“Well, everyone knows Custer died at Little Bighorn. What this book presupposes is…maybe he didn’t?”
Eli Cash, The Royal Tenenbaums, 2001
July 14, 2023 - Bottom line up top
U.S. inflation is going down. Consumer prices rose 3% over the past year, one-third the rate of the previous year. And there’s more disinflation in the pipeline.
Producer prices are moving closer to outright deflation, with headline PPI essentially flat over the past year. With input costs no longer rising, businesses will feel less pressure to raise prices on consumer goods and services.
Soft inflation prints drove down bond yields this week, but the Fed still seems likely to hike rates by 25 basis points this month. This may be a mistake, but it won’t be a catastrophic one.
The U.S. dollar turned weaker against pretty much everything this week. Changes in relative real interest rates between countries are the primary driver of currency movements. Lower U.S. inflation means a weaker dollar…for now.
Unemployment claims remain very low, a signal that the layoffs in tech and finance earlier in the year have not rippled through into the larger economy.
Corporate earnings reporting season for Q2 has kicked off. Companies may be reporting weaker revenues as consumer spending growth slows, but costs appear to be more contained, helping profit margins stay wide.
Chart of the Week - Les Misérables or just less miserable?
Unemployment is low and inflation is falling. What’s your excuse to be miserable now?
We all know inflation is sticky. What this section presupposes is…
U.S. inflation is not yet low, but it’s heading lower. Consumer price inflation (CPI) was 3% over the past twelve months, a two-thirds reduction from its 9% apex a year ago. Much of this drop is due to a 16.5% decline in energy prices from June 2022 to June 2023. But economists, including those employed by central banks, focus more on core indexes that exclude food and energy categories. June delivered good news on that front, as well, with core CPI rising just 0.16%, its smallest monthly climb since February 2021. Annual core inflation dropped to 4.8% from a 6.6% peak last September.
Slicing things even thinner produces still more good news. With goods prices flat and energy in free fall, service inflation, specifically on shelter, has been the main event in recent months. Rents have risen by 8.3% over the past year, but that rate is about to fall substantially given what we see in the private indexes that lead CPI:
Fed officials continue to see the labor market as a potential source of “sticky” inflation, so they’ve elevated an even narrower measure of so-called “supercore” inflation measuring core service prices excluding shelter. But whether we look at headline, core or supercore inflation, we’re now seeing the same story:
There’s no doubt that inflation remains a concern for many households, even as the official data shows it slowing. This is partly because inflation’s effect is cumulative. Weekly earnings for most households still do not go as far as they did two years ago. But with incomes now rising faster than prices, that may not be true much longer:
Real average hourly earnings isn’t quite the same thing as wages. For one thing, the massive composition spike in 2020 was due to composition effects as many lower-paying jobs vanished. That effect reversed in 2021 as a disproportionate number of newly created or returning jobs were lower paying. But in 2022 the story is a lot easier to interpret. Prices rose faster than pay. But now in 2023 that’s no longer true, which may be why we’re seeing rising consumer confidence and unexpectedly durable personal spending.
So, if inflation isn’t sticking around, why do rates need to go up?
Inflation has risen and fallen quite sharply over the past two years as each successive wave (first goods, then energy, and now shelter) has receded. None of these waves have stuck around for very long, but because we were hit by the three of them in rapid succession, overall inflation seems on the surface to have been sticky. Over the second half of this year, we should see the gap between core and headline inflation narrow as the two series converge to around 3.5% (headline inflation will edge higher as last summer’s months of rapidly falling energy prices fall out of the twelve-month window).
Despite this, and despite inflation reports for June that were as soft as could be hoped for, the Fed seems determined to get one more 25 basis point rate hike out of its system when it meets in two weeks. But this week’s data seems to have finally convince investors that the next hike will be the last. The odds of another hike in September or thereafter have fallen to just 15% from closer to 50-50 last week.
What happens after the next/last hike will be the key to driving markets from here. With recession risks pushed out and inflation still above target, the Fed may keep rates at their peak for longer than markets are currently pricing in. Investors are pricing in a more dovish path from the Fed than they were before the June employment report, with rate cuts priced in as soon as March. But there’s little chance of core PCE inflation falling to 2% by that time, and in the face of resilient growth the Fed is unlikely to be magnanimous and cut rates early.
What is Bidenomics and why should investors care?
Since I have a feeling we’ll be hearing this terms a lot in the next eighteen months I thought I’d spill some virtual ink this week on “Bidenomics”. Many people place too much emphasis on who the president is when deciding how the economy is doing or how it’s likely to do moving forward. But policy decisions, including bills passed by Congress, presidential appointments, and unilateral executive actions, can certainly matter at the margins. So it’s worth understanding what President Biden’s economic agenda has been and how it digresses from the policies of prior administrations.
