Author: Paul Gomme

The recently released CPI (Consumer Price Index) numbers for September are a bit of a mixed bag for the inflation outlook. Our preferred 3-month annualized change in CPI rose from 4.0% in August to 4.9% in September. However, the monthly inflation rate fell from 7.8% to 4.9% at an annual rate. On a year-over-year basis, CPI inflation was essentially unchanged at 3.7%.

Those who prefer core CPI also confront a mix. On a 3-month basis, core CPI inflation rose form 2.4% to 3.1% (annualized) and the monthly inflation rate was up from 2.4% to 3.1%. On the other hand, the 12-month inflation rate was down from 4.4% to 4.1%.

Producer Price Index (PPI)

October 11 saw the release of PPI data for September. While the monthly rate of PPI inflation fell, from 9.4% to 6.3% at an annual rate, the 3-month rate rose from 5.6% to 7.7% while the 12-month change was up modestly, from 1.9% to 2.2%.

For what it’s worth, the monthly change in the personal consumption component of PPI fell from 39.2% to 16.9% (annualized) while its 3-month inflation rate rose from 15.2% to 19.3% (also annualized). On an annual basis, this measure of inflation rose from 1.4% to 2.1%.

Policy Implications

To be sure, there is good news from the CPI report: On a monthly basis, overall CPI inflation is down while the annual inflation rate is unchanged. Core CPI inflation is down at on an annual basis, but not at shorter horizons. However, both CPI and core CPI inflation are running hotter than the Fed’s 2% inflation target (granted, for (core) PCE inflation). PPI inflation tells much the same story as CPI inflation: down on a monthly basis, but up when measured over longer horizons. However, it’s not clear that PPI inflation signals future CPI inflation — particularly for the PPI for personal consumption. It seems unlikely that the PPI and CPI releases for September will change policyholders’ predilections.

On September 29, the BEA released data for the August PCE price index. On an annual basis, PCE inflation was up marginally, from 3.4% in July to 3.5% in August. More concerning: the annualized monthly inflation rate rose from 2.6% to 4.8%. Even our preferred 3 month measure is up, from 2.0 (the Fed’s stated target value) to 3.1%.

Of course, our loyal readers know that the Fed focuses on core PCE inflation which excludes the volatile food and energy components. By this measure, the outlook is decidedly brighter: The annual inflation is down from 4.3% in July to 3.9% in August. At an annual rate, the monthly inflation rate dropped from 2.6% to 1.8% (below the Fed’s target). Finally, the somewhat smoother 3 month inflation rate also fell, from 2.7% to 2.2%.

What are we to make of this? First, this reading on inflation is nearly a month old. CPI inflation, released 2 weeks ago, already told us that August inflation was up. So, the PCE numbers are hardly a surprise.

Second, while we’re not big fans of core or even supercore inflation measures, there is useful information to be had by looking at these other measures. In particular, the increase in overall inflation is driven in part by higher food and energy price inflation. To the extent that these increases are driven by transitory factors (the reason to look at core or our 3 month average in the first place), the increase in overall inflation in August may prove ephemeral.

Was it wise for the Fed to hold rates steady at their last meeting? Certainly the headline number makes it more difficult to discern the underlying trend in inflation; however, the core measures have all come down. Given that the Fed looks past some of the transitory measures, it seems the core measures have responded to the rate increases.

August CPI

At an annualized rate, monthly inflation as measured by the Consumer Price Index (CPI) rose 7.8% in August, up from 2.0% in July. Our preferred measure of trend CPI inflation (the 3-month annualized) increased from 1.9% in July to 4.6% in August.

