It’s The Demand Curve, Stupid…
By Christopher Thornberg
The biggest obstacle to slowing inflation is that the real causes of it—excessive consumer demand and rapidly rising wages—are too politically toxic to acknowledge.
The August CPI report showed prices in the United States continuing to increase, contrary to the predictions of most Blue-Chip forecasts and the Federal Reserve. This has spooked the markets and caused a sharp decline in the various indexes—the S&P 500 dropped over 4%. The decline in the markets doesn’t surprise me—they are the ultimate drama queens of the economy, overreacting to everything. They will likely bounce back soon enough.
What does perplex me is how we collectively continue to be surprised when the official inflation forecasts fall well below reality. This same kabuki dance has been repeated almost monthly for more than a year now, with expert economists assuring us that price growth will soon decelerate and maybe even reverse, followed by a gnashing of teeth and predictions of doom when it turns out the data is not living up to the optimism.
I am certainly not suggesting that inflation is easy to forecast—especially on a month-to-month basis. But the problem I see here is different. The major forecasts and official prognostications aren’t just missing the mark, they have consistently predicted lower inflation rates than have been occurring. In statistical parlance the forecasts have bias. And this bias stems from the fact that the cause of inflation has been misinterpreted as primarily a supply chain issue, when in fact it is an excess demand and labor cost issue.
Consider the various explanations for inflation over the last year. They have typically attributed the problem to parts shortages (e.g., empty car dealer lots and high used-car prices), energy markets (the high cost of gasoline), the war in Ukraine and grain markets (food prices) among other issues. The following quote is from a Wall Street Journal reporter discussing her interviews with various economists prior to the summer CPI estimates:
“[June] will probably prove to be the peak for the annual measure of CPI. That’s because pretty much all of the major drivers of the inflation surge this year and last year are fading or outright reversing. Energy prices are on the downswing, most obviously gasoline prices. Upstream, energy and food commodity prices have come down a lot in recent weeks too, which suggests that there’s more easing to feed through to consumers in store, particularly on the grocery front. Supply-chain pressures seem to be gradually improving.”
If we think about inflation as being strictly driven by limitations in inputs, then any relief in those supply pressures should cause prices to fall. But this is not the case today, as the August number clearly demonstrates. The supply-chain theory of inflation is wrong. And the reason many experts continue to get it wrong is because the true causes of today’s inflation—excess consumer demand and rapidly rising labor costs—are politically toxic and difficult to acknowledge in these terse populist times.
Excess consumer demand has been caused by an overstimulation of the economy on the part of the Feds. As I have written many times, the pandemic hit to the economy was never the crisis it was portrayed to be, and the $6.5 trillion in fiscal stimulus, largely funded by $5 trillion in new money created through the Fed’s quantitative easing program, was vastly more than necessary. It set financial markets to new (unsustainable) highs and ultimately generated a 25% bump in household net worth ($30 trillion in new wealth) in just 2 years. This new “wealth” has driven consumer spending to new highs, and that is what is causing inflation. As Milton Friedman famously quipped: “Inflation is caused by too much money chasing after too few goods.”
Looking at the supply side only mistakes the symptoms for the disease. Gasoline prices shot up because the minor issues with supply were magnified by the major jump in demand. Estimates of short-run demand elasticity for gasoline suggest the market is inelastic, but still, an increase in price will lead to a decrease in consumption if those prices are only being driven by supply constraints. Yet, the Bureau of Economic Analysis’ GDP data shows that in the last 18 months, even as energy prices rose 97%, consumption of energy products increased by 7%. Prices rose so dramatically because of the surge in demand, not the limitations on supply.
And now that energy prices are falling as supply catches up, money not spent on energy is simply flowing to other spending—healthcare, housing, restaurants, travel—and causing more inflation in those categories. And those sectors also have supply shortages—driven by labor shortages rather than supply chain issues. Just as excess demand drove up energy prices, excess demand is also causing a rapid increase in worker earnings, which is another important contributor to business costs and output prices. According to the Atlanta Fed’s wage tracker, U.S. worker earnings are now growing at a 6.7% annual pace—the highest rate ever recorded in the 40 years of data they have created.
And therein lies the political problem. If we acknowledge that inflation is being driven by excessive consumer demand, then we must admit that Americans are overconsuming. That’s an idea that doesn’t fit the miserabilist narrative that underpins political debate today. Both parties consistently tell their supporters how terrible they have it and then immediately blame the other party’s policies. Apparently, in the political world, most U.S. households are living hand to mouth, workers are highly underpaid, and we’re all just one paycheck away from financial disaster. To suggest otherwise would be gauche.
For the record, U.S. consumers are overconsuming. Consumer spending as a share of nation’s GDP is the highest it’s ever been, except during the runup to the Great Recession—not a comfortable comparison. This overconsumption is one of the root causes of the growing U.S. trade deficit, currently at almost 5% of GDP, again the widest it’s ever been except for the 2005 and 2006 period. As for the idea that real earnings growth is negative, you only get this result if you use the CPI estimate of inflation, which overstates the situation for technical reasons we won’t dive into here. The appropriate deflator is the PCE deflator from the Bureau of Economic Analysis, and if we use that, real earnings growth is positive, albeit not at a 40-year high pace.
