23 November 2021

Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

23 November 2021
Ira Kalish

Ira Kalish

United States

Week of November 22, 2021

Inflation in Europe accelerates

  • Inflation in the Eurozone continued to accelerate in October. Consumer prices were up 4.1% from a year earlier, the highest rate since July 2008. Prices were up 0.8% from the previous month, the highest monthly increase since March of this year. When volatile food and energy prices are excluded, core prices were up 2.0% from a year earlier, the highest since October 2008, and were up 0.3% from the previous month. Thus, core inflation remains in line with the European Central Bank’s (ECB) target of 2.0% underlying inflation. In the larger 27-member European Union (EU), consumer prices were up 4.4% from a year earlier and up 0.9% from the previous month. The higher inflation in the larger EU was mainly due to relatively high inflation in Poland, Hungary, Czech Republic, Bulgaria, and the three Baltic nations.

Compared to a year earlier, consumer prices were up 4.6% in Germany, 3.2% in France, 3.2% in Italy, and 5.4% in Spain. Spain’s number was the highest in the Eurozone. Interestingly, despite very high inflation, Spain has seen only modest increases in wages, a reflection of a declining share of the labor force being subject to negotiated wage contracts. In Germany, the relatively high inflation is partly due to the rebound in the VAT rate after a decline early in the pandemic. Although Eurozone inflation is accelerating, the fact that core inflation remains modest suggests that the ECB will not shift monetary policy in the near term.

Indeed, the euro has declined in value following comments by ECB President Lagarde indicating that monetary policy will not be changed despite an acceleration in inflation. Lagarde said that tightening monetary policy now would “do more harm than good.” Markets are now pricing in only a modest increase in the ECB’s policy rate next year. Lagarde continues to subscribe to the view that the current surge in inflation will be transitory. She said, “We must not rush into a premature tightening when faced with passing or supply-driven inflation shocks.” Moreover, the current surge in virus infections (see the next story) in northern Europe is creating increased risk of an economic slowdown in early 2022.

Not surprisingly outgoing Bundesbank President Jens Weidmann has criticized the ECB policy. He said, “Given the considerable uncertainty about the inflation outlook, monetary policy should not commit to its current very expansionary stance for too long.” Meanwhile, the ECB choice to not shift monetary policy puts it at odds with several other central banks, such as the US Federal Reserve, the Bank of England, and the Bank of Canada, all of which have signaled an intention to begin to take their feet off the pedal.

  • Meanwhile, the United Kingdom, which is no longer a member of the EU, reported the highest inflation in a decade. Consumer prices were up 4.2% in October versus a year earlier, the highest rate since November 2011. Moreover, prices were up 1.1% from the previous month, the highest monthly increase since April 1993. Excluding volatile food and energy prices, core prices were up 3.4% from a year earlier, the highest since October 2011. Core prices were up 0.7% from the previous month.

These figures indicate that underlying inflation is now far above the Bank of England’s target of 2.0% inflation. Although the Bank of England failed to increase policy interest rates at its last meeting, there is now a growing consensus that it will act at its next meeting. Recent labor market data indicates an acceleration in employment growth as well as a big increase in job shifting. The latter generally results in much higher wages. In addition, data shows that there has been a sharp decline in labor force participation among very young and very old workers. This has led to a shortage of labor and rising labor costs. The inflation data reveals sharp increases in the prices charged by restaurants and hotels, likely due to higher labor costs. In addition, the economy continues to be affected by global supply chain disruption. As in the United States, supply chain problems have stifled the supply of new cars, resulting in a big increase in the prices of used cars.

Virus remains a risk to Europe

The biggest threat to economic recovery in Europe is a sudden surge in infections, principally in northern countries, including Germany, Austria, Slovakia, Czech Republic, the Netherlands, and Belgium. Infection rates remain low in southern countries including France, Italy, Spain, and Portugal. The main difference between these two groups is rates of vaccination, which are higher in the south. Moreover, the northern countries now have colder weather, meaning that people are likely spending more time indoors, thereby making it easier for the virus to be transmitted from person to person.

In the northern countries noted above, infections either match or far exceed the peak rates reached before this winter. However, rates of hospitalization and death remain far below the peak rates. This likely indicates that some of the people becoming infected are vaccinated and, therefore, less prone to sickness. It might also be due to a younger mix of people getting infected who are less likely to get sick.

