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Until last week, the US Federal Reserve predicted that inflation in 2021 would be 2.4% and that the first interest rate hike would take place in 2024. Then last Wednesday, the Fed altered its forecast. It now says that it expects inflation in 2021 to be 3.4% and that there could be as many as two interest rate hikes in 2023. It also increased its forecast for growth of real GDP from 6.5% to 7.0% in 2021. The Fed did not, however, make any changes to existing policy with respect to interest rates or asset purchases. Rather, it signaled the possibility that policy will change sooner than previously anticipated. In his press conference, Fed Chair Powell said that this should be seen as a good thing—an indication that the policy committee sees economic progress as being greater than previously expected, thereby causing a need to adjust policy sooner. However, Powell said that, with respect to the pandemic, we are not yet out of the woods and that the vaccination rate needs to be much higher to avoid the risk of another outbreak. The Fed’s statement was unanimously endorsed by the policy committee.
The Fed indicated that monetary policy will only change once the labor market tightens sufficiently to create a greater risk of inflation. Currently, employment is more than seven million people below the pre-pandemic level. The Fed expects to see full employment in the latter part of 2022. Moreover, many critics note that there are already significant labor shortages in some industries which are driving up wages. However, these shortages might be transitory, related to one-off factors such as the need to care for children not in school. Powell also noted a sudden surge in early retirements that have contributed to reduced labor force participation. Such factors are likely to abate over the course of the year.
The Fed’s stated intention to eventually adjust policy is part of a process meant to prepare financial markets so that, when change comes, there will be no taper tantrum as happened in 2013. Still, the Fed retains the view that the current rise in inflation is transitory. In its statement, it said that “inflation has risen, largely reflecting transitory factors.” Indeed, Treasury Secretary Yellen made that case in Congressional testimony last week. She said that “as the economy is opening back up again, prices are now moving back toward normal levels in leisure, hospitality, airfare and the like. In most cases, prices remain below pre-pandemic levels—but they’re rising, and that’s some of what’s going on here. We’re going to monitor this very, very carefully.” This implies that the year-over-year increase in prices (the CPI was up 5.0% in May) is distorted by the fact that prices fell so sharply a year ago. A more meaningful measure of inflation is the month-to-month change in prices. Notably, the month-to-month increase in the CPI decelerated in May versus April.
That said, some of the latest headlines suggest that one would be forgiven for thinking that a new era of high inflation is at hand. Moreover, commentary on the Federal Reserve’s statement, in which the Fed signaled an intention to tighten monetary policy in 2023 rather than 2024, was viewed as indicative of the Fed signaling greater inflation risk. And yet, once again the bond market is not cooperating with this narrative. After rising sharply immediately following the Fed’s statement, the yield on the 10-year US Treasury bond fell sharply the next day and remains well below the recent high. In addition, the so-called breakeven rate, which is an excellent proxy for investor expectations of inflation, remains lower than a few weeks ago and barely budged in response to the Fed’s statement. Moreover, the five-year breakeven rate is higher than the 10-year breakeven. This is an unusual situation and reflects investor expectations that inflation will surge in the short term but revert to a lower level in the longer term. This is precisely what the Fed expects to happen, based on its view that inflationary pressures are due to transitory factors. Thus, investors seem to have bought the Fed narrative, even if headline writers have not. This means that the Fed has been successful in anchoring inflation expectations, one of their prime levers of policy.
What does this situation mean for business leaders who continue to worry about much higher inflation? When asked, I have told many of our clients that, yes, inflation will likely surge this year and next. Indeed, this is already under way and it is what the Fed is expecting. However, most indicators suggest that higher inflation will be transitory, and that inflation will revert to the range of 2.0–2.5% within the next two years. If so, then companies needn’t plan on an inflationary environment. An inflationary environment would entail greater leeway to boost prices in response to cost increases. It would entail persistent rises in labor costs. And it would entail higher borrowing costs. For now, none of this seems likely, although it is by no means impossible. In case the Fed and others are wrong and that inflation becomes problematic, the Fed will likely reverse course quickly, even at the cost of stifling the economic recovery. The Fed’s best indicator is the breakeven rate. If it suddenly surges, the Fed will have to quickly reconsider its strategy.
The Chinese economy continues to grow at a good pace, but there are indications that it is performing below analysts’ expectations. Last week, the Chinese government released data on retail sales, industrial production, and fixed asset investment. The numbers were reasonably strong but lower than anticipated. Here are the details:
Retail sales in China were up 12.4% in May compared to last year, the slowest rate of increase since December. Also, retail sales were up 0.8%from April to May after having declined in the previous month. The increase was likely due to the extended Labor Day holiday. In addition, the virus situation appears to be improving, with reduced infections and increased vaccinations, thereby boosting consumers’ comfort level.
