The optimism of the Fed and markets seems to be at odds with historical experience.
If history is a guide, inflation hasn't been whipped yet.
M arkets in recent weeks have all but declared that the Federal Reserve has won the war against inflation. Futures markets have set the probability of a Fed rate hike to zero for next year, and are instead pricing in four rate cuts beginning in May 2024. At the same time, the data on economic activity have been fairly solid of late. So if inflation really were under control, it would be a unicorn event, unusual enough in economic history that one might genuinely begin to wonder whether Jerome Powell possesses mystical powers.
The historical macroeconomic experience has been a terrific guide to this inflationary episode. At the beginning of it, it was obvious that the massive increase in government spending and aggregate demand would lead to a spike in inflation unless supply jumped along with it.
As in the past, when the Fed finally began to tighten, that tightening began to put downward pressure on interest-rate-sensitive sectors. This approach has been moderately successful, but as I have mentioned in this space before, it runs into a roadblock on the way to price stability.
At the beginning, price inflation is much higher than wage inflation since wages are sticky. But wage growth eventually responds to the first inflation spike, and inches upward even as price inflation is declining. This helps workers recapture some of the spending power they have lost, but eventually price and wage inflation collide, and when that happens, the disinflation stops. Wages are such a high share of costs for producers that they can’t possibly cut prices while they are increasing wages.
The “mission accomplished” mood in markets implies that they believe that this normal historical pattern will be avoided this time. But are the data really supportive of such optimism? This chart plots average hourly earnings and wage inflation, both as measured by the Bureau of Labor Statistics, back to January 2022. As you can see, the textbook pattern is clearly evident in the data. Price inflation dropped to wage inflation, and then has been stuck there with super glue ever since.
In other words, the optimism of the Fed and markets seems to be at odds with historical experience. Price inflation can go down from here only if wage inflation does, and that will only happen when the signs of economic weakness are far more convincing than they are today.
Yes, one might say, but as Adam Smith taught us, markets aggregate all of the world’s information that is relevant to pricing an asset more efficiently than any individual ever could. Might there be something that our traditional story is missing?
Perhaps. Previous inflationary episodes in the U.S. happened when the U.S. was almost an island economy. Today, economies are intertwined, and events around the world can drive the movement of global prices in a way that depends little on U.S. labor markets. Energy prices have been coming down, putting downward pressure on prices. They have been doing that for a good reason: The world economy is on the ropes.
Last week, Japanese authorities revised down their initial estimate of Q3 real GDP from -2.1 percent to -2.9 percent at an annualized rate. While Japan’s economic environment is distinct, it is far from alone in facing what amounts to onset of recession. The euro zone as a whole saw real output contract by 0.1 percent from Q2 to Q3. The zone’s largest economy, Germany, contracted by 0.1 percent quarter-on-quarter, and Italy was stagnant.
Meanwhile, global commodity prices are beginning to display tendencies usually associated with the expectation of global recession. Despite heightened tensions in the Middle East and OPEC+’s announcement to further curtail production in 2024, Brent crude spot prices are down 22 percent from their 2023 peak. Despite the scramble for EV raw material inputs, copper spot prices are down 12 percent from their 2023 peak.
Perhaps inflation will hit its target and the dreams of a soft landing in the United States will be fulfilled. If that happens, it will be because there is a hard landing everywhere else.