Of course, this story is only explaining the mechanisms within basic monetary theory. If you want to predict how much prices will increase, you only need to look at money supply. The Federal Reserve’s quantitative easing program expanded the money supply of the United States by 40%. Therefore, holding all else constant, prices need to go up by 40% to equilibrate the size of the economy to the size of the money supply.
While the Fed’s quantitative easing caused inflation, oddly their response to the problem has been primarily to push up the Federal Funds rate, the old tool that Ben Bernanke had largely moved past during his tenure. The big hikes in the Federal Funds rate have done very little to reduce the money supply; it has only stopped growing. If the Fed is serious about slowing inflation, they need to engage in quantitative tightening—which they say they will be starting this month.
By tightening of course, they will, by definition, cool consumer demand and weaken labor markets, as these are the ultimate sources of inflation. Given that policymakers are seemingly unwilling to acknowledge that the problem is excessive spending as well as wage growth, it unfortunately suggests they will be unwilling to do what is necessary to slow inflation.
The only question then is how much longer will we continue to be surprised by it.
2 For more about the CPI’s inflation estimate see: https://www.clevelandfed.org/newsroom-and-events/publications/economic-trends/2014-economic-trends/et-20140417-pce-and-cpi-inflation-whats-the-difference.aspx
No Near-term Recession Says Leading Forecast; Supercharged Consumers will Propel U.S. Economy into 2023
Recession Potential Will Grow If Federal Reserve Tightens To Control Inflation… But The Sooner The Better; California On Verge of Recovering All Jobs Lost To Pandemic
Despite real signs of stress in parts of the system, for now, consumers will carry the U.S. economy through this year and into 2023 without a downturn, according to Beacon Economics‘ latest outlook for the United States and California. The wealth created by the excessive fiscal stimulus enacted in 2020 and 2021 continues to drive a consumer consumption binge and the new forecast anticipates economic growth to look better in the second half of 2022 (when final numbers are available) than it did in the first half.
Inflation will continue to run hot, and interest rates will continue to rise as a result, but those circumstances are not recession causing, according to the outlook. Instead, expect a slow pace of overall economic growth, with weaker numbers from the more rate sensitive sectors.
“Functionally speaking, policymakers went from maximum acceleration – the stimulus – to maximum braking – tightening by the Fed – over a single year, something that would create turbulence in even the healthiest economy,” said Christopher Thornberg, Founding Partner of Beacon Economics and one of the forecast authors. “But in the near-term, while parts of the economy will remain cool due to rising interest rates, that supercharged U.S. consumer, armed with a $30 trillion increase in household wealth over the pandemic period, will keep momentum going.”
The new forecast also argues that inflation may have peaked but will not decelerate rapidly. “Until the Fed gets serious about tightening, that is reducing the money supply and raising interest rates, expect price growth to remain elevated,” said Thornberg.
Although the potential for a real recession in the nation will increase if and when the Fed applies more aggressive quantitative tightening to control inflation and push up real (rather than nominal) interest rates, the faster the Fed acts the better in order to prevent a truly deep negative business cycle, according to the forecast.
Starting in 2023, if Fed action is inadequate the United States may be looking at 3 or more years of very weak growth, with consumers in a relatively poor financial position at the end. If the Fed stamps out inflation in the near-term by aggressively reducing its balance sheet, it will drive up interest rates, cool financial markets sharply, and possibly create a modest recession next year led by consumer cutbacks. However, the nation would come out of it with a strong private sector.
In California, the state is on the brink of a milestone: recovering all the jobs it lost during the pandemic-driven downturn. While many states have already reached full recovery, as of this writing, California still has a 73,000 job deficit. However, if the economy adds the same number of jobs as it did in the latest numbers in the next data release, the state’s job count will be above water.
“California’s labor force contracted during the pandemic and employers have struggled to hire the workers they need, especially in coastal communities,” said Taner Osman, Research Manager at Beacon Economics and one of the forecast authors. “These difficulties circle directly back to the long-term affordability crisis facing the state as the labor forces in more expensive coastal areas have declined while they have grown in relatively affordable inland communities.”
View the new The Beacon Outlook including full forecast tables here.
Demographic Dilemma: Slowing Population Growth, Not Pandemic, At The Root Of U.S. Worker Shortage
Ability To Meet Current, Future Demand Challenged; Problem Magnified In California Due To Housing Scarcity
Supply chain struggles have been widely blamed for the inability to meet consumer and business demand throughout the pandemic. While fixing the supply chain should be a top priority, it is worker scarcity, driven by the lack of basic, long-term population growth that is the true underlying cause—and a critical future challenge for the economies of the United States, and particularly California, according to a new analysis released today by the UCR School of Business Center for Economic Forecasting and Development.
“For several decades there has been a substantial slowdown in the growth of Americans in their prime working years,” said Christopher Thornberg, Director of the Center for Economic Forecasting and the report’s author. “Whether it’s the missing factory worker, delivery truck driver, or salesclerk, the scarcity of workers is hindering the ability to connect demand to supply and is slowing economic growth.”