In any event, governments are becoming concerned, both from a public health and economic perspective. The government of Austria announced that it will seek legislation to make vaccination mandatory from February 1. This move is already highly contentious. In addition, the government will initiate a strict lockdown for the next three weeks. After the lockdown is lifted, unvaccinated people will be restricted in where they can go. Meanwhile, other northern European governments are imposing new economic restrictions. What is happening in Europe is a cautionary tale for other countries, especially the United States, where the rate of vaccination is significantly lower than in Europe.

Supply chain bottlenecks and inflation

The surge in inflation in the industrial world is notably similar among major countries. Inflation has suddenly surged sharply in the US, Canada, Eurozone, and the overall OECD. There is, however, a modest gap between inflation in the United States and inflation in the other locations. US inflation is now roughly 2.0% higher than in the other places. A new study by the Bank for International Settlements (BIS), which is the central banks’ central banker, suggests that, for the most part, the overall inflationary trend across multiple countries is due to bottlenecks, or what is lately called supply chain disruption. Meanwhile, it has been argued that the slightly higher US inflation reflects the larger US fiscal stimulus of the past year. The latter fueled a considerable rise in US consumer demand. That excess demand probably contributed to higher inflation but was likely not the only reason for the surge in inflation in the United States.  

The BIS says that “bottlenecks in the supply of commodities, intermediate goods and freight transport have given rise to volatile prices and delivery delays.” These bottlenecks have been more persistent than previously anticipated. The BIS suggests that bottlenecks “have been aggravated by the attempts of supply chain participants to build buffers in already lean production networks – so-called bullwhip effects.” In other words, efforts by individual companies to hoard items in short supply have exacerbated those shortages, fueling more persistent price increases.

On the positive side, the BIS says that “the direct inflationary effect of bottlenecks will likely be limited after relative prices have adjusted. However, sustained inflationary pressures could emerge if bottlenecks persist long enough to trigger an upward shift in wage growth and inflation expectations.” In other words, the supply chain problem will likely go away eventually, rendering lower inflation. But if the persistence of inflation boosts expectations of inflation, people will likely act in ways that reinforce inflation, especially workers demanding and businesses paying higher wages.

Although consumer price inflation continues to accelerate, some commodity price increases have started to reverse. In addition, the sharp rise in the cost of shipping containers has already started to reverse. Still, backlogs of deliveries remain elevated while inventories remain very low. There is a long way to go before the problem is resolved.

Meanwhile, in the high-inflation United States, there is increasing debate about whether inflation is set to become a bigger problem. The vice chair and one other member of the Federal Reserve’s governing board have publicly suggested that the pace of tapering of asset purchases might be accelerated. Vice Chair Richard Clarida said that this topic could be discussed at the Fed’s December meeting. In the most recent meeting, it was agreed that tapering would begin and that it will involve reducing asset purchases by US$15 billion each month until no new asset purchases are taking place, sometime in mid-2022. Fed Chair Powell said that the Fed will not likely boost interest rates while asset purchases remain under way. The Fed did indicate that the pace of tapering could be adjusted depending on data. Clarida said that he sees greater upside risk on the inflation front. Specifically, he said, “I’ll be looking closely at the data that we get between now and the December meeting, and it may well be appropriate at that meeting to have a discussion about increasing the pace at which we’re reducing our balance sheet.”

Chinese economy rebounds modestly, but headwinds remain

Economic indicators suggest a modest acceleration in China’s economic activity in October, after growth bottomed in September. Both retail sales and industrial production accelerated from their September growth rates. However, fixed asset investment appears to have slowed and house price inflation abated. Thus, China continues to face important headwinds. Let’s consider the details.

Retail sales in China were up 4.9% in October versus a year earlier, up from 4.4% growth in September. Some categories of spending saw very strong growth. For example, spending on telecoms was up 34.8%, on jewelry 12.6%, on home appliances 9.5%, and on cosmetics 7.2%. Spending on oil products was up 29.3%, likely due in part to the sharp rise in the global price of oil. Meanwhile, spending on clothing was down 3.3% and on automobiles 11.5%.

