Luke Bartholomew
Hello and welcome to Macro Bytes the economics and politics podcast series from abrdn. My name is Luke Bartholomew. Just this week, I'm standing in for our usual host Stephanie Kelly, and Paul Diggle. And today we are talking about the outlook for inflation in the US. This is an extremely important debate in economics, financial markets and policy circles at the moment. In fact, I think it's probably a bit of a misnomer to call it a debate in the sense that there's at least two or three quite different debates going on around this inflation topic about short term reopening effects, longer term impacts, and how policy sits within all of that. So I'm delighted to say that I am joined today by my colleague, James McCann, our Deputy Chief Economist who leads on US economic coverage to help us untangle some of those debates. So hello, James, and welcome back to the podcast.
James McCann
Thank you very much for having me.
Luke
Not at all. So before we start, I think it might be useful to hear a little clip from deputy Federal Reserve Chairman Richard Clarida, as he talks about his views on the inflation outlook
Clip from Richard Clarida
"...On the inflation outlook, obviously, the CPI number that we got recently was a very unpleasant suprise. We and other forecasters expected both PCE and CPI inflation to move up upon reopening but that increase certanily caught my and other's attention. I continue to believe, as my baseline case that this will prove to be largely transitory and I think the details of that recent report are consistent with that."
Luke
So James, there, we heard Richard Clarida talking of an unpleasant surprise in the recent inflation numbers. So maybe it would be pretty useful for our listeners, if you sort of explain the details around that unpleasant surprise and what it's telling us about inflation dynamics at the moment.
James
Yeah, absolutely. And we know in terms of context, and we've spoken about it on this podcast, that there's a pretty active debate, and you flank a little bit there. But about the extent to which the amount of stimulus running through the US economy combined with reopening momentum, and already pretty robust recovery will lead to a potential overheating. So I think there's a latent sensitivity there in markets and more broadly, about inflation. And that probably is not helped by a record month from the inflation side. And in April, we got headline inflation spiked to 4.2% year on year. And we got a record increase month on month in core inflation, which put the yearly rate over 3%. So unusually high inflation, and not just something we can explain away with this is an energy price effect. We saw core inflation rise as well, which also always creates a little bit more concern when people see that core inflation basket rising. And it's not just driven by those headline effects. So, certainly more than the market had been anticipating and more than we've been anticipating, I think it was well baked in. And inflation was set to rise in April, we knew that there were large base effects from April last year. And what by now it is, the weakness in inflation as the economy shut down, meant that the year on year comparison, just naturally, as we move through to this April report was going to be flattered upward. So that was absolutely the case. But what we saw as well, one or two really, really sharp increases in some of the components. And that push those headline and core rates were noticeably higher than than had been anticipated. I think, as you said, just really added to this debate around what's happening on the US side. And how can we explain that? And what should we think about it going forwards?
Luke
Well, through to that very question, do you think there are many lessons that we can learn from that one month's print? Or is it all sorts of weird idiosyncratic noise going on that people talk about the extreme rise in used car prices, for example, as a result of semiconductor shortages, and there being a huge amount of demand that has to suddenly hit that market very quickly as rental car companies sort of stock up their fleets again, that doesn't strike me as necessarily the kind of thing that generates sustain price pressure going forward. But is there more to it than meets the eye than just some weird stuff in a few markets?
James
I think it's really important to highlight those effects and the volatility and some of , what we would consider to be to be largely transitory factors that are affecting the data at the moment. I think, what you find and then in the global, not just the US to the global vehicle sector, link to the supply chain issues around microchips is really important. If we look at the contribution from used car sales, they were around 20% year on year and alone used car sales added another point eight percentage points to that annual core inflation rate. If we then think, just moving to look at a slightly different interpretation of the effect of car prices on the economy. As you mentioned rental prices. They're worth 80% year on year. That's going to slow down all the way only adding 0.2. But already, we've got around a third of the increase in the core CPI over April, year on year terms, and it's all related to these two pretty small components altogether. They account for around 4% of the mass to US consumers typically spend on that they've had a really outweighed in size on overall inflation dynamics. So I think it's really important to highlight where we've got one or two really extreme things happening in a couple of components. And that's biased on upwards. More generally, what we've seen, though, too, is pressure across the goods sector. So if I look at goods inflation, excluding energy prices, again, because we know energy prices can be very volatile. But if I look at core goods inflation, that's really at 4.4% It's 20 year average is an odd point 1%. Normally, we get very, very low inflation in the global goods sector. But this is really extraordinary. It's not as extreme as we've seen in things like used car prices, but across appliances, TVs, computers, etc, certain parts of apparel, certainly, we're seeing more heat there. And it speaks to this, this tightness and bottlenecks in the global goods sector more generally. I think that's something that's maybe got a little bit more signal. If we think about coming months, it will take a little bit of time to move through that similar to the issues with used cars, and new car production in the link to microchips. But it speaks to this issue that you've got a bit of a dislocation between global goods amount of the global good supply, and that's creating some crashes, which, of course, is natural as economies are reopening. We've had huge dislocation in activity. But I think that's maybe we can take a little bit more medium term signal from that. But we might see those issues persist for a little while longer. But more fundamentally, I don't think we should read too much in terms of a long term inflation environment from that goods misalignment. No, certainly, we do think that the supply side we'll be able to recover and adapt to that demand. And also we think that the demand may moderate at least or at least normalise. So it's been interesting to monitor how, what's normally a very benign environment in global goods inflation has really flipped on its head. And I think an interesting question might pose to yourself is - we've seen it's very clearly in the good sector- as economies and in the US, in particular, opens up here, is there a chance that this spreads more broadly, is there a risk that actually it's not just for goods, whether it's time to put the spot on more broadly, across the index?