According to the analysis, long-run population growth of people between the ages of 25 and 54 accelerated dramatically in the U.S. in the 1970s, peaked in the mid 1980s at over 2% growth per year, and then collapsed just as fast, driven by sharp declines in birthrates. International migration into the United States jumped in the 1990s, offsetting some of this baby bust, but that too slowed sharply after the turn of the century. Today, the population growth rate of prime working age people in the nation is 0.2%, one-tenth of what it was 40 years ago.
Thornberg notes that these population trends have been observed in the data for many years, but because it’s the kind of thing that happens gradually, the issue simply hasn’t been a primary focus for policymakers or business leaders.
The mass wave of retirements that occurred during the pandemic both accelerated and exacerbated today’s worker shortage, but it is not the root cause. “This is a long-term demographic problem, not a short-term cyclical one,” said Thornberg. “It is not going to disappear as the COVID crisis fades.”
As bad as the labor shortage is nationally, it is worse in California, especially Southern California, according to the analysis. The state’s lack of housing acts as a functional cap on population and labor force growth, degrading affordability and driving workers and businesses to other locations. Moreover, the state’s demographic forecasts do not paint an optimistic outlook for future trends.
According to the analysis, all of this means government agencies and policymakers need to concentrate on increasing labor supply and helping employers adapt to a new world where workers are a scarce resource. In the immediate term, there is a relatively passive way leaders can help: they can relax labor market regulations to allow employers maximum flexibility in how they hire their workforce.
Specifically, the analysis calls out the following:
- Restrictions on gig work and flexible work schedules should be reduced, not heightened as California is currently doing.
- Older employees who wish to remain active in the labor market should be encouraged and supported by reducing or eliminating potential reductions to existing retirement benefits.
- Regulation should shift to allow employers to offer a variety of wage/benefit/training packages depending on worker desires rather than being based on preset publicly mandated minimums.
- Policymakers should relax licensing requirements and staffing rules.
In the longer-term, elected and regulatory officials can make a difference in numerous ways:
- At the national level, Congress can address broken immigration policies and work to allow more people to legally move to the United States.
- State and local leaders in California can expand housing supply, particularly multifamily housing, to slow out-migration.
- Policymakers can increase earned income tax credits to support workers in moving off public assistance into lower-wage, lower-skill jobs.
- Government leaders can subsidize employer-based worker training programs to allow and encourage lower-skilled workers to enter higher skilled career paths.
- Policymakers can invest in Pre-K education and publicly subsidized childcare facilities to help workers (particularly women) remain on their chosen career path as they build families.
- Government can provide grants and training to assist small businesses in adopting labor saving technology.
View the report, The Big Shortage: California’s Worker Scarcity and Economic Growth, here.
Inland Empire Business Activity Still Going Strong; Region’s Performance Starkly Contrasts Economic Slump At National Level
Investors Buying Up More Housing Stock Than Ever Before
Business activity in the Inland Empire has continued to grow, and in the context of today’s increasingly uncertain economic environment, stands in stark contrast to growth trends in the nation, according to the new Inland Empire Business Activity Index released today by the UCR School of Business Center for Economic Forecasting and Development. The region’s economy officially transitioned from recovery to expansion in the fourth quarter of 2021 and growth is forecast to continue throughout 2022.
In the first quarter of 2022 (the latest data available), business activity in the Inland Empire expanded by 4.7% compared to 6.4% in the fourth quarter of 2021. Although regional growth has slowed somewhat, it unambiguously outperformed U.S. GDP, which declined by 1.5% in the first quarter. Moreover, the regional slowdown is to be expected as the local economy has reached and surpassed pre-pandemic conditions. Over this year, the Inland Empire’s business activity is forecast to rise between 2.5% and 3.5%.
“Despite greater instability in the macroeconomy today, there are still very few, if any, signs of weakness in the Inland Empire’s economic activity,” said Taner Osman, Research Manager at the Center for Economic Forecasting and one of the Index authors. “Employment has continued to expand and the workforce in the region is now larger than it was before the pandemic, something that is not true for the state as a whole.” Osman cautions, however, that while momentum still exists, the Inland Empire will eventually share in the effects of the broader economic contraction, but not likely in 2022.
The new report also calls out the hot, inventory-constrained local housing market. According to the analysis, it would take 2 to 3 times current inventory levels to move the region out of the seller’s market it’s currently in. The Inland Empire’s high home prices are being driven by a number of other factors as well, including an increase in investor appetite for real estate in the face of a shaken stock market. Investors purchased 17.2% of the homes sold in the Inland Empire in the first quarter of this year, up from 15% one year ago.
“Today, across the entire nation, investors are buying up a larger share of homes than ever before,” said Osman. “Rising mortgage rates should help temper the double-digit price appreciation we’ve seen in the Inland Empire, but at this point we don’t foresee a scenario where home prices will decline, due largely to limited inventory.”
The analysis was authored by Taner Osman and Senior Research Associate Justin Niakamal.
View the new Inland Empire Business Activity Index here.
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