Chinese industrial production was up 3.5% in October versus a year earlier. This was up from 3.1% growth in September. The manufacturing component was up a modest 2.5%. That said, the mining component was up 6% and the utilities component (electricity, power, gas, water) was up 11.1%. The latter two figures indicate that China boosted production of coal to provide more electricity at a time of shortages and rationing. Although manufacturing grew slowly, two sub-sectors did very well. Production of high-tech products was up 14.7% and production of new energy vehicles was up 127.9%.

Fixed asset investment in the first 10 months of 2021 increased 6.1% from a year earlier. This was a deceleration from the 7.3% growth in the first nine months of the year. Both private sector (up 8.5%) and public sector (up 4.1%) investment posted a deceleration from the previous month.

Finally, the deceleration of the residential property sector took a toll on home prices. In China’s 70 largest cities, the average new home price was up a modest 3.4% in October versus a year earlier. This was the slowest increase since January 2016. Prices were actually down 0.2% from the previous month. Notably, China’s largest cities experienced bigger price increases than the national average. For example, prices were up 4.9% in Beijing, 3.8% in Shanghai, 8.0% in Chongqing, 7.9% in Guangzhou, and 3.4% in Shenzhen. China’s property market has been shaken by the financial troubles at major developers, such as Evergrande. It appears that the government is keen to engineer a decline in the size of the industry that is bloated and backed by excessive debt.

While China’s domestic demand appears to be stabilizing as the electricity shortage is easing and as virus-related troubles abate, China faces a possible slowdown in its rapid export growth. That is because the strong global demand for Chinese-made durable consumer products, already at a highly elevated level, is expected to recede in the months to come. As that happens, demand for Chinese exports will likely lessen. This could help to alleviate supply chain disruption and reduce the cost of transporting goods.

China has a demographic problem in the long term

China has a large population of more than 1.4 billion people—yet that might not be enough. There was a time when China’s leaders worried about too many people and imposed restrictions on the number of children that couples could have. That is no longer the case anymore. Now, leaders are worried that, with a low birth rate, China faces a growing proportion of old population with fewer younger people to support them. The working age population has been shrinking since 2012. The government has eased restrictions on births, but couples continue to have fewer children. In 2016, China recorded 17.9 million births. By 2020, that number had fallen to 12 million, the lowest since 1961 when births fell sharply due to the famine caused by the Great Leap Forward. As recently as 1987 there had been 25.5 million births.

If births remain low, China’s overall population will soon start to decline. The government has taken steps to encourage people to have more children. Even if this works, the impact on the labor force won’t be felt for another 20 years. Meanwhile, a declining labor force means that, all other things being equal, economic growth will decelerate further. Aside from boosting births, there are a few other things that could be done to address the problem. These include more immigration, having people retire later in life, encouraging more women to join the labor force, and investing more in labor-saving and labor-augmenting technology in order to accelerate productivity growth. In the past few decades, the lion’s share of productivity gains took place in the private sector. Yet the government is providing more support to the state sector. Thus, the growth outlook could be problematic.

Week of November 15, 2021

Federal Reserve tapers, markets yawn

  • The Federal Reserve announced that it will commence the long-awaited tapering of asset purchases. Markets barely budged in response, which is testimony to the communication skills of Fed leaders. They prepared markets for what was coming, explained it clearly, and the result was a modest decline in inflation expectations and strong performance of equity prices that are now at historic highs. The Fed will reduce asset purchases by US$15 billion each month until no new purchases are made. It indicated it could slow or speed up the pace of tapering depending on data. Fed Chair Powell said, “It is time to taper, we think, because the economy has made substantial progress towards our goals.” However, the other major policy too, interest rates, will not be changed quickly. Powell said, “We don't think it's time yet to raise interest rates. The time for lifting rates will depend on the economy. I think we can be patient.” Most people now expect a rate increase in 2022.

Powell continues to view inflation as transitory, although he defined transitory as not leading to sustained higher inflation over the long term. He acknowledged that inflation will likely go higher in 2022 before it recedes. Investors evidently agree, having pushed down bond yields and inflation expectations since Powell’s announcement. The gap between five-year and 10-year expectations of inflation grew, suggesting that many investors expect fairly high inflation in the short term, reverting to a normal level in the longer term. 

Powell’s term as chairman comes to an end in February and there is uncertainty as to whether he will be reappointed by President Biden. But markets are relatively sanguine about this. If Powell is not reappointed, his likely successor would be Fed Governor Lael Brainard, who is expected to follow a monetary policy similar to that of Powell. Thus, either way, investors expect continuity of monetary policy.

