While inflation measures are improving, they are all still well above the Fed’s 2% target, suggesting that the central bank has more work to do to finish the job. Many feel that the easy pickings are over and the last mile to the finish line will be a much harder slog. That’s particularly so if the economy remains as muscular as it is and generating hefty wage increases that businesses are pressured to pass on to consumers. But this may be a simplistic way of looking at the issue. After all, inflation has steadily receded even as the economy continued to grow amid a historically tight job market. Why take away the champagne if the party is keeping everyone happy?
That, of course, is where the rubber meets the road. The Fed understandably believes that inflation fell despite that unforgiving backdrop because the special pandemic-era forces that propelled prices higher have unwound and punctured the inflation balloon. Supply bottlenecks that created product shortages have mostly cleared, the energy price spike from the Ukraine war shock has unwound and the lockdown-related surge in demand for goods has ebbed as the economy reopened, prodding consumers to shift buying preferences away from physical goods to experiences. The normalization of consumer spending is still underway.
Hence, the Fed is now striving to correct traditional demand and supply imbalances that it believes is keeping a floor under inflation. Most notably, it wants to tame demand to bring it more in line with the economy’s output potential and to restrain job growth to bring it more in balance with the increase in labor supply. The two, of course, go hand-in-hand. By curbing demand, business revenues would suffer, and employers would likely respond by reducing labor costs – the largest expense on most balance sheets – through cuts in hiring. As the job market turns weaker, so too would worker bargaining position, curbing wage demands and the pressure on employers to raise prices.
Misplaced Target?
But the argument that sustaining the disinflationary trend requires more policy tightening to squeeze businesses and labor is not overly compelling. True, rising wages puts pressure on employers to raise prices. This is most evident in the service sector that is more labor intensive than the goods sector, which can rely more on productivity to offset labor costs. A barber can only cut one head of hair at a time, but a new machine in a factory equipped with the latest technology can increase a worker’s output -- or replace the worker. (Although the actors strike stoked by fears of AI replicating the image of an actor may soon do the same in the service sector).
But it’s unclear how much blame for inflation should be attributed to labor costs. It is true that wage gains have finally caught up with inflation, at least by one measure of average hourly earnings compiled by the Labor Department. But rather than leading inflation higher – the causal input that the Fed worries about – worker pay has lagged inflation for more than two years, the longest stretch in which workers lost purchasing power since the late 1980s. That was also the last time the Federal Reserve lifted its policy rate into double digits, both to tame inflation and check inflation expectations by workers.
This time, workers have not increased wage demands in anticipation of higher inflation but to make up for more than two years of lost purchasing power. In fact, inflation expectations have remained well anchored throughout so it is fair to say that wages have followed inflation, not the other way around. Hence, as inflation continues to gradually recede, so too will wage gains, hopefully at the same or slower pace so that workers would retain the purchasing power they recaptured. Not only would a recession induced by an overly restrictive Fed policy throw millions of workers out of jobs – and reverse the pay gains they achieved – it would primarily victimize lower-paid jobholders and undo the reduction in income inequality brought on by a robust job market.
Lots of Drag in the Pipeline
When the Fed decided to keep rates steady at its June policy meeting, following ten consecutive increases, it did so partly to assess the impact that past rate hikes were having. In the month since then, not much has changed with the economy, as job growth and consumer spending have both held up well. While headline inflation, as noted, has fallen significantly, prices on a broad list of services have remained sticky. As this is written, it is highly likely that this backdrop will prompt the Fed to raise rates again at the conclusion of the July 25-26 policy meeting.
At the same time, many expect that the increase will be the last of the tightening cycle, which has underpinned the growing sentiment that the economy can avoid a recession. No doubt, a move to the sidelines would increase the odds the economy can stay afloat. We fear, however, that there is enough tightening in the pipeline that will push the economy into a downturn. It’s important to remember that monetary policy affects the economy with long and variable lags and the lagged impact has yet to play out. Most of the strong data the Fed is looking at are either backward looking or driven by forces that are poised to weaken.
Indeed, a host of time-honored leading indicators is pointing to a recession, including the Conference Board’s leading economic index, a deeply inverted yield curve and low consumer expectations of economic conditions as well as buying plans. Home sales, which are always the first to succumb to a recession, are being clobbered by high mortgage rates. Some believe that “this time will be different” because of the unusual pandemic-related forces behind the current business cycle. That reasoning has been invoked many times in the past, but has never worked out. Recessions come and go for a variety of reasons, and it is hard to believe that this time would be any different.