Inflation has not yet been overcome | Barron

Did Dr. Pangloss have a Ph.D. in economics? It seems so.

in Voltaire CandideAnd Dr. Pangloss He declared himself the best of all possible worlds, despite the evidence around him. And sure enough, things are getting better, and the markets and media are increasingly in agreement, at least as far as inflation is receding.

But they might be putting Panglossian shaders on optimization and ignoring the basic, but still annoying aspects. Price pressures are declining, albeit from their worst levels in four decades last year. Markets expect not only a slowdown in the pace of rate hikes by the Fed, but also cuts by the end of 2023 – although inflation will continue to be above the central bank’s 2% target, while recession forecasts remain speculation rather than reality.

The latest CPI reading matched economists’ optimistic estimates. A widely watched inflation measure in fact dropped in decemberby 0.1% as a result of the 9% drop in gasoline prices. The so-called core rate, which excludes food and energy costs, rose 0.3%, in line with expectations. More importantly, core CPI slowed to 5.7% yoy in the rate of increase from a 40-year peak of 6.7% in September.

But Michael Lewis, president of the free market consultancy, warns that other measures that dig deeper into the data “may tell another, less optimistic but more nuanced story,” he wrote in a note to clients. The Atlanta Fed measure of “constant” prices rose 6.7% from the prior year, while the Cleveland Fed CPI averaged 6.9% in that period, showing a slight net improvement over the past year.

Instead of just throwing out food and energy, as the core CPI does, Cleveland takes out the most volatile items each month, while Atlanta focuses on the more stable prices. Federal Reserve Chairman Jerome Powell has cited these measures in the past. Lewis cites this data as the main reason he cautioned against overconfidence in the central bank’s fight against inflation.

Medicare has been a major factor in curbing inflation, at least as has the Bureau of Labor Statistics measures them. This category rose just 0.1% in December, after corresponding declines of 0.7% and 0.6% in the previous two months. That reduced the annual increase in Medicare services to 4.1% in December, which Citi economist Veronica Clark called “misleadingly weak”. Those costs are likely to show a sharper increase in the December producer price index to be released next week, which will be even more important for the Fed’s preferred measure of inflation, the core personal consumption deflator, she wrote.

Another surrogate measure on Powell’s radar is essential services, excluding housing costs, which account for nearly a third of the overall CPI. Admirers of the measure say the BLS method reverses the delayed impact of past increases and ignores the recent decline in the pace of rent increases seen in online measures from Zillow.

This ‘core’ ex-housing chain is the new big thing in tracking inflation because it is driven by all-important labor costs. Inflation optimists were hopeful that average hourly earnings would slow to a 4.6% increase in December from a year earlier. But the broader measures favored by the Fed are likely to show more upward pressure on employment costs.

The Labor Cost Index is only released once a quarter, but it is a more comprehensive measure that includes changes in workforce composition and benefits as well as wages and salaries. Compensation costs increased 5.0% — and by 5.2% for private sector workers — in the twelve months ended Sept. 30.

The next ECI will be released on January 31, the first day of the upcoming meeting of the Federal Open Market Committee, which will issue its interest rate decision the next day. Look for continued relatively rapid gains in wages, reflecting tightening business conditions, as evidenced by the most recent Employment Turnover Survey and the National Federation of Independent Business survey, says Joshua Shapiro, chief US economist at MFR.

Such a pace of increase in the cost of labor would be consistent with the imminence of inflation The Fed’s 2% target Only if productivity is strong. But Neil Dutta, head of economics at Renaissance Macro Research, points out that productivity gains have been slow, only about 1%, against a 5% increase in labor costs.

The danger for the Fed is that it may pause rate hikes while the economy is actually accelerating — unlike last year, when it boosted rates sharply during a slowdown, he warns. Futures markets are pricing in quarter-point increases at the next two FOMC meetings, to 4.75%-5%, which is the peak, per CME FedWatch website.

Dutta notes that overall financial conditions have softened significantly, reflecting declines in Treasury yields, credit spreads in the mortgage and corporate markets, and higher stock prices, particularly the sharp decline in the dollar in recent months. He says the traditional concept of monetary policy operating with “long, variable delays” is flawed. Instead, the delays are “short and predictable”, working through the financial markets. Reflecting this, Dutta notes, housing stocks are “exploding,” up nearly 40% from their mid-2022 lows.

Despite persistent inflation and lack of recession – with a record unemployment of just 3.5% – markets expect the Federal Reserve to pause increases and then cut interest rates by the end of the year. Based on this unanimous reading of the fundamental data, the market optimism that fueled gains in bonds and stocks may be misplaced.

Sorry, Dr. Pangloss.

write to Randall W. Forsyth at

Leave a Comment