Interestingly, both Powell and Brainard were spotted at the White House recently. It is not known why. Treasury Secretary Yellen is reported to have urged that Powell (her successor as Fed Chair) be reappointed. She is reportedly happy with his performance and likely believes in the importance of bipartisanship in the Fed role. In recent history, most Fed Chairs were appointed by a president of one party and reappointed by a president of another party. President Trump broke this pattern by not reappointing Yellen, despite lavishly praising her performance. Instead, he appointed Powell. Now, Yellen thinks that bipartisanship can be restored by reappointing Powell. He has considerable bipartisan support in Congress. However, some left of center Democrats favor Brainard instead, mainly because she is seen as tending toward more intrusive regulation of banks than Powell. One possible solution is to reappoint Powell and appoint Brainard as vice chair of the Fed with responsibility for regulatory matters. Biden has not indicated his preference, likely waiting until after he can get the reconciliation bill passed. 

  • After Fed Chair Powell announced that the Fed’s asset purchase program will be reduced in the months ahead, bond yields declined sharply. This is odd. The Fed’s reduction in bond purchases means that, all other things being equal, there will be a greater supply of bonds available to the public. That, in turn, should lead to higher yields. Instead, the opposite happened. In contrast, one could argue that the Fed’s announcement signals an intent to fight inflation. Thus, expectations of lower inflation can partly explain the decline in yields. Still, measures of expected inflation have fallen only modestly. The sharp decline in yields cannot fully be attributed to lower expectations of inflation. Instead, it appears that the real (inflation-adjusted) yield on bonds has fallen.

Normally, a decline in real yields reflects a change in expectations about supply and demand conditions in the bond market. If the government is expected to borrow less, then yields should fall. Government borrowing is, indeed, expected to decline next year, but that expectation was likely already baked into yields prior to Powell’s announcement. What, then, explains the recent sharp decline in yields?

My theory (and it is only a theory) is that recent events in China have led investors to downgrade China’s economic outlook. This could have influenced US bond yields in two ways. First, greater uncertainty about the world’s second-largest economy is the kind of event that would lead global investors to seek safety, and nothing is safer than US Treasury securities. Moreover, troubles in China’s property sector could create financial instability, thereby fueling greater demand for US bonds. Indeed, the US Federal Reserve has warned that property market problems in China “posed some risk to the US financial system.” Specifically, the Fed said that “given the size of China’s economy and financial system as well as its extensive trade linkages with the rest of the world, financial stresses in China could strain global financial markets through a deterioration of risk sentiment, pose risks to global economic growth, and affect the United States.” Evidently many investors agree and are shifting assets into US Treasuries.

Second, expectations of slower economic growth in China imply slower economic growth in the United States, thereby reducing business demand for credit. That, in turn, would imply lower bond yields. For now, there is uncertainty about the degree to which China’s headwinds will suppress growth. However, investors tend to react quickly to a shift in sentiment, even if there is uncertainty about the potential impact. 

US inflation accelerates, but views on future inflation remain diverse

  • If you had asked me last week, I would have said that inflation in the United States has begun to decelerate based on the data from the last few months. I wouldn’t say that now that the government has released alarming inflation numbers for October. However, I still contend that, although inflation is likely to accelerate further in the coming months, it will revert to a more normal level by 2023. That is the view held by Fed Chair Powell and he defines it as transitory inflation. For those who think transitory means that inflation will be back to normal in a few months will be sorely disappointed.

In any event, here are the numbers. The consumer price index (CPI) increased 0.9% from September to October and was up 6.2% from a year earlier. The latter figure is the highest annual inflation since November 1990. When volatile food and energy prices are excluded, core prices were up 0.6% from September to October and up 4.6% from a year earlier. The latter figure is the highest since August 1991. The difference between headline and core inflation is largely due to the increase in energy prices, which are up 30.0% from a year earlier and up 4.8% from the previous month.

Inflation continues to be driven by very large increases in a relatively small number of categories, such as used and new vehicles. For example, if used car inflation were excluded from the numbers, the headline annual rate of inflation would have been 5.3% rather than 6.2%—even though used cars account for only 3.3% of the CPI. Other categories, including new cars, hotels, rental cars, some types of food, furniture, and televisions, also saw big increases. Some categories, such as airline fares and mobile telephones, saw declines. Moreover, the cost of housing accelerated as “owner’s equivalent rent,” a measure of what homeowners think they could get if they rented out their homes, accelerated.

