Macro Updates

What to make of recently released macro data? History may inform us.


On Friday July 7, 2022, the US Department of Labor announced that non-farm payroll jobs grew by 372,000 in June 2022 while the seasonally adjusted U-3 unemployment rate remained unchanged at 3.6%. This is where it has been for the previous 3 months. The seasonally adjusted U-6 stood at 6.7% in June, down from 7.1% in May 2022 (you may recall that the U-3 is what the press commonly refers to as "the" unemployment rate, while the U-6 attempts to correct for those who have given up looking for work, aka the discouraged worker problem, and those working part-time but want a full-time job).

It was also reported that nominal wages, year on year, in June rose 5.1% in June compared to 5.3% in May. On July 13th, we will get the June inflation estimates, but given that May inflation was at an 8.5% annualized rate, this means that real wages are, mostly likely, continuing to decline.

Yet, many stories in business and popular press report that these "tight" labor market conditions will result in the Federal Reserve once again raising interest rate out of fear of a wage/price spiral. The journalists are, most likely, parroting what they hear from the Fed Chair Jay Powell, who in a May 2022 press conference stated: "We can't allow a wage-price spiral to happen. And we can't allow inflation expectations to become unanchored. It's just something that we can't allow to happen, and so we'll look at it that way."


What to make of these developments? Let's go back in time…

Ah, the wage/price spiral explanation of inflation. To understand this, one needs to travel back in time, to say, the 1970s.As we drive around in our brand-new American Motors Gremlin, we hear on the AM radio of how labor unions are pushing for cost-of-living adjustments in their negotiations with employers. We also learn listening to the Gremlin's radio, that President Nixon is considering wage and price controls to control inflation, since "we are all Keynesians now. "Meanwhile the Federal Reserve continues to increase the growth rate of money supply to keep interest rates low. We pull our Gremlin into the bank parking lot to make a deposit into our savings account that pays "the highest interest rate allowed by law. "As we make our deposit, we offer the teller one of our Marlboros, share a lit match, and we chat about the war in Vietnam.


So what does this have to do with 2022?The answer: almost nothing.

In the 1970s as rates of inflation increased, workers had market power in the setting of wages, thanks to labor unions and collective bargaining. With this market power workers could demand and get higher nominal wages. This was (as it turns out, erroneously) believed caused inflation. It didn't because despite their best intentions labor unions were often backward looking in determining inflationary expectations. Thus, wages did not keep pace with inflation, so real wages were actually falling, which helped control inflation, not add to it.

But, Nixon thought there was a wage/price spiral that caused inflation. This idea was developed by Keynesian economist who thought that when the economy was at full employment levels of real output competition for inputs, such as labor, would push production costs higher and result in high market prices, or inflation. So, Nixon imposed wage and price controls August of 1971, thinking that would stop inflation. The wage and price controls didn't stop inflation. By the way Nixon wasn't the only one to try this. President Gerald Ford tried a version of voluntary wage and price controls to stop inflation in the summer of 1974. They were a complete disaster.

Continuing with our 1970s story, interest rates are no longer subject to Regulation Q as they were back then. Regulation Q was an interest rate ceiling that had banks pay the "highest interest rate allowed by law" even though in real terms the interest rates paid on deposits were negative. So, people did not save much instead they would spend money as fast as they got it.

Which gets us to the one piece of this 1970s flashback that IS relevant today. When the Fed, or any central bank, attempts to keep interest rates "artificially low" they do it by increasing the growth rate of the money supply. Now, this is not necessarily inflationary so long as there are not any "shocks" to hit the economy such as excessive spending or shortages or very screwed up market incentives.Just like the 1970s the Fed has been increasing the growth rate of the money supply in recent years. And guess what? Now with various "shocks" (e.g. supply chain bottlenecks, war in Ukraine, push for higher short term corporate profits, all sorts of labor market distortions, etc.) we have inflation. In the 1970s one of the major shocks was the increase in defense spending for the war in Southeast Asia which we were discussing with the bank teller.

But, we can no longer smoke inside bank buildings, nor can we drive around in a new AMC Gremlin. So the 1970s is not a perfect replication of today.


When history informs…if you let it.

As Yale historian Timothy Synder has written: "History does not repeat, but it does instruct." The key is that we must understand what history instructs.

Jay Powell does not seem to understand this. Powell, like Nixon and Ford, seems to be latched onto this idea of the wage/price spiral. Even if the story was true, that workers today (despite having almost no market power) can demand and get higher wages, he faces a problem that recent wage increases are below the rate of inflation. Thus, real wages are declining, so how could they be the cause of inflation? Instead, being the good lawyer that he is, the esteemed Mr. Powell continues to argue his case, no matter how counter factual it might be.

So, what does history instruct?

Milton Friedman got many, many things wrong. But, one thing the Chicago economist did get right was when he demonstrated (again using historical data) that "inflation is always and everywhere a monetary phenomenon." That is: it's the money supply growth, along with those shocks, that one has to worry about when it comes to inflation.