I should start by pointing out that it’s far from clear that “Bidenomics” is really even a cohesive set of policies flowing from a single ideology. The term has only entered wide circulation in the past few weeks now that the White House economics team — led by former Fed Vice Chair Lael Brainard — seems more confident in the improving outlook. This reduces the chance that attempts to take credit for disinflation, growth and low unemployment will end in embarrassment and ruin. (But they still could!)
Distilling the administration’s major economic policy accomplishments from 2021 through today, I see two main pillars:
Greater use of fiscal policy as a countercyclical force against weak demand and/or high unemployment, with central banks left to clean up the inflationary mess via tighter monetary policy.
More frequent and more significant government intervention in the economy via industrial policy, including subsidies and trade restrictions, to help certain favored U.S. sectors remain globally competitive and ensure the country has the infrastructure it needs to continue to power itself and remain productive.
These represent significant deviations from the post-Cold War economic and political consensus that produced freer trade, lower inflation and interest rates, and less regulation of industry. Will they endure? Well, the tilt toward less restrained fiscal policy may be dead already given the current divided state of government. A policy to err on the side of larger stimulus may not be an option when the next downturn arrives. The effects of the 2020 and 2021 stimulus bills are in large part still with us and have helped produced an economy with greater household wealth, higher inflation, and higher interest rates.
It will take some time to judge the efficacy of laws like the CHIPS and Inflation Reduction Acts, and the money from the bipartisan infrastructure bill is just starting to be spent. But the Wall Street Journal this week published commentary from Greg Ip pointing out that a lot of these plans lack any established economic foundation. Mainstream economists (Hi, Professor Irwin!) are quick to point out that trade restrictions and subsidies for domestic firms shrink the size of the overall economic pie, helping workers in favored industries at the (greater) expense of consumers and workers in non-favored industries. In the near term, public and private investment in infrastructure and manufacturing will add to GDP. The true test will be whether they will be productivity enhancing once the investments have been made.
The current political consensus seems to be centered around a mix of nationalism and populism that produces “Buy America”-type policies and is at least tolerant of looser fiscal policy. In fact, one could argue that “Bidenomics” is in many respects not that different from the policies of the Trump administration. Both are skeptical of freer trade and neither had any qualms about widening budget deficits to deliver large transfer payments to individuals and businesses. And Trump’s fruitless efforts to pass an infrastructure bill may have softened up the Republican Party just enough on the issue to get Biden the votes he needed to pass his bill last year.
If the U.S. economy has lower inflation a year from now with a strong labor market, expect President Biden to run on his policies, even if they’re not directly responsible, and expect voters to buy it. James Carville’s motto, “It’s the economy stupid!” remains the rule until proven otherwise. How the term Bidenomics is referred to years from now — with either earnest admiration or derisive scorn — will depend on whether next year’s economy is friendly to incumbents. One, in particular.
What to watch for over the next week (and beyond)
The U.S. Census Bureau will release retail sales data for June, which will probably tell us which side of 2% GDP growth we landed on last quarter. I’ll also be interested to see whether industrial production delivers an upside surprise.
Housing starts and building permits probably rose again in June, at least for single-family units. Multi-family construction activity is at an all-time peak but should start to come down soon based on the softer rents we’re seeing.
The worst kept economic secret in the world at the moment is that China’s post-pandemic recovery has been a bust so far. But we shouldn’t necessarily expect to see that in the Q2 GDP data next week. Official government statistics in China are not always accurate reflection of real conditions. #understatement
I’m watching the Hollywood actors and writers strike. This has the potential to disrupt not only the firehouse of content we get (which often provides me with material for the next section) but also to disrupt a major U.S. industry and a significant number of jobs. We have more reasons to be optimistic than pessimistic about the economy right now, but this is one for the “worry” list.
What else I learned last week
I learned that our penalty for trying to enjoy two days away at the beach last week was a ten-hour trip home from Miami to New York and a few hours in the ER with my wife who got sand in her contact lens and lacerated her cornea. Message received!
I learned that my 5-year old is now watching kids chess videos on YouTube and getting visibly frustrated when they go into some block or trap that he can’t easily understand. I may have created a monster.
I learned that you know something has gone very right in your life when you’re driving to the same dance studio five times in one day.
I learned that my family’s long-drive summer music rotation includes a lot of Taylor Swift, a lot of the current Broadway production of Sweeney Todd, and a lot of a kids’ song called “Hug a Turtle”. So…diversity!
I learned that I loved the first season of The Bear so much that I literally went out to buy a bunch of cans of San Marzano tomatoes and make some braciola. Onto season two!
Cheers,
Brian