Although some categories saw very big increases, it appears that, even after excluding the most volatile categories, inflation accelerated in October. The Federal Reserve Bank of Cleveland publishes a measure of underlying inflation called the “16% trimmed mean,” in which the 16% of merchandise and service categories that are most volatile are excluded. This measure has been trending far below headline and core inflation but has lately accelerated. In October, it hit an annual rate of 4.1%. This is lower than the core rate of 4.6%, but still fairly high. It suggests that underlying inflation is worsening, providing fodder for those who argue that inflation is becoming more systemic and will likely be sustained.

What is the counterargument? The rise in underlying inflation can be attributed to the greater than expected disruption of global supply chains. Moreover, it can be argued that, over the next two years, this disruption will likely go away. The disruption stems from changes in both supply and demand. On the demand side, many US consumers have vastly increased spending on goods while they are spending less than prepandemic levels on services. That reflects a change in behavior related to the pandemic as well as the positive impact of government stimulus payments. The surge in demand for goods affected the prices of goods.

Meanwhile on the supply side, factories, ports, and shipping have been disrupted by the pandemic, electricity shortages in China, and difficulties in shifting production and transport patterns in response to rapid changes in consumer spending patterns. The result has been a big increase in the prices of goods, as well as increases in the prices of services due to increased input costs for service providers. Going forward, it is likely that the blistering consumer demand for goods will wane. Indeed, this is already starting to happen. In addition, it can be argued that supply chain problems will gradually unwind as capacity increases and the virus recedes, although likely more slowly than previously anticipated. If that happens, then inflation should abate.

Still, it can be argued that, as inflation continues, expectations of inflation will rise, thereby causing workers, consumers, and businesses to adjust their behavior in ways that reinforce inflation. So far, this does not seem to be the case. For example, although wages have accelerated, they have been relatively tame—with the notable exception of the leisure and hospitality sector that has seen massive gains in compensation. Moreover, if businesses invest in labor-saving or labor-augmenting technologies, then worker productivity gains could offset wage gains, thereby suppressing unit labor costs. That, in turn, would suggest lower inflation. Conversely, the Conference Board reports that, in October, 49% of small firms reported having job openings that they cannot fill, an unprecedented number. This bodes poorly for wage stability. Part of the problem is a decline in labor force participation, especially among older workers. Indeed, participation by college-educated seniors has fallen sharply since the pandemic began.

In the end, we always return to the bond market as it tends to reflect the preponderance of market sentiment regarding inflation and other factors driving financial markets. The yields on US government bonds increased sharply on the inflation news but remained well below the peak reached in mid-October. Moreover, yields are historically low, suggesting that investors remain relatively sanguine about longer-term inflation. Notably, it was short-dated bonds that saw the biggest increase in yields, indicating that many investors are more concerned about inflation in the short term than in the long term. This is also reflected in the fact that the five-year breakeven rate, a measure of investor expectations of inflation, is higher than the 10-year breakeven rate. In addition, the gap between the two has been increasing lately.

  • There is a disconnect between the views of US consumers and business leaders and those of investors concerning inflation. Many consumers are evidently very worried about much higher inflation, as indicated by a sharp decline in a measure of confidence. Indeed, the index of consumer confidence published by the University of Michigan fell sharply in October, hitting the lowest level in 10 years. The decline was attributed to concerns about inflation. Anecdotally, I can say that many business leaders with whom I have spoken have expressed considerable fear that we are heading into a new era of much higher inflation.

And yet these fears have not been manifested in the bond market. Bond yields and related measures of investor expectations of inflation, while somewhat volatile, have remained in a range suggesting that investors expect relatively modest inflation in the coming decade, after a brief (two-year) period of high inflation. Fears of stagflation (slow economic growth combined with high inflation), often expressed by business leaders, have not been revealed in the behavior of equity prices, which continue to rise to new levels. Evidently investors expect strong economic growth combined with relatively low borrowing costs. That, in turn, implies a return to lower levels of inflation.