Luke
Yeah. So as you say, a lot of this that we're seeing at the moment is very concentrated in the goods sector that reflects the fact that as reopenings happened, it's been the case that the good sector has been the one that's experienced the rush of demand. Services is still somewhat slow. And the recovery is, there is social distancing. And whatever else it is, and people sort of reluctance to come back to that. And so yeah, if demand suddenly hits the services sector, do we see exactly those same price pressures? I suppose the first thing to say is normally we would think of the services sector as being a lot more supply elastic. So supply turns on quicker when prices move, ultimately, we have to remember that, in a market economy, prices are signals. Their way of destroying demand that's too high and encouraging supply to be brought on. And the problem with the goods sector at the moment is we're having difficulty bringing that supply on quickly. Normally, in the service sector, we can bring supply on relatively quickly and those dynamics are less pronounced. However, I think there are reasons to be a little bit more concerned about the services sector experiencing those same dynamics this time around, there are quite particular features of recovering from the pandemic that might speak to the fact that we could also see bottlenecks in the service sector. In particular, there does seem to be evidence that the short run labour supply is much more constrained than you might think just by looking at the headline unemployment rate or employment to population ratio or any other broad range of macro level indicators that we typically look at to measure the degree of labour market slack. Those all screen out that there's a lot of spare capacity there anecdotally. And also, I think, evidentially as well, it does seem that firms are finding it a bit harder to fill vacancies than you would expect. And that's the sense in which short term supply is a bit lower. And I think there are several reasons why that may be. First of all, still some sort of residual concerns about going back to work in professions that involve higher degrees of social contact when people perhaps aren't fully vaccinated. And then taking them perhaps more controversially, but also around this idea that their unemployment insurance was expanded quite significantly as part of the COVID relief measures. And for some people, the Employment Insurance represents more than 100% of the salary they would otherwise be earning if their worked. And so perhaps the combination of that, along with stimulus checks that are still in bank accounts means that there's somewhat less of a rush to return to work than there otherwise might be. People's outside option, relative to going back to work is improved. And so their reservation wage, the amount they need to be paid to do a job has probably gone up somewhat at the margin. And so therefore, we might start to see some wage pressure there, and some difficulty hiring people relative to what you might otherwise have expected. So it is plausible that , as demand moves out of the good sector, and towards the services sector, we see sort of bottleneck effects stayed in the goods area, but start to be recreated again, in the services sector. So I wonder James, again, does any of that, even though that this period might be quite a long period, if you can really work through these effects, if any of that fundamentally change the medium to long term dynamics? Or are these just adjustment effects that just take a little bit longer?
James
Again, I think these would probably be thought out as the latter adjustment effect so that we can talk more about what would make us concerned that they will be more persistent. But yeah, all things being equal at this stage, I think we should be fairly sanguine, about these adjustments effects. I think if you run through a really nice summary of why we might have some blockages in the supply side of labour, an interesting anecdote here in Boston, all COVID restrictions have now been eased just a few days ago that came through. And obviously, sports stadiums, Fenway Park, back to full capacity immediately, which is a huge sort of switch and quite short term switching headlines talking about the difficulty and shifting back to full capacity because of being able to hire so many so many stadium workers. And I guess it's a friction thing there. It's difficult to do that quickly when policy changes quickly. But then as you say, there might be some things which are holding up labour supply. But, , I think crucially, and I tend to agree with you, I think many of those factors should ease in the coming months, and that should boost labour supply. Be it around viral concerns as case numbers continue to decline and, and vaccination rates continue to rise, be it around public health restrictions. As schools reopen and there's less issues around childcare, for instance, or be it around, as you say, this issue with what is the level of unemployment insurance benefits, and is that discouraging workers? We know that a number of states are bringing those federal tops ups to an end this month in June and the latest they can run at the moment, according to legislation in September. So we know that the reservation rate should be falling, I suppose over the coming months. So if those supply constraints were more persistent, I might be a little bit more nervous. But I think the base case should be that those supply constraints are starting to ease and it means that while we might see pockets of friction short term. Again, short term tension volatility, as we try and fill Fenway Park very quickly, maybe in the next few weeks, you are having to pay a little more to get concession workers etc, into the stadium. We do think that is something which should ease as we go forward and doesn't really change that more medium term dynamic around how we think the inflation process should work. Absence of any sort of big shift in be it inflation expectations, etc, which would mean something that we see as being transitory into more persistent. , maybe you can talk about from our perspective, what the things that would make that I suppose relatively sanguine view on the short term dynamics in both the goods sector in the services sector, more concerning on a medium term to long term horizon. What are the things that we should watch out for, that would tell us that actually, this could prove much more persistent than we're currently expecting?
