 and start of 2022. The 3.4 percent rate is roughly the same as what we saw in the two years prior to the pandemic, when inflation was in line with the Fed’s 2.0 percent target. (It’s also worth noting that most measures of inflation expectations are close to their pre-pandemic rate. Insofar as expectations are a major factor in wage growth, there is little cause for concern here.)
The Employment Cost Index (ECI) tells a somewhat different story. Here also there was a sharp slowing in wage growth, which showed a peak annual rate of 6.5 percent in the third quarter of 2021. (This is using the wage component for private sector workers to make it comparable to the AHE.) However, the ECI shows an increase over the last year of 4.5 percent, with the annualized rate for the last quarter of 4.4 percent. This is likely faster than would be consistent with the Fed’s 2.0 percent inflation target.
This seems to be a case where data series are telling us inconsistent stories about the labor market. There is some difference between the series in their construction. The ECI holds the mix of industries and occupations fixed, so it is effectively measuring the increases in pay for workers in the same job. The AHE is a simple average for all workers, so changes in composition, such as people shifting from lower paying jobs to higher paying jobs, will affect the AHE, but not the ECI.
Historically, this has led to slightly more rapid growth in the AHE, as we do see a trend for people to move into higher paying jobs over time. Composition effects were large in 2022 with the return of many of the low paying jobs in hotels and restaurants, which were shut down during the peak of the pandemic. However, the composition effects have been minimal in more recent months and cannot explain a divergence of this magnitude.
While many economists seem to prefer the ECI as a measure of wage growth, it is worth noting that the AHE has a hugely larger sample, 651,000 for the Current Employment Situation Survey (the basis for the AHE) compared to just 16,900 for the ECI. Perhaps even more importantly, the response rate for the AHE survey is over 95 percent, after its data collection process is completed, compared to just over 80.0 percent for the ECI. The response rate for the ECI has fallen sharply since the pandemic, from an average of close to 90 percent in the prior decade.
It’s also worth noting a private index, the Indeed Wage Tracker, is showing a pattern of slowing wage growth that is very similar to what we see in the AHE. Its measure of year-over-year wage growth for new hires has fallen from a peak of 9.2 percent at the start of 2022 to 4.2 percent in the most recent data. It is expected to fall to the pre-pandemic pace by the middle of 2024. In any case, there is zero doubt that the direction of change is downward in this measure.
We could split the difference between the AHE and ECI and still be looking at a pace of wage growth under 4.0 percent in the most recent period. While this would be somewhat faster than the rate of wage growth we saw in 2018-2019, there are two reasons to believe that the economy can accommodate a faster pace of wage growth and still hit the Fed’s 2.0 percent target.
The first is the shift to profits noted earlier. Unless we think that a shift to profits can never be reversed, we need to see some periods where wage growth exceeds the rate of inflation, plus the rate of productivity growth, in order for the profit share of income to be reduced.
If we have wage growth for a couple of years that is a half percentage point above the sustainable rate (inflation, plus productivity growth), this would be roughly sufficient to bring the profit share back to its pre-pandemic level. As a practical matter, the profit share was well above its 1990s level even before the pandemic, so we could see the erosion in shares go considerably further and still have businesses earning healthy profits. (The 1990s were seen as a very good decade for corporate profits.)
The other factor is that we could be on a faster productivity growth path. Productivity grew at a 3.5 percent annual rate in the second quarter and a 4.9 percent rate in the third quarter. No one expects this growth pace to be sustained. The quarterly data are highly erratic and subject to large revisions, but it is plausible that we could be on a faster growth path, say 2.0 percent, compared to the 1.1 percent rate in the decade prior to the pandemic.
The spread of AI and related technologies offers substantial potential for productivity gains. Past promises from technology have often not been realized, but AI can reduce labor requirements in everything from legal writing and diagnosing patients, to self-driving cars. It is easy to envision scenarios in which we see large gains in productivity in the year ahead.
But stepping back from these more optimistic stories, suppose that the pace of wage growth is in fact somewhere close to 3.9 percent. This is still very close to a pace that would be consistent with the Fed’s inflation target, especially when we allow that 2.2 percent or 2.3 percent inflation is near enough to be consistent with an average rate of 2.0 percent. In other words, we should be pretty confident that this economy has landed.
I will throw in an obvious caution. Bad things can happen in the world. Back in 2021, when Team Transitory was confident that the wave of inflation would soon slow, we were surprised by two more major waves of COVID and Russia’s invasion of Ukraine in 2022. We could see other bad surprises upending the economy next year that would change the story outlined above.
But bad events can always throw a monkey wrench into the workings of the economy. If something awful had happened in 2018 or 1998, we also could have seen a jump in inflation. But that is a separate issue from whether we have brought the inflation from the last set of bad events under control. We have.
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