The concern about inflation on the part of consumers is interesting. Wages have nearly kept up with prices, thereby providing relatively stable purchasing power from wages. In addition, household saving increased dramatically during the pandemic, giving consumers considerable leeway to boost spending without taking on debt. Household wealth has also increased as a result of rising asset prices, including both equities and homes. Thus, although consumers are evidently perturbed by the sharp rise in the prices of some goods and services, especially gasoline, their material situation has not deteriorated. Rather, it appears that consumers find the sharp rise in prices to be unsettling, something with which many consumers are unfamiliar, except for those that can remember the 1970s.

Business leaders are also flummoxed. I have heard several business leaders wonder what it will take to be successful in an environment of persistent high inflation. Yet the investor community evidently buys into the argument made by Fed Chair Powell and others that the current high inflation is driven mainly by temporary disruption of supply chains, not by fiscal and monetary stimulus. Powell says that it will abate over time. I continue to subscribe to that view, although it is becoming increasingly lonely.

Perhaps one of the principal risk factors that could drive more persistent inflation is the fact that the expectations of consumers, workers, and business leaders is changing. If they expect higher inflation, they might behave in ways that reinforce higher inflation— although the degree to which this has been true in the past is now a topic of heated debate among economists. In any event, Powell’s job is, in part, to anchor expectations. He has done that quite well when it comes to the investment community, but not so much when it comes to ordinary people and business leaders.

Week of November 1, 2021

US economy decelerates, mainly due to delta and supply chains

The headlines last week reported a significant deceleration in US economic growth in the third quarter. Yet it is not likely that this reflects a new trend in demand. Rather, there is considerable evidence that the slowdown was due to two important factors: supply chain disruption and the outbreak of the delta variant of the virus. For now, the delta variant is abating. In addition, there is reason to expect that supply chain disruption will wane over time as demand for goods lessens and supply constraints in Asia ease.

In any event, here are some details: Real GDP increased at an annualized rate of 2.0% from the second to the third quarter. This was a substantial deceleration from the 6.7% growth in the second quarter. The biggest change from the previous quarter was a sizable shift in consumer spending on goods. Having grown at a rate of 13.0% in the second quarter, goods spending fell at a rate of 9.2% in the third quarter. Moreover, this was mainly due to a decline in spending on durable goods that fell at a rate of 26.2%. In addition, that decline was largely driven by a big drop in purchases of automobiles. The latter was likely due to the shortage of semiconductors which is disrupting supply chains in the industry.

Despite the sharp decline, real spending on automobiles remained 5.2% above the pre-pandemic level in the fourth quarter of 2019. Overall consumer spending on goods was 15.2% above the pre-pandemic level. Thus, even as goods spending declined, the level of spending was unusually high, thereby contributing to supply chain stress and rising prices.

Although consumer spending on services continued to grow in the third quarter, it decelerated sharply from 11.5% growth in the second quarter to 7.9% in the third quarter. There was an especially sharp deceleration in spending at restaurants—indicative of the effect of the delta variant on social interaction. Overall spending at restaurants remained below the pre-pandemic level.

If spending on automobiles and restaurants had grown in the third quarter at the same pace as in the second quarter, then real GDP would have grown at a rate of 6.6%—almost the same as the second quarter. Thus, the sharp deceleration in GDP growth can largely be attributed to supply chain disruption and the impact of the delta variant.

As for business behavior, investment in equipment fell at an annual rate of 3.2% while investment in structures fell at a rate of 7.3%. These declines were more than offset by a sharp 12.2% increase in investment in intellectual property. Thus, overall business investment increased at a modest pace of 1.8%. Business investment in inventories increased strongly, offsetting the decline in the previous quarter. Residential investment fell at a rate of 7.7%, slower than the decline in the second quarter.

Both exports and imports of goods declined in the third quarter. However, imports of services increased sharply. Overall, trade made a negative contribution to GDP growth. Finally, Federal government purchases fell sharply in both the second and third quarters as fiscal support for the economy waned. If the US Congress passes the infrastructure bill now under consideration, this will likely have a positive impact on purchases in the quarters to come. State and local spending increased at a healthy rate of 4.4%.

