Inflation is an expectations game, and we may be expecting too much.
For the better part of two years now, Wall Street traders have been obsessed with a single question: when will Jerome Powell and the Federal Reserve Bank pivot from its current course and decide to cut interest rates. Every hint of inflation settling down near the Fed’s 2% target has sparked a frenzy in the bond market, as traders positioned their trades to get ahead of the first cut in the Fed Funds rate.
There is a lot at stake. Traders hoping to cash in when the Fed pivots and begins to cut rates, have visions of the windfall of a lifetime. Partnerships in storied Wall Street firms. Penthouses in Manhattan. Waterfront homes in the Hamptons, or perhaps on private islands in Biscayne Bay.
But so far, all those bets have gone south, as they did again last week. Once again, continued resilience across the economy — the kind of news normal people celebrate — has prolonged the agony for that rarified cabal in the finance world hoping to cash in on the Fed’s next move.
Inflation came in high last week. Not real high, just higher than expectations — the headline Consumer Price Index indicated year-over-year inflation was 3.5%, vs. consensus expectations of 3.2%. That may seem like a fairly marginal difference, but just like betting on sports, it is an expectation game.
For two years now, every piece of data, every utterance by a Fed Governor or shift in the Fed dot plot has been interpreted, and trades have been positioned in hope that the trade of the century will finally come to pass. [Don’t worry if you don’t know what a Fed dot plot is, that just means you have better things to do with your time]. This week, once again, Jerome Powell told people to calm down; the Fed may not be cutting rates any time soon. And at least one Fed Governor went further, joining former Treasury Secretary Larry Summers in suggesting that the next move in interest rates may be up, not down.
Media coverage of inflation is as much about the narrative surrounding the number as the number itself. When the Bureau of Labor Statistics published the CPI number last week, the release was framed not only against expectations, but against what alternative measures of inflation might tell a different story. Sure the CPI came in at 3.5% last month, but if you exclude food and energy, the number was really 3.8%. Not so fast, Bloomberg Intelligence pointed out, homeowners insurance was up 21% over the past year, which would have added 0.8% to last year’s inflation number. And on and on.
While the Consumer Price Index continues to dominate as the headline number, when that number comes in high, or perhaps low, we are quickly reminded that the Fed has its own preferred measure, the broader Personal Consumer Expenditures (PCE) index. As soon as inflation seems close to being under control by one measure — as it did last month, when the PCE came in at 2.5% — any number of critics pivot and point to another one that shows a less favorable result.
And there are myriad others to choose from. There is the “CPI Less Food and Energy,” that removes volatile food and energy prices from the calculation, though I challenge anyone to find the consumers who spend no money on food or energy. There is the “supercore services” index, which focuses on services such as healthcare and insurance, while excluding housing and energy costs. The “Sticky CPI” looks at prices that change less frequently and are harder to get under control. The “Trimmed Mean CPI” is like Olympic scoring, throwing out the lows and highs. The “Median CPI” throws out everything but the item with the median price change. Then there is the Underlying Inflation Gauge published by the powerful New York Fed.
And just to show that the world of economics has a sense of humor, The Economist magazine publishes the Big Mac Index (BMI) that looks at the relative pricing of the McDonald’s burger across the world. What began forty years ago as a spoof on the industry’s penchant for indexes, the BMI — not to be confused with the Body Mass Index, with which it surely has some correlation — has become a serious measure of inflation and global currency markets.
Left undiscussed in this superabundance of data is the more basic question of whether 2% is a reasonable inflation target. In some respects, it is unarguable that the Fed should hold to that goal, as Powell has, through thick and thin. After all, inflation remained well below 2% for more than a decade, before the world came unglued in the wake of the Covid-19 pandemic. And a 2% inflation is about more than just a number. For millions of Americans, returning to 2% inflation means there is hope for a return to the 3% home mortgage, and renewed faith in home ownership as the cornerstone of the American Dream. That is also why Powell must be loath to abandon a 2% goal, as the political blowback would be fierce; he would be denying people their dreams for the future.
Yet it is important to understand that the years before Covid-19 were anything but normal. The 2008 global financial collapse distorted economic activity for the better part of a decade and a half. The collapse led to previously unimaginable policies by central bankers across the world, as they were consumed by fear that the collapse would lead to a global economic depression and cascading price deflation.
First, central bankers across the world pushed interest rates to zero. Then, many countries went farther, pushing official rates below zero, as the notion of negative interest rates went seemingly overnight from unfathomable to the norm. Then, finally, Fed Chair Ben Bernanke took things a step further, when he introduced “quantitative easing” — an opaque term for policies that enabled the Fed to push interest rates on everything from Treasury bonds to home mortgages toward zero — taking Fed monetary stimulus to previously unimagined heights.
And those policies worked, as they amplified the ability of the Fed to stimulate economic activity in the face of looming depression and deflation. Subsequent studies of quantitative easing ultimately concluded that the “QE” policies undertaken by the Fed had effects comparable to pushing the Fed Funds rate to 400 basis points, or 4.00%, below zero.
Even as the 2008 global financial collapse has receded into distant memory, its impacts have been enduring. Seven years of zero interest rates punished those on fixed incomes, and catapulted wealth disparities into the stratosphere. The failure of the political establishment to prosecute those in the finance world that the public believed to be responsible deepened public cynicism. The financial crisis cascaded into a political crisis, ultimately giving birth to the Occupy and Tea Party movements, and our politics became unglued.