While we prefer to look at the overall CPI when looking to its trend, others prefer to look at core CPI inflation. Excluding food and energy, monthly inflation rose from 1.9% in July to 3.4% in August. However, the 3-month core CPI inflation rate actually fell, from 3.1% in July to 2.4% in August

What to make of all this? CPI inflation in August is up and well above the Fed’s 2% target for inflation. Comparing the overall CPI inflation with core CPI inflation shows that part of August’s increase in inflation is due to food and energy. The BLS specifically pointed to gasoline prices and the cost of shelter. Some commentators look at so-called `supercore’ CPI inflation, and that some of these supercore measures specifically exclude the cost of shelter. (What’s the end game for all these core measures? Will commentators be watching the price of bananas?)

August PPI

Producer Price Index (PPI) inflation for August similarly accelerated, from 4.9% in July to 9.3% in August (annualized monthly percent changes). The 3-month annualized PPI inflation rate also increased, from -0.1% (July) to 4.3% (August).

Looking instead at the PPI for personal consumption paints a more alarming picture: its monthly inflation rate rose from an annualized 4.3% in July to 40% in August! Its 3-month annualized counterpart also shows a marked increase, from -6.1% (July) to 15.4% (August).

It seems intuitive that producer prices should, eventually, be reflected in consumer prices. Looking across many years of data, the pattern that emerges is simply that inflation rates tend to move together. It seems difficult to make a case that higher PPI inflation is the harbinger of higher CPI inflation.

PCE for July

The PCE price index is released nearly a month after the CPI, and so August PCE inflation is not yet available. At an annualized rate, monthly PCE inflation rose slightly from 2.5% in June to 2.6% in July. On the other hand, the 3-month annualized PCE inflation rate fell from 2.5% (June) to 2.1% (July). Core PCE inflation shows a similar pattern.

Policy Outlook

Fed watchers know that its preferred measure of inflation is the PCE. The key question is: Will the large increases in CPI inflation in August also show up in the PCE inflation measures? It’s tempting to think that they must since the prices of individual items used in these indices are, presumably, essentially the same – the chief difference, then, being the weights associated with the prices of individual items. While PCE inflation generally tracks both CPI and core CPI inflation, these various measures of inflation exhibit considerable disparity.

Will the Fed take a pause, or continue raising its target for the Federal Funds Rate? If we knew the answer to this question, we’d probably be working on Wall Street. Answering this question probably means getting inside the heads of the voting members of the FOMC. Do they think that inflation is continuing to trend down? Or are the August CPI and PPI numbers the harbinger of an increase in inflation that needs to be nipped in the bud? Does the FOMC wish to avoid getting “behind the curve” as seems to have happened during the pandemic when they kept repeating that it was likely that the inflation was transitory due to supply chain issues?

By Paul Gomme and Peter Rupert

The BEA release of the advance estimate of Q2 Real GDP showed an increase of 2.4% at a seasonally adjusted annual rate. The BEA noted:

The increase in real GDP reflected increases in consumer spending, nonresidential fixed investment, state and local government spending, private inventory investment, and federal government spending that were partly offset by decreases in exports and residential fixed investment. Imports, which are a subtraction in the calculation of GDP, decreased.

Bureau of Economic Analysis, July 27, 2023

The 1.6% increase in Personal Consumption Expenditures (PCE) represented nearly half of the contribution to overall growth, due to the fact that consumption is about 70% of total output. Real non-residential fixed investment increased 7.7% while real residential fixed investment declined 4.2%.

On a year-over-year basis, inflation as measured by the Personal Consumption Expenditures Price Index is the lowest since mid-2022, rising 3.0%, a full percentage point over the Fed’s 2% target. However, as emphasized in earlier posts to this blog, year-over-year measures are quite sluggish. Our preferred measure, the 3-month annualized inflation rate, is 2.5% in June, slightly higher than the 2.3% recorded in May. For what it’s worth, the 1-month annualized PCE inflation rate in June was 2.0%, up from May’s 1.5%.

As an aside, it seems curious to us that commentators are quite comfortable annualizing quarterly growth rates (as emphasized by the headline numbers for GDP growth), but are reticent to do the same with price data (for which headlines compute 12-month growth rates). Perhaps consistency is too much to ask.