Regarding inflation, the GDP report provided evidence that inflationary pressures are abating. The personal consumption expenditure deflator (often call PCE-deflator), which is the favorite measure of inflation of the Federal Reserve, increased at an annual rate of 5.3% in the third quarter, a deceleration from the 6.5% increase in the second quarter. Interestingly, and not surprisingly, the price index for consumer durable goods was up at a rate of 9.6% in the third quarter while the index for consumer services was up at a rate of 4.2%. In other words, prices rose strongly in the category that was most disrupted by supply chain problems. This offers hope that, when supply chain issues are resolved, inflation will decelerate. That, in fact, is one of the arguments suggesting that current inflation will turn out to be transitory.

US consumer spending shifts in a new direction

The US government reported that personal income declined in September but spending increased as consumers dipped into their savings and saved a smaller share of their income. This is not unexpected given the decline in income due to the expiration of enhanced unemployment insurance. Wage and salary income continued to grow at a healthy pace and consumers continued to spend. However, their spending also continued to shift away from durable goods and toward services, which would be expected as the impact of the virus fades.

Here are the details: In September, total personal income fell 1.0% from the preceding month. However, wage and salary income increased 0.8%, partially offsetting a 7.0% drop in government transfers to individuals. After adjusting for inflation and taxes, real disposable personal income fell 1.6% from August to September. Yet real personal consumption expenditures increased 0.3%. This was facilitated by the savings rate falling from 9.2% in August to 7.5% in September. 

The composition of spending was interesting. September was the fifth consecutive month in which real consumer spending on durable goods declined, this time by 0.5%. In fact, in the last five months real spending on durables fell 12.2%. Yet here is the interesting part: in September, real spending on durables was still 17.9% above the pre-pandemic level of February 2020. This huge demand for durable goods, even as it abates, is contributing to massive supply chain disruption and higher inflation. If spending on durables falls further, this can help to alleviate supply chain congestion and reduce inflationary pressure. Moreover, as people spend less on durable goods, they are spending more on services, something that should continue provided the virus stays in abeyance. Finally, it makes sense to spend less on durables. After all, how many big screen televisions, dishwashers, and treadmills can a family have in one home? That said, some of the decrease in spending on durables is due to troubles in the automotive industry, not due to lessening demand. 

Meanwhile, real spending on nondurable goods increased 0.4% in September. Real spending on services was up 0.4%, the seventh consecutive monthly increase. However, despite strong growth in spending on services, real spending remains 1.7% below the pre-pandemic level of February 2020. 

US inflation may have peaked, but wages accelerate

  • Last week’s report on income and spending included the latest monthly data on the Federal Reserve’s favorite measure of inflation—the  PCE-deflator. The overall PCE-deflator was up 0.3% from August to September and was up 4.4% from a year earlier. When volatile food and energy prices are excluded, the core PCE-deflator was up 0.2% from August to September and up 3.6% from a year earlier. The latter number was unchanged for the last four months, suggesting that underlying inflation might have peaked. A few more months of data might confirm this. Notably, the price index for durable consumer goods was up 7.3% from a year earlier while the price index for consumer services was up only 3.5% from a year earlier. This reflects the fact that inflation has been disproportionately due to supply chain stress in an overheated sector. 
  • Meanwhile, the US government released the latest employment cost index (ECI) which looks at the overall cost of employing workers, including both wages and benefits. The ECI was up 3.7% in the third quarter versus a year earlier. This was the biggest increase in compensation costs since 2004. Wages were up 4.2% while benefit costs were up 2.5%. 

In addition, the ECI was up 1.3% from the previous quarter, the highest since records began in 2002. The gains varied by industry and by occupation. On a quarter-to-quarter basis, the ECI was up 1.4% for manufacturing, 1.6% for retail, 2.2% for financial services, and 2.5% for leisure and hospitality. There was a stunning 7.0% increase in the ECI for aircraft manufacturing. Nonetheless, the ECI was up a more modest 0.8% for government workers, 1.1% for transportation and warehousing, and 0.9% for wholesale trade. 

By occupation, the quarterly ECI was up 1.5% for workers involved in production, transportation, and material moving. Meanwhile, it was up 1.0% for management, professional, and related occupations. 

The acceleration in employment costs, especially wages, reflects the massive labor shortage that is vexing many businesses. Still, the increases in wages have not kept pace with rising prices. In other words, real wages have declined in the past year on average. If wages continue to rise at a rapid pace, this could contribute to sustained higher inflation. However, if businesses invest sufficiently in labor-saving or labor-augmenting technologies, then worker productivity gains can offset higher wage costs, thereby nullifying the necessity of raising prices. 