Now, as Snyder's statement makes clear, history does not repeat perfectly, so it is not always the case that increases in the money supply trigger higher rates of inflation. Due to financial market innovations, changes in the economy, etc. it is no longer a one-to-one mapping of changes in the growth rate of the money supply result in increases in the rate of inflation. This, the esteemed Mr. Powell has repeated in public by either by reading it off a teleprompter or he has memorized it from a PowerPoint Slide. The bigger issue is, Mr. Powell does not seem to understand that while the velocity of money (or the turnover rate of money) may have declined in certain time periods due to financial market innovations, and thus increases in the growth rate of the money supply do not always trigger increases in the rate of inflation. That, in turn, does not mean that velocity will always remain low, and thus increases in the rate of money supply have nothing to do with the rate of inflation.

This misunderstanding by Mr. Powell led him to erroneously believe that any price increases were "transitory" and his massive increases in the money supply would thus never trigger inflation…until they did.

So, now the Powell Fed is trying to stop the inflation that they have let get out of control. They have raised interest rates and called for lower wages and slower job growth. The first one might be defensible (although perhaps too little, too late) while the blaming workers who real wages are falling for inflation, is well…questionable at best.


What is happening right now…

Which gets us back to the current labor market data and what will the Fed do next?

To answer this question, we need to get inside Jay Powell's lawyer head. Keep in mind, he is not an economist and (as far as I can tell) has studied much economics either formally or informally. But, he seems whetted to this idea of wage/price spiral, despite what history (including Milton Friedman and Anna Schwartz's work on the subject) informs us.

Hopefully, Mr. Powell will look beyond just the non-farm payroll and U-3 unemployment data. If he were to examine the labor force participation rate and other labor market data, such as the quit rate (which I discussed in previous MacroUpdate) he might come to the realization that the labor market has "supply" issues not just demand side issues.

For example, let's look at the labor force participation rate. As you may recall this the number of people over age 16 that are either employed or actively seeking employment divided by the total civilian population over age 16 not in an institution. It tells us, basically, what percentage of the potential population is "in" the labor market. From 2013 onward it has been around 63% (it can be influenced by social, demographic, and economic conditions so that is why I am looking at roughly the last 10 years). It fell dramatically during COVID reaching a low point of 60.2% in April 2020.

In June 2022 it was 62.2%, little changed from 62.3% in May 2022. Before the pandemic in February 2020 it was 63.4%. One would hope that with the unemployment rate being as low as it is the labor force participation rate would be increasing. It's not. So, why?We are not completely sure, but we think it has to do with 1) child care issues (parents are having a hard time finding or affording child care and thus not entering the labor force), 2) transportation issues (potential workers find it expensive to purchase a car and/or to put gas in it and thus can not get to a job), and 3) the "great quit" continues as workers want either better work/life balance, better working conditions, and "better" managers. Thus, a large number of Americans are simply not "in" the labor market. This is a labor supply problem. One that needs to be addressed.

We currently have about two jobs open for every job seeker, so clearly there is something "wrong" with our labor markets. But, is this necessarily inflationary? Doubtful. Will higher interest rates "correct" this labor market "problem?" I can't see how.


So if the Fed increases interest rates will it tank the economy?

Again, let's turn to the data. The GDP data is released only quarter, but the New York Fed along with the Dallas Fed puts out the WEI (or Weekly Economic Index) in an attempt to give us more "real time" GDP data. Now, this is an index designed to mimic real GDP, not a GDP forecast.

For the week ending July 2, 2022 the WEI stood at 3.17% which is scaled to four quarters of real GDP growth. The WEI was 2.90% for the week ending June 25, and for reference it was 1.37% for the week ending February 29, 2020.So, this suggests the economy is not "falling off the table" at this point. So that is good news…for what it is worth.

On the inflation front the Core PCE for May 2022 (the most recent data we have) was at 4.7% change from the same month one year ago.That is down from 4.9% in April, and 5.2% in March and 5.3% in February 2022.Naturally the Headline PCE was higher (remember this includes food and energy prices) increasing 6.3% in both May and April, 6.6% in March, and 6.3% in February. So we can see the impact of those higher energy prices in the difference between the Core and the Headline. But, the downward direction, especially in the Core PCE, is what we would like to see.

So, what will the Fed decide to do? Increase interest rates? Perhaps. Hopefully this will reduce the growth rate of money supply and allow interest rates to "return to normalcy" (to borrow a phrase from Woodrow Wilson).If done "properly" this should bring about continued decline in the rate of inflation.

On the other hand, if Mr. Powell continues to obsess on his wage/price spiral he may increase interest rates significantly, and very quickly, attempting to stamp out a (potentially nonexistent) "cause" of inflation. This could push the economy into a recession. One that is completely avoidable.

So, here is hoping we do not return to those days of the 1970s, with its failed attempts at controlling inflation. Hopefully we will have wiser macroeconomic policymakers who understand what history informs them in terms of the causes of inflation.

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