What’s significant is that output growth accelerated from 2.0% in the first quarter of 2023 to 2.4% in the second quarter. In this context, the BEA’s discussion of the second quarter, quoted above, is strange. The BEA focused on the fact that GDP increased, listing off the major components that contributed to this increase (consumption, investment, government spending and imports) while noting those that detracted from the increase (exports and residential investment); see the following table.

	Quarter 1	Quarter 2
Output	2.0%	2.4%
Consumption	4.2%	1.6%
Investment	-11.9%	5.7%
– Non-residential	0.6%	7.7%
– Structures	15.8%	9.7%
– Equipment	-8.9%	10.8%
– Intellectual Property	3.1%	3.9%
– Residential	-4.0%	-4.2%
Government	5.0%	2.6%
Exports	7.8%	-10.8%
Imports	2.0%	-7.8%

But why did output growth increase? The answer lies principally in the swings in investment and imports growth. Investment growth rose from -11.9% to 5.7%, transforming it from a drag on output growth to a contributor. Drilling deeper into investment, the growth rate of residential investment was largely unchanged (-4.0% to -4.2%). The big increase in non-residential investment growth was driven principally by investment in equipment, rising from -8.9% to 10.8%. To be sure, the growth in non-residential structures was very strong (9.7%), but it grew even faster in the first quarter (15.8%).

The growth rate of imports fell from 2.0% to -7.8%. However, since imports enter with a negative sign in the output identify, Y=C+I+G+X-M, the lower growth rate of imports contributed positively to output growth.

As noted by the BEA, growth of exports was negative in the second quarter (-10.8%) while it was positive in the first quarter (7.8%). While growth of consumption and government spending were both positive, their growth rates fell which has the effect of lowering quarter two output growth relative to the first quarter.

Overall, the strong growth in GDP coupled with the subdued (though still above the 2% target) price change shows a still-resilient real economy that is disregarding the increases in the Fed Funds rate. Based on available data, it is hard to make the case for a nascent recession in the U.S.

Personal Income

On Friday, the Bureau of Economic Analysis released personal income data. Real personal income growth fell from 8.5% in the first quarter to 2.5% in the second (both at annualized rates).

Disposable income data is also available on a monthly basis. The chart below shows that the first quarter was driven by very strong growth in January (21.9%) while the second quarter was hampered by negative growth in April (-0.4%).

Employment Cost Index

On Friday, the Bureau of Economic Analysis also released updated employment cost index data. Growth in the wages and salaries component fell from 4.9% in the first quarter to 4.1% in the second.

Overall, the current data suggest that the real economy continues to chug along at a respectable clip and the price numbers indicate that Fed policy is helping push down inflation. The Fed has indicated that the round of tightening is not yet over and the strength of the real economy gives no reason to alter that view.

By Paul Gomme and Peter Rupert

The April employment report was released by the BLS and revealed a 253,000 increase in payrolls. However, there were downward revisions totaling 149,000 (down 78,000 in February and 71,000 in March) that threw a little cold water on the report. There were few sectors that had any decline except for temporary help services that shed 23,300 jobs. The workweek held steady at 34.4 hours so that total hours worked increased by 2.1%.

Measured over the past year, average hourly earnings rose 4.45% in April, up from 4.3%. However, when measured relative to the previous month, earnings growth accelerated from 3.3% to 5.9%. As the figure below shows, month-to-month growth rates for earnings are quite choppy. The 3 month change is somewhat smoother; measured this way, earnings growth rose from 3.4% to 4.3%.

The household survey showed that the labor force participation rate remained at 62.6% despite the labor force falling 43,000. The employment to population ratio was also unchanged at 60.4%. The unemployment rate fell from 3.50% to 3.39%.

Unemployment insurance claims spiked up to 264,000, the highest since October of 2021. Continued claims, however, were little changed.

