There Are Many Things to Worry About. Inflation Isn't One of Them.
“The whole thing is quite hopeless, so it’s no good worrying about tomorrow. It probably won’t come.” -JRR Tolkien, author of "Return of The King"
Worrying about the coming wave of high inflation is all the rage these days. Last week, the Federal Reserve's former vice chairman of the Federal Open Market Committee, Bill Dudley, put out a column titled " Four More Reasons To Worry About U.S. Inflation."
This was an update to his column of a few months prior, "Five Reasons To Worry About Faster U.S. Inflation." Nine reasons is a lot of reasons! It’s probably not a coincidence that the article was released on the day that January consumer price index inflation data was released which showed continued weakness, with core CPI decelerating to 1.4% year over year from 1.6% in December.
We’ve heard many more than nine reasons why inflation will spike, and from a variety of sources. They range from things that aren’t actually inflation (“The prices of things went down during the spring of 2020, so if they just return to normal by the spring of 2021 … inflation!”) to questionable logic. For instance, one line of thinking suggests that a rising dependency ratio of retired population to working-age citizens will cause inflation. On that, Japan would like a word. Another recent argument for higher inflation is based on the Census Bureau’s median asking rents data series. The most recent release, just two weeks ago, saw rents skyrocketing nearly 20%. That certainly sounds inflationary. Just for fun, let’s throw those against CoStar’s similar series.
A quick visual analysis shows that these kinds of large spikes in the Census series usually either coincide with or lead periods of decelerating rent growth, not the other way around. When the Census and CoStar series disagree most, rents tend to be weakest in the coming quarters and years. This time looks similar.
Assuming the CoStar forecast proves accurate, rising multifamily rents will more likely contribute to a rise in inflation during 2022, not 2021, and even then only briefly sustained.
Inflation during a pandemic makes for tough analysis. Households drastically shifted spending from one bucket to another in response to the quarantine, from in-store retail to online spending, or from travel and entertainment expenditures to durable goods like home computers, or even bigger homes and apartments (more on that last point next week). Those are a lot of crosscurrents. Inflation is defined as the fall in purchasing power, which shows up as a general increase in all prices. In order to see a sustained upward rise in inflation, there should be more coordinated price rises across all or most spending buckets. A good way to see whether or not this is happening is not to look at average inflation across all categories of spending, but to look at median inflation. In that way, large price rises or falls in one or two buckets won’t skew the analysis, and should do a better job of measuring that loss of purchasing power.
Our favorite data series for this is the Cleveland Fed’s Weighted Median CPI series. This index is created by finding the median price change among all sub-components, removing the noise of, say, skyrocketing indoor plant prices or deep clothing deflation, as we’ve seen over the past year. In January data released last week, Median CPI increased by an annualized 1%, the lowest since November, and before that, 2010. The year-over-year increase has fallen by a full 1% in the past year, reversing seven years of progress. Authors’ note: Median CPI tends to overstate inflation by 50-150 basis points compared to the Fed’s preferred Core Personal Consumption Expenditures measure.
It takes a long time to make the cumulative economic progress needed to sustain 2% inflation. The concept of a non-accelerating inflation rate of unemployment, or NAIRU, became popularized in the 1990s. This essentially stated that there’s a “natural” level of unemployment, below which inflation accelerates in an undesirable manner.
Through the last recovery, NAIRU was estimated by the Fed to be 5% as of 2015 … until the unemployment rate fell below 5% without inflation (in fact Core PCE fell to 1%). The estimate of NAIRU was then lowered to 4.5%, until unemployment fell to 4.0% without sustained higher inflation. Today, the Fed estimates long-run unemployment at 4.1%, but has all but removed the concept of NAIRU from this framework entirely.
Instead, Powell and company have embraced the broadest possible view of inflation. With their new inflation framework announced last year, the Fed now desires overshoots of inflation above 2% to make up for prior misses, showing how comfortable they are with being reactive to higher inflation rather than proactively assuming it’s about to rise at X threshold. The existence of this new framework is perhaps the best argument that, at some point in the future, we will have higher inflation. But just because the Fed wants higher inflation, doesn’t mean it can create it on its own.
A broad view of economic and labor market slack is more useful than the headline unemployment rate. In the past two cycles, inflation hasn’t been sustained at or near the Fed’s target until the most disaffected — part-time workers who want full-time jobs and non-participants who have been discouraged, titled “deep labor slack” below — find the employment they want. This is typically the last shoe to drop, and with the deep damage done in 2009, didn’t normalize until 2018. The quarters below where inflation was consistently within 20 basis points at the Fed’s target have been shaded blue. There aren’t that many of them, and they generally only come deep into a recovery when deep labor slack has ground down to much tighter levels than they are today.
The last time we saw the Fed’s goals met, ironically, was supported by a roughly $1.5 trillion Tax Cut and Jobs Act signed by the Trump administration. Enacted at the close of 2017, the unemployment rate fell below 4% for the first time since the 1960s. Core PCE surpassed 2% from March to November 2018, though also boosted by more restrictive trade policies which made imports more expensive.
We currently have three-and-a-half million more people in the “deep labor slack” bucket than what has proven consistent with stable 2% inflation, a number that will take quite a while to recover even with expansive fiscal policies. We are not worried about inflation becoming a problem in 2021. Fed Chairman Jerome Powell does not appear to be either, if recent comments are taken at face value. And it appears that Powell wasn’t even worried before the pandemic. Speaking on the prospects of running the economy too hot, he recalls the economic environment in years leading up to the pandemic:
These late-breaking improvements in the labor market did not result in unwanted upward pressures on inflation, as might have been expected; in fact, inflation did not even rise to 2 percent on a sustained basis. There was every reason to expect that the labor market could have strengthened even further without causing a worrisome increase in inflation were it not for the onset of the pandemic.
There are many things to worry about these days, most of them real and tangible. For today, we choose not to create new worries.
The Week Ahead …
The coming week should provide more details around Powell's patient approach, as the Fed's minutes from its January meeting are to be released on Wednesday. While some members, mostly the occasional regional Fed president, seem interested in beginning the discussion around eventually tightening policy, the core of the committee appears content with waiting for inflation to prove itself before reacting.
In the coming weeks, this column will focus on single-family housing, finally experiencing the long-awaited boom in first-time homebuyers over the past six months. Housing starts data should show if January continued 2020's gains, to be released on Thursday. Existing home sales for January are to be released on Friday.
Retail sales data should also be of interest, released for January data on Wednesday. Retail sales slowed into the winter months given the surge in COVID cases, likely to remain the case until households feel more comfortable spending in person.