OPINION:
Inflation has improved lately, and investors are optimistic that the Federal Reserve will soon lower interest rates. Whether that’s prudent comes down to three questions.
Are we there yet?
In June, the consumer price index was up 3% over the last year. We’ve had no better reading since March 2021, but that’s still above the Fed’s 2% inflation target. And we have some good reasons to be cautious.
Most of the gains were in the goods sector — food and energy were up only 2.2% and 1%, and other goods were down 1.8%. Inflation in the services sector remains stubborn.
Though decelerating a bit, the cost of housing — 36.2% of the index — is still rising at a 5.2% annual pace. Other services — everything from brain surgery to theater tickets and accounting for 26.7% of the CPI — are up 5%.
We should expect some continued progress, but shortages and wage pressures abound.
According to Freddie Mac, the nation has about 3.8 million fewer housing units than needed, and repair technicians are scarce with more complex and computerized automobiles. Wages in residential construction and auto repair are rising 9.2% and 7.2% annually.
Higher labor costs help push up the cost of repairing collision damage, and in turn, motor vehicle insurance has increased 19.5% over the last year.
Those are just examples, and as big a worry, President Biden has put a donkey’s hoof on the scales in the run-up to the elections. He recently released 1 million barrels from the Strategic Petroleum Reserve and is slowly rolling sanctions on Russia and Iran to keep the price of gasoline down until November.
Gasoline prices were down 2.5% in June, but it’s doubtful those policies can continue if the war in Ukraine and Iran’s support of Red Sea pirates and other terrorists remain unresolved.
The history of battles with inflation, as studied by the International Monetary Fund across 100 episodes in 56 countries, indicates that central banks that pull back restrictive policies too soon see inflation reignite. The penalty for a premature celebration would be another round of rate increases later and slower growth over the next five years.
Financial journalists and economists such as Chicago Fed President Austan Goolsbee know these things and shouldn’t advocate looser monetary policies yet.
How much longer can the Fed hold out?
Pandemic savings to support consumer spending have finally run out, and families have gone from cheaper pleasures — snack foods instead of eating out — to shifting to store brands and cutting back altogether.
Unemployment is 4.1%, which is up from 3.5% last July, but the economy is still creating jobs.
Eventually, the economy reaches a point of inflection where rising joblessness causes consumer spending and business investment — so far held up by the artificial intelligence craze — to tip down. Layoffs accelerate, job creation becomes scarce and employment shrinks — the hallmark of a tough recession.
According to the Sahm Rule, named for its author, former Fed economist Claudia Sahm, when the three-month moving average for the unemployment rate exceeds the lowest observation for that statistic over the previous 12 months by half a percentage point, the economy is likely headed for a recession.
Currently, that statistic is 0.43%, but if unemployment rises to 4.2% in July, the Sahm Indicator hits 0.5% — code red!
Is immaculate deflation even possible?
The unemployment rate, currently 4.1%, is not the best indicator of labor market tightness; it reflects only the supply side.
A more meaningful statistic is the ratio of job vacancies — a labor demand measure — to unemployed job-seekers — a labor supply-side indicator.
That ratio is currently about 1.2 and approximately where it was for the three months before the March 2020 COVID shutdowns and ensuing recession. As importantly, for those three months, inflation was above target, averaging 2.4%.
An influential study by former Fed Chairman Ben Bernanke and the respected MIT and Peterson Institute economist Olivier Blanchard indicates that to get to 2% inflation ,the ratio of job openings to unemployed would have to fall well below 1.
That would imply a much higher unemployment rate — something closer to 4.5% or higher.
That busts through the Sahm threshold and implies that getting to 2% inflation would require a recession. Or we must settle for inflation in the 2.3% to 2.7% range and 10-year Treasury yields of 4.3% to 4.7%.
Inflation was unusually tame between the global financial crisis of 2007-2009 and COVID-19 and well below the 2% target. Easing interest rates now risks establishing expectations of greater future volatility and inflation ratcheting up over time.
For the 40 years prior to the financial meltdown, inflation across the economy was 4.0%, and the 10-year Treasury yield averaged 7.4%. Yet the economy and stocks thrived — the return on the S&P 500 averaged 10.5%.
• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.
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