Between March and April, there was little change in inflation as measured by 12 month percentage change in either the Consumer Price Index (CPI) or core CPI (excluding food and energy). However, the annualized monthly percentage change in the CPI rose from 0.6% to 4.5% while core CPI rose from 4.7% to 5.0%. As we have stressed in earlier posts, these annualized inflation rates are quite volatile while 12 month percentage changes respond sluggishly to changes in trend. The 3 month annualized percentage changes strike us as a good compromise between smoothing and quickly capturing trend changes. On this basis, CPI inflation was down slightly, from 3.8% in March to 3.2% in April; core CPI inflation was essentially unchanged at 5.1%. All of these measures of CPI inflation are currently running well above the Fed’s target of 2%.

Given that CPI inflation is higher than the Fed’s 2% target, it may not be surprising that inflation expectations similarly exceed this 2% target. While the May readings for the 1 year and 2 year expected inflation are unchanged at 2.65% and 2.4%, respectively, the 5 year and 10 year expectations rose marginally.

It seems that monetary policymakers no longer look at what’s happening to money growth. That the Fed changed its definition of monetary aggregates starting in May 2020 makes it difficult to take a long view on money growth. Nonetheless, since May 2021 (given the change in the definition of “money” in May 2020, the earliest date for which year-over-year growth rates can sensibly be computed) growth of the monetary aggregates M1 and M2 has slowed. Indeed, both have been contracting since late 2022. A traditional monetarist like Milton Friedman would likely look at the chart below and predict future deflation. One way to think through all this is via the quantity theory of money: Mv = PY where M is money, v velocity, P the price level, and Y real output. This relationship can be recast as: money growth + velocity growth = inflation + real output growth. If velocity is roughly constant (so that its growth rate is 0), and long run real output growth is constant, the quantity theory of money predicts a tight relationship between money growth and inflation. As Milton Friedman put it, “Inflation is always and everywhere a monetary phenomenon.”

Of course, there have been important developments within the banking system. One such development is that the Fed now pays interest on excess reserves of banks held at the Federal Reserve Banks (“excess” meaning above-and-beyond what is required to satisfy reserve requirements). Plausibly, changes in the gap between this interest rate on reserves and the Federal Funds Rate (the rate banks pay in an overnight market for reserves) might explain the above deceleration of money growth. However, as shown below, the interest rate on reserves and the Fed Funds Rate move in lock step.

By Paul Gomme and Peter Rupert

According to the Establishment Survey from the Bureau of Labor Statistics , employment increased by 236 thousand in March 2023. While this increase is the smallest thus far for 2023, it’s close to the average for the second half of 2022. The BLS also revised the change in employment for February up from 311 thousand to 326 thousand, and revised its reading for January down from 504 thousand to 472 thousand.

The BLS also reported that even though employment was up, average weekly hours were down, so that total hours worked fell 6.8 million hours in March which follows on the heels of a 4.1 million hour decline in February. The chart below shows considerable variation in the change in hours worked.

Private sector employment was up 189,000 and the government sector added 47,000 jobs. The private service sector added 196,000 jobs while the goods producing sector shed 7,000 workers. The largest gain in the service sector came from Leisure and Hospitality, adding 72,000 jobs.

Commentators have noted the decline in average hourly earnings, down 4.24% compared to March of 2022. This has been portrayed as a positive development for policymakers. The reason for this positive portrayal is that if higher inflation expectations become entrenched, then workers will want higher wages (to compensate for the higher inflation) which may lead to wage-price spiral in which wage increases feed to price increases which, in turn, feed into further wage increases, and so on. However, as with our commentary on inflation, year-over-year wage changes (the ones discussed by commentators) are slow to pick up changes in trend. And, as with annualized monthly inflation rates, month-to-month changes in average hourly earnings can be quite noisy; indeed, the annualized percentage change over the month actually rose 3.3% compared to 2.5% for the previous month. A 3 month average of monthly earnings growth smooths out some of the monthly fluctuations while, at the same time, picking up changes in trend in a timely fashion.