What do investors think about US inflation?

One measure of investor expectations of inflation is the breakeven rate. Here is how it is calculated. The US Treasury (and other governments) issues two types of bonds: ordinary bonds that promise that the principal will be fully repaid and Treasury Inflation Protected Securities (TIPS; in the United States) that promise that the principal will move in line with inflation. Because investors are protected from inflation, the yield on TIPS is a real (inflation-adjusted) yield. Ordinary bonds provide a yield that, theoretically includes both the real return and investor expectations of inflation. Thus, the difference between the yields on ordinary and TIPS bonds is the investor expectation of inflation, also known as the breakeven rate. 

In recent months, breakeven rates for five- and 10-year bonds have been rising as investors became increasingly worried about the potential for longer-term inflation. Still, breakeven rates have remained relatively muted, far below the actual inflation we have lately seen and reasonably close to the Federal Reserve’s target of 2.0% inflation. This likely reflected investor expectations that the current high inflation would turn out to be transitory. Indeed, the five-year breakeven rate has lately exceeded the 10-year breakeven rate, indicating that investors expect higher inflation in the short term than in the long term. This is consistent with the story that current inflation will be transitory. For some time, I and other economists have argued that, if breakeven rates suddenly spike, then investors will have become worried and will have upwardly revised their expectations, possibly compelling central banks to tighten monetary policy faster than anticipated.

In the past two weeks, breakeven rates started to spike. That is, they increased sharply, suggesting that the market zeitgeist is shifting as business leaders increasingly bemoan the apparent persistence of inflation. The supply chain problems in the global economy increasingly appear difficult to undo and the continuing rise in oil prices is a source of distress. Indeed, oil prices are now at the highest level since 2014. From October 19 through 22, the 10-year breakeven increased from 2.54% to 2.64%—a jump of 10 basis points and hitting the highest since 2006. The five-year breakeven increased from 2.71% to 2.91%, a jump of 20 basis points and hitting the highest since 2005. 

Federal Reserve Chairman Powell was asked about this on October 22. Here is what he said: “The risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation. Supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages. If we were to see a risk of inflation moving persistently higher, we would certainly use our tools.” He did not walk away from the transitory narrative. However, he appeared to suggest that the definition of transitory is a bit more prolonged than previously believed. He also attempted to reassure investors that the Fed is prepared to change course if things get out of hand. 

Meanwhile, two-year US bond yields have risen sharply recently. These yields are a good proxy for investor expectations about short-term rates, which are controlled by central banks. Thus, a rise in the yield on short-term bonds suggests that investors expect the Federal Reserve to increase short-term rates sooner and by more than previously anticipated. In other words, investors evidently believe that the probability the Fed acts soon has increased, if only a little. Currently, the market is pricing in an increase in the Federal Funds rate late in 2022. 

Finally, US equity prices have rebounded to a record high. If those who worry about stagflation are correct, equities should be sinking. What is happening? First, let’s define stagflation. Stagflation describes what happened in the 1970s when the economy was stagnant amidst unusually high inflation. Given that, historically, there has often (but not always) been an inverse relationship between growth and inflation (at least in the short term), stagflation is seen as perverse in that prices rise rapidly even amidst slow growth, and growth remains slow, even with significant inflationary pressure. That is not the case for now, at least not yet. The economy appears to be growing rapidly, with very strong consumer demand, something that is likely contributing to the current high inflation. Rising equity prices suggest that investors expect continued strong growth. Moreover, perhaps they recognize that inflation can often be good for corporate profitability as it reduces consumer sensitivity to price movements. 

At the same time, perhaps investors expect inflation to ultimately fade, thereby allowing for continued low borrowing costs amid healthy growth. Indeed, an index of the prices of industrial metals fell sharply last week, suggesting that prices had previously overshot, or that shortages are starting to abate. Either way, this is evidence in support of transitory inflation. Finally, investors might be pleased that the yield on TIPS, which is the real, or after-inflation yield, has been falling into deep negative territory. That means that, after inflation, the cost of government borrowing is negative. That, in turn, is favorable for businesses that want to invest heavily.

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Ira Kalish

Ira Kalish

Chief Global Economist, Deloitte Touche Tohmatsu


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