Luke
Yeah, sure. Just before I do that, I just wanted to make a quick observation that at least one bit of good news from all of this is that this will provide future economists with an extremely rich dataset of natural experiments in seeing how different states' labour markets respond as the unemployment insurance ends at different rates due mostly to political factors rather than underlying economics, which should make as I say, quite a nice time series to study. So yeah, perhaps there is some good in all of this. But in terms of your question, I think it's a very good one. In the past, we've identified what we called three necessary and sufficient conditions that we think are required to move to sort of very different inflationary regime. And the first of those is a sustained period of excess demand.- so when the economy is running well above potential. The second is a weak nominal anchor. So this is what underpins people's inflation expectation, and gives them a sense of what's going to ensure that the currency preserves value over time. So you can think of a time where there wasn't inflation targeting regimes and central banks, and we're off the gold standard, that period the 1970s. It was a very weak nominal anchor in that sense. And that's part of the reason why inflation did get so high during that period. And then the third is the policy, monetary policy, in particular, fails to deliver on its commitments to price stability over the medium to long run, it fails to adhere to what we call the Taylor principle -this idea that you can't allow real interest rates to keep on progressively falling, and therefore, over stimulating the economy that way. Now, I think stacked up against those three conditions, you can start to paint an interesting question about the future outlook for the US economy, because it does seem to be the case that there will be a period of above trend, above potential output in in the US. That was a big reason why the likes of Larry Summers and other very big name economists were quite sceptical about the full size of the stimulus package, they were worried they're gonna push output well above potential. And in our forecast, as you will know, James, we see US output above its pre crisis level, above its potential level over the next couple of years due to this very strong stimulus. So in a sense, you've got one of these conditions may be met. So then what becomes crucial, is a monitoring how inflation expectations form in that environment. And trying to find series, that gives us some sense of a forward looking view on inflation expectations. And second, getting a sense of how we think monetary policy will respond. And I suppose that sort of brings us back full circle to Clarida at the start there and where the Fed fits into this whole picture. James, you do want to give us a sense of how we see Fed monetary policy evolving around this and how the Fed itself sees this inflation dynamic that we've described?
James
Yeah, absolutely. I think baked into the Feds forecast, making to everyone's forecast says this sense by which US growth is going to be pretty, pretty extraordinary. We will pass in pretty short order pre crisis COVID peak, so the economy will be larger than it was before this crisis. And we'll go on to probably as you set out there to demand or run above what we would expect the US potential supply to be for a period of time, it's always difficult to estimate exactly how big an overshoot is, and how much excess capacity is there. But certainly the Fed has, I think they did to its forecasts, and we see that very clearly and what the unemployment rate does. And the summary of economic projections, the Fed expects the economy to normalise and then I suppose in to some extent, start to move a little bit tighter as we move through its forecast horizon. I think what's also been baked into the Feds forecast is that we don't start to see that excess demand will lead to very, very significant acceleration of US consumer price growth on that medium term horizon. Certainly, there's a caution around how quickly inflation is rising towards the end of their forecast horizon in 2023. And I think this builds in the view linking to your second point, first of all, the inflation expectations are very well anchored. The Phillips curve is relatively flat and also stable. So as you mentioned, you won't get a dynamic, as we saw in the 1970s, where a period of high prices becomes embedded more and more in the economy as people change their expectations of future inflation demand, higher wages, etc. We think the Fed expects that to remain relatively orderly and has built in that relatively muted response between excess demand and price pressures in the economy into its forecast. And according to that it has policy signal at the moment which is cautious. It's one in which it's looking through this transitory increase talking about, as Clarida there, a transitory increase in inflation, but then thinking forward and expecting the more medium term dynamic of price growth to be relatively well behaved. And thinking that it will achieve and overshooting its inflation target will take a while to credibly declare, to credibly achieve that. It's later somewhere he can make projections, the median and not thinking that the conditions are in place for a high before the end of 2023. So, absolutely the Fed is taking a cautious stance on that. That doesn't mean that if inflation surprises that the Fed will not shift that. I think it will take more than a period of high prices during reopening, I think the Fed would need to see some evidence of a more sustainable and more troubling increase in inflation to change policy. But to your point around those necessary conditions to see sustained higher inflation, it does not seem to be the case that the Fed would sit back and stand idly by, if we were to see sustained high levels, inflationary pressure, and couldn't be explained away by transitory frictions around reopening an economy following the COVID shutdown. And in that case, I think the timetable for Fed tightening be through asset purchases, interest rate hikes, we would naturally move forward. So we still think that despite the Fed shift to an average inflation target, despite its different way of looking at how it targets inflation and meets that inflation target, it's still absolutely not willing to let our very high period of inflation to set it in the US economy. And we should expect that to be a natural ceiling on what price growth should do based on that reaction function, which I still think is very, it's very credible.