Readers of this blog know that inflation has generally been running higher than earnings growth. In previous posts, we have plotted average hourly earnings along side various price levels. Here, instead, we present real average hourly earnings: earnings divided by measures of the general price level. So that these measures are all comparable, we divide the consumer price index (CPI) by its average for 2012. The choice of 2012 is motivated by the fact the personal consumption expenditures (PCE) price index is already set to equal 100 in 2012. The chart below expresses average hourly earnings in 2012 dollars. Both CPI measures exhibit declines since 2021: For the overall CPI, average hourly earnings have declined by roughly $1 per hour, while core CPI records a decline of $0.42 per hour. Alternatively, using the PCE price index, earnings fell by $0.36 per hour; using the Fed’s favorite price index, core PCE, earnings have been essentially flat since the start of 2021.

The Household Survey from the BLS showed a 577,000 increase in employment. Moreover, the labor force, the participation rate and the employment to population ratio all increased. The unemployment rate fell from 3.57% to 3.50%. The Jobs Opening and Labor Turnover Survey still shows significant job openings even though they have come down some over the last few months.

Overall, the employment report shows a still-strong labor market, albeit there are signs of slowing in some areas. The Fed seems to have calmed inflation at this point and, depending on what unfolds over the next month or two, there may be a pause in raising rates since monetary policy tends to work with a lag.

The specter of inflation has received considerable attention over the past year. Indeed, the Fed’s increases in its target for the Federal funds rate have been couched in terms of reducing inflation. The Fed’s aggressive increases are likely geared to avoiding an increase in inflation expectations. When will the Fed know it has done enough?

Headline CPI (Consumer Price Index) inflation, based on year-over-year changes in the CPI, has remained well above the Fed’s stated 2% inflation target since early 2021. However, as shown in the chart below, annualized monthly inflation rates were running above target starting in late 2020. This figure illustrates some of the problems associated with looking at annual inflation rates: they are slow at picking up changes in trend. That said, monthly inflation rates are quite volatile as can be seen in mid-2022. In a sense, what we would like is to draw a line free-hand through the monthly inflation rates. The chart below shows that annualized inflation rates over a 3 or 4 month horizon do pretty well in responding reasonably quickly to the ups and downs of the monthly inflation series, while at the same time exhibiting less volatility relative to the monthly series. The 6 month annualized inflation rate suffers the same problem as the year-over-year measure: too much of a lag in following the monthly inflation rate up and down.

So, while monthly inflation rates were pretty much on target by late 2022 (the grey line is at 2%), the 3-month inflation rate was still running above target. In the first two months of 2023, monthly inflation has, again, risen above target; the 3-month average “sees through” these fluctuations. The graph below removes the 4 and 6 month lines to make it a little clearer.

In broad terms, core CPI (that is, excluding food and energy prices) inflation tells the same story: the annual inflation rate took a considerable period of time to reflect the increase in the monthly inflation rate. Roughly speaking, the trend for monthly core CPI inflation has been flat at 5.6% since the start of 2021. Again, the 3-month average core CPI inflation rate presents a nice compromise between smoothing out the month-to-month changes in inflation, and the over-smoothing associated with the annual inflation rate.

The usual motive for looking at core inflation is that removing the volatile food and energy components gives a better measure of trend inflation. Comparing the two charts above, it is difficult to see that core CPI inflation is, in fact, a good measure of the trend in overall CPI inflation.

Those attuned to monetary policy know that the Fed’s preferred measure of inflation is based on the Personal Consumption Expenditure (PCE) price index. Keep in mind that the PCE is only available until January 2023; the February numbers will be available much later this month. The chart below shows that this measure of inflation poked above the Fed’s 2% target early in 2021, and has pretty much stayed there. Once again, the annual inflation rate lagged behind the monthly inflation rate trend; the 3-month inflation rate smooths out many of the wiggles in the monthly inflation rate while responding reasonably quickly to changes in trend.

