U.S. Economic Snapshot

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

The BEA announced that Q1 real GDP increased 1.1% at an annual rate. Many in the press have, obviously, noted the declines over the last two quarters indicates the economy is slowing. Indeed, today’s report “undershot” expectations that were around 2%. However, the underlying components were a bit more mixed and the strength of the economy might be in the eye of the beholder. Real consumption spending increased 3.7%, the largest increase over the last 7 quarters, and disposable personal income rose 8.0%.

The output identity, Y = C + I + G + X – M, tells us the uses of output (the “demand” side). If output growth is down, then one or more of the right-hand side components must be down. From above, consumption growth rose from 1.0% in the fourth quarter to 3.7% in the first quarter. Growth in government spending likewise rose, from 3.8% to 4.7%. However, real investment spending fell 12.5% in the first quarter compared to a 4.5% increase in the fourth quarter. Within real investment, real inventories grew 0.4% (up from -3.7%), non-residential structure investment grew 11.2%, and residential structure investment fell by 4.2% (although this decrease was an improvement over the very negative growth rates for this category late in 2022).

While it has become standard in the U.S. to annualize the quarterly growth in GDP, one could also look at the year-over-year growth rate. Now, Q1 does not look so bad relative to the past few quarters and, in fact, has actually increased over the previous quarter.

The Personal Consumption Expenditure Price Index (PCE) rose 4.2% in the first quarter compared to growing 3.7% in the previous quarter, obviously high above the FOMC’s 2.0% target.

These developments lead to a murkier monetary policy outlook. Output growth has slowed, perhaps reflecting the cumulative effects of monetary policy tightening over the past year. Yet, PCE inflation is still well above the Fed’s 2% target (see also the CPI and PPI), and consumption growth actually accelerated in the first quarter. In previous posts, we have noted that the labor market is still quite strong, with an historically low unemployment rate, and roughly two job openings for every unemployed person. Given that, there is nothing new to dissuade the FOMC from another rate hike or two.

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.

By Paul Gomme and Peter Rupert

The BEA announced a downward revision from 2.7% to 2.6% in the third and final estimate of Q4 GDP. The revision primarily reflected downward revisions to exports and consumer spending. The final estimate for 2022Q4 GDP did not change the overall stance of the US economy.

Several sources picked up on the fact that the PCE price index, the primary inflation index cited by the Fed, fell. CNBC reported: “On a 12-month basis, core PCE increased 4.6%, a slight deceleration from the level in January.” The New York Times remarked,

The measure of inflation most closely watched by the Federal Reserve slowed substantially in February, an encouraging sign for policymakers as they consider whether to raise interest rates further to slow the economy and bring price increases under control.

The Personal Consumption Expenditures Index cooled to 5 percent on an annual basis in February, down from 5.3 percent in January and slightly lower than economists in a Bloomberg survey had forecast. It was the lowest reading for the measure since September 2021.

NYT, March 31, 2023

However, as we remarked in an earlier post, measured inflation is sensitive to the time horizon over which it is computed. Annualized month-to-month inflation rates are quite volatile; year-over-year inflation is much smoother, but is slow to reflect changes in trend inflation. And it’s trend inflation that policymakers, among others, are concerned about. Yet, identifying trend inflation is difficult. One approach is to average monthly inflation rates over a few months. In the figure below, we include the 3-month average of monthly inflation rates which is our attempt to balance the desire to smooth monthly inflation rates while capturing changes in trend in a timely fashion.

The Fed tends to focus on so-called core PCE inflation for which the volatile food and energy components are removed. Presumably, the reason for looking at core PCE inflation is that it gives a better read on trend inflation. To be sure, core PCE inflation is less volatile, as shown in the chart below. Nonetheless, this measure continues to exhibit large fluctuations when measured on a monthly basis. And, it should not be surprising that the annual (year-over-year) inflation rate is smoother, but slow to reflect changes in trend inflation. Again, we include the 3-month average of monthly inflation rates.

One way to think about the problem of extracting a measure of trend inflation from the data is that observed inflation is composed of trend inflation and an ‘error’ which reflects issues in measuring trend inflation. In the jargon of the profession, we face a signal extraction problem: we are trying to extract the signal (trend inflation) from noisy data (measured inflation). Averaging monthly inflation rates over some horizon (for example, over 3 months, as above) can be thought of as canceling out the positive and negative error terms in this signal extraction problem. (Again, using some jargon, ideally the errors are uncorrelated over time, or independently and identically distributed.)

Finally, what are the policy implications of the latest PCE price index numbers? As mentioned above, some commentators have noted that PCE inflation was down in February relative to January. True enough when looking at either the monthly inflation rate, or the year-over-year inflation rate. However, the 3 month average inflation rate is up. It is hard to make a strong case that there has been a change in trend inflation. In any event, all of the gauges of inflation presented above continue to run well above the Fed’s stated 2% target.

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

By Paul Gomme and Peter Rupert

GDP

The BEA announced that the advance estimate for Q4 GDP came in at 2.9% after increasing 3.2% in Q3. Personal consumption expenditures remained pretty stable, increasing 2.1%, contributing about 1.4 percentage points of the total increase in GDP. The basic message being that recessionary fears are somewhat allayed, at least for now.

While real investment increased 1.4% overall, the components were mixed. Investment in nonresidential structures increased 0.4%, the first rise in 6 quarters. Residential investment, however, fell for the seventh straight quarter, falling 26.7%.

The BEA also announced Personal Income and Outlays for December. The report showed that real personal income increased 0.2% from November to December while real personal consumption expenditures declined by 0.3%. The PCE price index rose 0.1% over the month and core PCE rose 0.3%.

Labor Market

The BLS announced the employment situation showing payroll employment increased 517,000, and, as per usual, crushed the estimates that hovered around 190,000. The report, along with a strong December continued a robust labor market in 2022 after coming through pandemic-related turmoil. Pre-pandemic employment stood at 152,504,000 in February of 2020. The pandemic created a massive decline, down to 130,515,000 in April of 2020; a decline of 21,989,000 (17%) in just two months! The decline rapidly reversed, however, and by January, 2022 employment stood at 149,744,000, about 2% lower than its February 2020 level. Since January of 2022 employment has increased by about 4,000,000 and now stands at 153,743,000.

The bulk of the increase in the January data was in the service sector, rising 397,000. The information sector lost 5,000 jobs for the second straight month. Information employment saw a large fall in employment starting around the beginning of 2000 and another large dip during and after the Great Recession, in total, that sector lost about 1,000,000 jobs during that period. Since then, the information sector has gained back about 500,000 of those jobs and now has roughly 3.1 million workers.

Average weekly hours of work shot up from 34.4 to 34.7. This, accompanied by the 517,000 increase in employment, led to about a 15% increase in total hours of work in the US, far surpassing any increase over the last couple of years.

Also just released by the BLS was the preliminary estimate of Q4 non-farm productivity. Output per hour rose 3.0% with output rising 3.5% and hours of work rising 0.5%.

The recent JOLTS showed that the number of job openings increased in December, now standing at just over 11 million, that is, about 2 job vacancies per unemployed individual. It is certainly clear that this is one of the strongest labor markets ever seen, at least since the unemployment data began in 1948.