Wednesday, June 7, 2023

Death of a soft-landing salesman

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Edward Price is principal at Ergo Intelligence. A former British trade official, he also teaches at New York University’s Center for Global Affairs.

Question: If chances of a soft landing have “narrowed,” why does the Federal Reserve foresee US unemployment reaching only 4.4 per cent? Answer: It shouldn’t.

The forecasts of Fed policymakers — [that] inflation will return to target while unemployment rises only to 4.4 per cent — are reasonable only under quite optimistic assumptions . ..

That’s per a new paper from the National Bureau of Economic Research, titled Understanding US Inflation During the Covid Era. Honestly, they really wanted to call it Misunderstanding US Inflation, but after Yellen’s mea culpa, this is the best apology we’ll get. Treasure it:

As inflation began to rise in March 2021, Fed Chair Powell predicted that the increase would be “neither particularly large nor persistent.”… Powell’s view was supported by the many economists on Krugman’s . . . “Team Transitory,” including the authors of this paper . . . Today, it is clear that inflation was much higher than we expected.

What went wrong? Understanding US Inflation has three ideas.

First, Team Transitory didn’t think. At least, not about how price shocks can settle into core (aka underlying) inflation. Maybe that was fair enough. Events and structures are, after all, locked in a Viennese waltz. Disentangling them is tricky, even impossible.

Second, Team Transitory didn’t foresee exogenous shocks. Again, maybe fair enough. Russia invaded Ukraine. China stuck to zero Covid. Both snarled up the supply chain to inflationary effect. Fewer ships = fewer chips.

But third was unforgivable. Dogmatic economics. Economists have long fixated on unemployment as a measure of labour market slack. However:

. . . the unemployment-inflation tradeoff has worsened during the pandemic . . . [how] the inflation rate is now higher for any given unemployment rate, especially when unemployment is low.

Thus, the paper proposes something quicker: the ratio of vacancies to unemployed workers. That’s a better measure of labour market tightness (which is becoming more important to inflation dynamics over time).

This is the lesson. Don’t ignore high-frequency deviations from core inflation (as Team Transitory did). Instead: “headline inflation = core inflation + headline shocks.” Fast inflation should be added to the slow Philips curvy stuff when calculating the headline rate.

Glad that’s settled. Team Transitory snoozed. But we’re still in trouble. See below for the paper’s six pathways to purchasing power oblivion (inflation doom in orange, slightly less inflation doom in blue):

Makes sense. 8.2 per cent annual inflation and a year-on-year 6.6 per cent jump in the core consumer price index are no bueno. Behold:

So, “transitory inflation” is dead. Should we kill a “soft-landing” too? Larry Summers votes yes. He has unemployment reaching 6 per cent. As does Laurence Ball, the paper’s lead author. He thinks 7 per cent

The data suggest they’re right. Look at the chart below. As the red line (expenditures) tugs the blue line (rates) up, expect the green line (unemployment) to follow. Get ready for another “shaded area” folks.

Per the paper:

All in all, it seems likely that policymakers will need to push unemployment higher than . . . SEP projections if they are determined to meet their inflation goal.

Farewell transitory inflation. Farewell soft-landing. You’re both unsellable now.

Convinced? Bloomberg’s Jonathan Levin isn’t. He thinks non-farm payrolls, at 261,000 in October, lower the chance of disaster. Unemployment is, after all, a speck at 3.7 per cent.

Plus, as the FT’s Colby Smith reminds us, upward price pressures are not distributed evenly across the US. A homogenous inflation target. A heterogenous inflation rate. That makes future Fed hikes harder to read. As do financial stability concerns.

Nonetheless, here are the killer questions. What justifies the Fed’s lingering optimism? Does the Fed believe unemployment will reach only 4.4 per cent? Or is the Fed keeping an unrealistically dovish scenario open so that, if rate hikes can slow, it doesn’t appear to have changed its new hawkish approach?

Probably the latter. With the “Flexible Average Inflation Target” (lol), the Fed promised to run inflation well above 2 per cent. The Fed can now ill-afford to break its new promise of, erm, doing the exact opposite. For example, it just hiked by another 0.75 bps. The NYT’s Fed watcher Jeanna Smialek:

Maybe Arthur Miller had it right. The Fed is a salesman. And for a salesman, there is no rock bottom. Until, of course, there is.




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