So, why is this such a big issue? There are some obvious and maybe not so obvious reasons. The most obvious reason for the fight against inflation concerns the purchasing power of a dollar. Inflation erodes nominal earnings. The easiest way to see this is to compare year-over-year changes in the CPI to year-over-year changes in nominal average hourly earnings. In the graph below, the red line plots CPI year-over-year inflation and the blue line plots year-over-year changes in average hourly earnings. When the red CPI line is higher than the blue average hourly earnings line, it means real earnings are falling…an hour of work buys fewer goods and services since prices grew faster than wages. Real wages rise when the blue average hourly earnings line is above the red CPI line. Starting in 2010 until the pandemic, average hourly earnings were growing between 2 and 3%; however, inflation was lower than that and so real earning were rising. After the pandemic, average hourly earnings were growing in the 5-6% range, the fastest growth in a decade, yet real earnings started to fall due to the higher level of inflation. At the height of inflation in mid 2022 (around 9% inflation) real earnings were falling by about 4% since the growth in wages was about 5.4%.

The chart above shows that sometimes workers “win” (earnings growth exceeds inflation), and sometimes they “lose” (earnings growth does not keep up with inflation). What’s relevant is whether workers tend to win more than they lose. To see this, the chart below plots average hourly earnings against two price levels, the CPI and the PCE deflator. All three series are set to 100 at the onset of the pandemic, and are measured in logarithms. There are two practical consequences of using logarithms: (1) straight lines represent constant growth rates, and (2) a constant gap between any two lines represents a constant percent difference between the two. This chart shows that real earnings rose during and after the pandemic: the blue earnings line rose above both of the price indices. No doubt, some of the rise in average hourly earnings early in the pandemic reflected the fact that job losses were concentrated among lower wage workers. Starting in mid-2021, CPI inflation started rising, and the red CPI line exhibits faster growth than the blue earnings line. By mid-2022, the red CPI line passed above the blue earnings line. Since then, average earnings have more-or-less tracked the CPI. By this metric, real earnings are more-or-less back to where they were prior to the pandemic. Notice that when earnings are measured against the PCE price deflator, real earnings are higher now than at the start of the pandemic: the blue earnings line is above the green PCE deflator line.

The next chart gives a longer view of earnings and prices. Now, earnings and prices are set to 100 in early 2006. During the Great Recession, real earnings fell: the red CPI line rose above the blue earnings line. Since then, the blue earnings line consistently exceeds either of the price lines reflecting an increase in real earnings since 2006. However, remember that the gap between earnings and, say, the CPI represents the percentage difference between earnings and prices. With this in mind, after 2010, the gap between earnings and the CPI shrank: real earnings fell relative to 2010. Starting in 2014, a growing gap emerged between earnings and the CPI reflecting increases in real earnings. So, while the chart above indicates that real earnings are back to where they were 3 years ago, over the past 15 years, real earnings have risen.

Inflation, however, does not affect everyone equally. For example, lower income individuals have by way of net wealth. Hand-to-mouth consumers suffer when the prices of the goods they buy rise at a faster clip than their incomes. Those with higher incomes also, typically, have positive net worth. Not only can they buffer their consumption against fluctuations in their real incomes, they also have access to investment opportunities that tend to protect their wealth, and so investment income, from the ravages of inflation. These investment opportunities range from interest-bearing bank accounts to the stock market.

The outcome of the March 21-22 FOMC meeting was a 25 basis point increase in the Fed Funds rate:

Recent indicators point to modest growth in spending and production. Job gains have
picked up in recent months and are running at a robust pace; the unemployment rate has
remained low. Inflation remains elevated.
The U.S. banking system is sound and resilient. Recent developments are likely to result
in tighter credit conditions for households and businesses and to weigh on economic activity,
hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly
attentive to inflation risks.
The Committee seeks to achieve maximum employment and inflation at the rate of
2 percent over the longer run. In support of these goals, the Committee decided to raise the
target range for the federal funds rate to 4-3/4 to 5 percent.

Federal Reserve Press Release