July 07, 2024
Federal Reserve Board Chair Jerome Powell has been saying for some time that he needs to see more evidence that inflation is under control before he lowers interest rates. We can never be certain of where the economy is going, so it’s understandable that he remains worried that inflation could reaccelerate.
However, there are risks in the opposite direction as well which Powell has explicitly recognized in the past. He has stated that the Fed has an obligation to maximize employment and said that this part of the Fed’s mandate needs to be taken as seriously as its commitment to price stability. That is why many of us were happy President Biden reappointed him as Fed chair. But he has to act now to show this commitment.
June Jobs
The June jobs report released Friday can hardly be viewed as bad. The establishment survey showed the economy creating 206,000 jobs, while the household survey reported the unemployment rate was 4.1 percent (4.05 percent before rounding). Those topline numbers are healthy by almost any standard, but there is cause for concern on both sides.
On the establishment side, the prior two months’ numbers were revised down by a total of 111,000, which means that the June number was only 95,000 larger than the estimate of jobs from the establishment survey that we were looking at in May. This makes the average job gain for the last three months 177,000. That is a reasonable number given current estimates of potential labor force growth, but certainly not a pace that should give the Fed cause for concern about excessive inflationary pressures.
It’s also worth noting that more than a third (70,000) of the job growth in June was in the government sector, almost entirely at the state and local level. Government jobs substantially lagged behind the private sector in this recovery, so this growth is mostly a catch-up story, but it is likely an anomaly. With many state and local governments now facing shortfalls as COVID funds get depleted, they will not be hiring at anywhere near this pace going forward.
Over the last three months, we have created an average of 146,000 private sector jobs. Again, this is a fine pace, but hardly one that should prompt fears of accelerating inflation.
On the household side, we have been seeing a gradual uptick in the unemployment rate since it bottomed out at 3.4 percent last April. If this trend continues, we will be having a serious issue with unemployment. As it is, we should be able to do better than 4.1 percent. The unemployment rate averaged 3.7 percent in 2019, with no clear evidence of inflationary pressures.
As Chair Powell has noted, higher unemployment disproportionately impacts groups that face discrimination in the labor market. We see this clearly with the unemployment rate for Black workers. This bottomed out at 4.8 percent last April (an all-time low). It now stands at 6.3 percent, an increase of 1.5 percentage points.
Getting the unemployment rate down by another half percentage point will make a noticeable difference in the prospects for disadvantaged groups. It should be an important policy goal.
Other data in the household survey also provide some basis for concern. The share of long-term unemployment (more than 26 weeks) has edged up to 22.2 percent of the unemployed. It had been under 19.0 percent at the start of the year. This indicates more people are having serious problems finding jobs.
Another item showing labor force weakness is the relatively small share of unemployment due to voluntary quits. This share stood at 11.2 percent in June, which was up slightly from 10.8 percent in May. This is very low given the overall unemployment rate. It averaged 13.1 percent in the two years before the pandemic. It peaked at 16.0 percent in September 2022. This indicates that workers don’t feel the sort of confidence about their labor market prospects that we would expect given a 4.1 percent unemployment rate.
The June job report also shows that wage growth has slowed to a level that the Fed should feel comfortable with. The annualized rate for the last three months was just 3.6 percent, only a couple of tenths higher than the average for 2018-2019. The year-over-year rate was 3.9 percent.
Other labor market data show a similar trend. The JOLTS data show the job openings rate falling back from a record high at the start of 2022 to roughly the same level as pre-pandemic peaks. The quit rate has fallen to a level slightly below the peaks of 2018-2019. Unemployment insurance claims and continuing claims, after hitting record lows, are now actually slightly higher as a share of the workforce than before the pandemic.
Non governmental data tell the same story. For example, the Indeed Wage Tracker in April showed that wage growth for new hires averaged just 3.1 percent more than a year ago. This is the same as the rate of increase before the pandemic. Since this measure only looks at new hires, it tends to lead movements in the labor market as a whole. This supports the view that wage growth is likely to continue to slow.
It is also important to remember that the profit share of income has increased by almost 2.0 percentage points since the start of the pandemic. Unless the Fed has the view that any rise in the profit share is permanent, it should be prepared to see wage growth somewhat in excess of what might be a sustainable noninflationary long-term rate in order to restore the wage share at least to its pre-pandemic level. It will have to rise considerably further in order for the wage share to revert to its level at the start of the century.
Inflation Is Near the Fed’s Target
Chair Powell has repeatedly said that the 2.0 percent target was an average, not a ceiling. That should mean that an inflation rate close to 2.0 percent is consistent with the target.
Taking the year-over-year numbers we are still considerably higher than 2.0 percent, but this is mostly a story driven by rent. In the case of the Consumer Price Index (CPI), the year-over-year figure is 3.3 percent, but without shelter, it is just 2.1 percent. With the PCE, year-over-year inflation is 2.6 percent, but without shelter it is less than 1.9 percent.