Luke
Yeah, I think that's absolutely right. The nature of an inflation targeting regime is that you shouldn't be especially worried about economic price pressure, overheating, showing up in inflation. The point is that the Central Bank will do, broadly speaking, whatever it takes to contain the inflationary pressures, they just might have to put up interest rates or tighten monetary policy quite significantly to do it. So if you're worried about an overheating, don't worry about inflation so much, worry about what it means for the structure rates. And I suppose maybe this one, one final thought, if I can from you, James. I guess a lot of that discussion there was based around lift off and the tightening of the Feds's first move to tighten policy. And whilst that is certainly an interesting debate, and a lot turns out, there is also another debate about what the path of policy looks like after liftoff. And it seems to me, one of the logical consequences of the Feds average inflation targeting regime is that if you allow for a period of above target inflation, and at some point, you do need a period of interest rates being a bit higher than normal, right, to put that inflation pressure back down again. So maybe the thing if you're really worried about overheating is is less about the timing of the first time and more about how high interest rates ultimately end up going. So I don't know if you just have any final thoughts about how high interest rates could possibly rise in this cycle, whether we're, anything that we've seen should make us fundamentally reassess ours? And I think the widespread perception that equilibrium normal interest rates are extremely low and going to stay that way.
James
Yeah, I think it's a nice shift in focus. It's often the case that these threshold dates are seen as so important. So much focus in the market now or when tapering is announced when, let's face it, given the size of the Fed's balance sheet a few months here and there on tapering and a difference in the flow of asset purchases makes very different stance to the overall stance. It's a real difference to the overall stance of monetary policy. And similarly, a few months aside, in terms of the date of liftoff for the Fed funds rate is not huge. I think what is important is where that terminal rate potentially is that the Fed is shooting for, how long it takes to get to that terminal rate. And absolutely almost, what the Fed is committing to do now has been falling behind the curve might be a bit too strong maybe, but it's certainly waiting longer to, it's seeing the winds of the eyes of inflation. So this sense by which you might need, had you waited to tighten policy just policy a little bit more quickly, I think probably does have a lot of merit, and then we can build in. Often we think about our interest rates in nominal terms. We should also think about the real aspect of things and inflation in sustainably higher the Feds hitting its target and achieving an overshoot. And that would argue for a little bit of a higher peak nominal rates potentially in the in the US. And the equilibrium rate is one that's difficult to nail down. But perhaps there's some argument that if the Fed is successful in this in raising inflation expectations back to target, and that could make us more confident that that real interest rates may rise a little if some of the Biden infrastructure investment style initiatives are able to raise the productive capacity of the US economy a little that could be helpful, maybe more generally, lower levels of governments saving is another thing that could drift this higher. So maybe there's some chance as well with the US economy is able to live with a slightly higher nominal rate, and that peak of interest rates is higher. But, , an interesting dynamic is how will the rest of the global economy cope with this? I think that will be an interesting spillover effect. We know that during the last cycle when US had a lot of stimulus through the Trump tax cuts, interest rate hikes in the US caused a great deal of disruption in emerging markets, in global financial markets and they wash back quite quickly into the into the US So that sort of the potential sting in the tail - could be, is there a risk that the US has dislocated or will dislocate to a significant extent and that will create its own stress in in global markets as it tries to exit its policy assessments?
Luke
Well, I think that is an excellent note to leave it on. So thank you so much, James, for joining us today. I really appreciate all your insights there. We have a mailbox macrobyte@abrdn.com and we would love to hear from you. If you have any questions, topics, thoughts or feedback please do email us on that address there macrobytes@abrdn.com. Thank you so much for listening and speak to you again soon.