When the New York Times published the graph below to put the 3.5% inflation number into an historical context, it intended to illustrate how much work the Fed has yet to do to reach its 2% policy target. Yet, one can draw a different conclusion from this graph. Looking back over the past 60 years, the only period when the Fed’s 2% inflation target has actually been achieved was during the decade following the 2008 global financial collapse, when it averaged 1.6% (as illustrated by the red dashed line that I added for emphasis).
But those years were an aberration. As noted above, the challenge that the Fed faced in the wake of the 2008 collapse wasn’t to hold inflation down to 2%, as Jerome Powell and his colleagues are currently trying to do, but rather to push inflation up to two percent, as central banks across the globe fought a decade-long battle to prevent a global depression and deflationary spiral.
In contrast, the quarter century from 1983 to 2008 arguably represents a more “normal” comparison to the current economic landscape. That period began during the last five years of the tenure of Paul Volker, the iconic Fed Chair who implemented draconian policies to tame post-Vietnam War inflation. During Volker’s last five years in office, from 1983 to 1987, inflation as measured by the Consumer Price Index averaged 3.8% annually (it had peaked at nearly 15% shortly after he became Chair) and during the ensuing 20 years it averaged 3.1%. During the entire twenty-five year period, from 1983 to the financial collapse in 2008, inflation as measured by the CPI only dipped as low as 2% three times: 1986, 1998, and 2004.
As this historical data suggests, the years since the 2008 financial crisis have distorted the notion of what “normal” should be with respect to interest rates and inflation. In a similar vein, we are only beginning to grapple with the impact of the Covid-19 pandemic on labor markets and employment, and what normal might look like going forward. By traditional measures, the economic impact of the pandemic was more severe, but of significantly shorter duration than the 2008 collapse. As illustrated in the graph below, it took almost two years for the unemployment rate to double from pre-collapse lows of below 5% in late 2007 to its 10% peak in late 2009. In contrast, the pandemic impact was immediate, as commerce came to a grinding halt with the onset of the pandemic, and the unemployment rate quadrupled from 3.5% in February 2020 to 14.8% just two months later.
The differences between the recoveries from the 2008 collapse and the pandemic are similarly stark. It took until early 2016 before the unemployment rate recovered to the level seen before the 2008 collapse, or almost seven years since unemployment peaked in late 2009. In contrast, the unemployment rate returned to pre-pandemic levels in a little over a year from the onset of the pandemic in early 2020.
But while the recovery from the pandemic came quickly with respect to the unemployment rate and pace of economic growth, the economic landscape seemed qualitatively different after the pandemic ran its course. It felt like we had morphed overnight from a world of unrelenting technological advancements, where people wondered how there would be enough work to go around in the future, to a world of remote work and labor shortages.
The emergence of an economy characterized by previously unimaginable levels of labor scarcity has directly impacted the effectiveness of the tools available to the Fed as it seeks to control inflation. The entire premise of the Fed raising interest rates is to slow down the economy, increase unemployment, reduce demand for goods and services, and bring down inflation. The threat of unemployment, and the availability of a pool of unemployed workers — what Karl Marx described eons ago as the “reserve army of labor” — is critical to that process. If business did not feel free to lay off workers as business slowed down, it would undermine that cycle, and hinder the ability of the Fed to do its job.
And that would appear to be exactly what has happened. In the post-Covid world of labor scarcity, labor “hoarding” has become common practice, as businesses have proven to be reluctant to lay off employees, even if conditions warrant, as they fear they will not be able to find employees when business picks up.
The way things used to work, after two years of severe efforts by the Fed to slow economic activity, the number of unemployed workers should be a multiple of the number of open jobs, but instead, the number of open jobs continues to be a multiple of the number of unemployed workers. Last month, the unemployment rate ticked down slightly, to 3.8%. It remains within spitting distance of historically low levels, and the scarcity of workers continues to threaten entire industries.
As Jerome Powell and his Fed colleagues continue to debate where interest rates should go from here, perhaps people should step back, recognize that the Fed is navigating an economic landscape unlike anything in recent memory, and give them credit for the progress they have made to date in their battle to contain inflation.
In a world where inflation has been spurred on by an extraordinary confluence of events, including trillions of dollars in continuing fiscal stimulus, global supply chain disruptions, titanic shifts in labor markets, ongoing wars that are directly impacting global food and oil supplies, and repeated outbreaks of the avian flu, the tools that the Fed has at its disposal are very blunt, indeed. Against that backdrop, bringing inflation down as low as it has can be seen as quite an accomplishment.
The inflation story is going to be with us well through the end of the year. Indeed, the Presidential election may come down, at least in part, to both what the rate of inflation is by Election Day, and how the overall inflation story is understood by the public. Thus far, while Inflation has come down significantly, the dominant narrative remains that the Fed has a ways to go to reach its goal of restoring inflation to within its 2% target.
But a fair reading of the history of the past half-century suggests that 2% inflation has proven to be an elusive goal in the best of times. If 3.1% was the best the Fed could do over the quarter century before the 2008 financial collapse, 2% inflation may simply not be a reasonable expectation going forward, particularly if labor scarcity is here to stay.
You can find all of David’s recent posts at dpaul.substack.com, and his writing dating back to 2004 at https://authory.com/DavidPaul
Artwork by Joe Dworetzky, some of which may have been facilitated by AI. Follow his cartooning on Instagram at @joefaces and his journalism at authory.com/JoeDworetzky