It is reasonable to pull out shelter since this is driven by leases that were signed 1–2 years ago. The inflation rate for rent on housing units that go on the market is very low and possibly less than zero. The inflation rate for shelter will converge on the rate for new units even if the timing of this convergence is uncertain. But the point is that the Fed can be confident that the direction of inflation in the near-term is lower, going towards the Fed’s target.
We also know that expectations of inflation by many measures are back or nearly back to their pre-pandemic levels. The Atlanta Fed’s measure of business expectations of year-ahead inflation is 2.3 percent, a rate that we saw at several points in 2018–2019. The other regional Feds’ indexes for manufacturers’ expectations of prices paid and prices received also show a return to pre-pandemic rates.
The breakeven inflation rate for five-year inflation-indexed bonds is now just over 2.2 percent, virtually the same as the rate at several points in 2018. Also, it is important to remember that the index used for these bonds is the CPI, which typically has an inflation rate that is 0.2–0.3 percentage points higher than the PCE that the Fed targets. This means that expectations in the bond market are that inflation will be at or perhaps slightly below the rate targeted by the Fed.
The story here is that the risk of an inflationary spiral like what we saw in the 1970s is now near zero. Wage growth has moderated to a pace that is almost the same as what we saw before the pandemic and is likely to slow further. In addition, inflation has been gradually slowing for the last two years and is virtually certain to continue to slow.
The Fed’s Rate Cut Trade-Offs
Much reporting has framed the rate cut decision as one where the Fed has to be worried about being embarrassed by lowering rates too soon and seeing a reacceleration of inflation. The argument is that the Fed erred by waiting too long before raising rates in 2022, which allowed inflation to get higher than if the Fed had been more vigilant. Since the Fed had made this mistake, it doesn’t want to again err on the side of excessive inflation by cutting rates too soon, which would be a major embarrassment.
While that may be the framing of some observers, there is little logic to the argument. The Fed has its dual responsibilities of maintaining low inflation and maximizing employment. If it now errs by needlessly allowing the unemployment rate to continue to rise, it does not somehow even the score. This mistake is not made any better by the fact that it made a mistake in the opposite direction three years ago. The Fed has to try to make the right call now, based on the data it has.
On that front, it seems difficult to maintain that excessive inflation is a greater threat than a weakening labor market. The unemployment rate has risen 0.7 percentage points in the last 14 months. It is now 0.3 percentage points higher than the average we saw in the last two years before the pandemic. That corresponds to another 510,000 people being unemployed who would be employed if we had a stronger labor market. If current trends continue, this figure will rise further over the next year. This should be taken seriously.
There is also the point that high interest rates have put a serious dent in the housing market. Sales of existing homes are down by more than 30 percent from their peaks in 2021 before the Fed started raising rates. As a result, hundreds of thousands of potential first-time buyers are being kept out of the housing market. Millions of homeowners who might otherwise sell their homes are keeping them off the market and being prevented from making moves they want to make.
While rates will not decline to the point where we again see the 3.0 percent mortgages of 2021, it is reasonable to believe that lower rates from the Fed can get the mortgage rate back under 6.0 percent and eventually close to 5.0 percent. That would make a huge difference in the housing market.
High rates are also increasing financial instability. It is unlikely that we will see more failures like the collapse of Silicon Valley Bank in 2023, but banks will be hit in the months and years ahead by the write-down of loans on commercial real estate. Lower rates will make it far easier for them to get through a rash of defaults and bankruptcies in this sector. The housing market and financial stability may not rank as high as maximizing employment and low inflation on the Fed’s priority list, but they are factors it should take into account in setting interest rates.
There are events in the world that could see a reigniting of inflation. The Houthi attacks on shipping in the Red Sea have sent shipping costs soaring, which will be passed on in higher prices. A larger war in the Middle East could take oil offline and send gas prices soaring again. Many other possible disasters could be added to this list.
But these sorts of events are always a risk. The Fed can’t design monetary policy with the idea that it should try to limit inflation in the event some crisis occurs. It needs to respond to the economy that it is seeing at the time. And right now, this economy is arguing for lower rates.
Addendum – June CPI Decline Cements the Case
The CPI fell 0.1 percent in June, the first drop since the shutdown days at the start of the pandemic. The decline was to some extent an anomaly since a sharp drop in energy prices took the overall index into negative territory but inflation in the core index was just 0.1 percent.
The good part of the story is that just about everything in this report seems to be going in the right direction. Slower rental inflation, which we have been predicting based on the rents in marketed units that change hands, is now showing up in the CPI. The rental indexes both rose just 0.3 percent in June.
Inflation in medical services rose just 0.2 percent. New vehicle prices fell by 0.2 percent, used vehicle prices fell 1.5 percent. The index for household furnishings and supplies fell by 0.2 percent. Even the index for veterinarian services, which had been rising rapidly, fell by 0.5 percent in June.
More important than the topline number here is the fact that there is now basically zero evidence of ongoing inflation at an excessive rate. The index excluding shelter has risen just 1.8 percent over the last year. It is definitely time for the Fed to cut rates.
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