Meanwhile, Chinese industrial production was up 8.8% in May versus a year earlier, the slowest rate of increase in five months. It is likely that the slowdown in industrial output was due, in part, to supply chain issues that have plagued manufacturers around the world. In addition, there has been disruption to production in southern China due to an outbreak in Guangdong Province (see below) and the response by local authorities. In addition, the slowdown was partly driven by troubles in the automotive sector which has experienced a shortage of semiconductors. In fact, automotive production in China was down 4.0% in May compared to last year.
Meanwhile, it is reported that Chinese authorities are concerned about the rising value of the renminbi and the impact it could have on the competitiveness of manufactured exports going forward. While their concerns are valid, a rising renminbi lessens the impact of rising prices of imported commodities. Also, as China moves up the value chain, it competes with products that are less price-sensitive than low value-added products such as apparel and textiles. In fact, production of those types of products has been moving offshore. Moreover, a rising renminbi boosts the purchasing power of Chinese consumers by suppressing import prices. This will be beneficial to China as it attempts to shift toward an economic model in which growth is fueled more by consumer demand and less by investment and exports.
Finally, Chinese fixed asset investment was up 15.4% in the first five months of 2021 versus a year earlier. This included strength in manufacturing investment. Private sector investment was up 18.1% while public sector investment was up 11.8%.
It has been argued that one of the key factors that contributed to the recent low global inflation scene was the introduction of China’s vast labor force to the global economy. This boosted labor supply, putting downward pressure on global labor costs. In addition, China’s favorable demographics of a rapidly expanding urban labor force put downward pressure on Chinese wages and therefore on Chinese export prices. But things are changing. China is now fully integrated into the global economy. Internal migration in China, which brought a huge number of rural workers to factories in the big cities, is waning. China’s demographics have shifted, with the working age population now declining and the country facing a potential labor shortage. All these trends are contributing to a significant increase in Chinese wages. At the very least, this suggests that one of the important contributors to several decades of low inflation is going away.
Does this mean that the world will now face a new age of higher inflation? Possibly. It depends, in part, on two things. First, will the increase in Chinese wages be offset by a rise in productivity? If so, then the wage increases will not necessarily boost the prices of exported goods. Second, as China moves up the value chain, will there be a massive shift of low value-added production to lower wage countries? The answer is that this has already started to happen. For example, as some apparel production moves from China to Vietnam, the impact of higher Chinese wages will be offset, and the price of apparel exported to the rest of the world needn’t rise.
China’s footprint in global production is massive. It would take a massive shift out of China to make a difference in terms of export prices. It is not clear that this can happen quickly. The biggest potential pools of alternative labor include India, Indonesia, and Africa. Yet a lack of sufficient infrastructure, restrictions on trade and investment, and restrictive rules on labor usage are among the obstacles to moving a large amount of production out of China and to these other locations. Meanwhile, the recent rise in the value of China’s renminbi will put upward pressure on export prices, thereby contributing to a rise in inflation in the rest of the world.
China has been in the news lately for rapidly easing restrictions on the number of children that families can have. This shift in policy reflects a recognition that China has a serious demographic problem. The low birth rate in the past has led to a shortage of labor, a decline in the working age population, the prospect of slower economic growth, and a decline in the ratio of workers to retirees. The latter creates stress for the country’s system of pensions and health care. China’s president said that an aging population is a threat to national security. In response to this crisis, the one child policy applied to urban households was first eased to two children several years ago and, more recently, to three children. Moreover, it is reported that the government is considering eliminating all such restrictions.
And yet, despite these actions, the birth rate continues to fall. Last year the number of live births was the lowest since 1961. In addition, it is reported that the infertility rate in China has increased substantially, from 12% in 2007 to 18% in 2020. It is reported that 5.6% of couples are having difficulty bearing children. A government scientist said that “besides age-related infertility, infertility is probably affected by environmental exposures, chromosome abnormalities, lifestyles and unexplained factors.” The trajectory of China’s economy in the coming decades will be significantly influenced by the success or failure of policies meant to boost the number of children.
Recall that, when a container ship got stuck in the Suez Canal for six days recently, it created a major disruption to global shipping that has not yet been completely resolved. Yet there is a new disruption that is getting less publicity but might be more impactful. At the Port of Yantian near Shenzhen in southern China, a new outbreak of the virus is suppressing activity and causing significant disruption. Yantian is the largest and busiest port in China, accounting for about 10% of China’s exports. In the first two weeks of June, 298 container vessels skipped the port, a 300% increase from the previous month. Skipping a port means that a ship avoids or cancels a scheduled visit to a port because it is not permitted to discharge or load cargo. This, in turn, has caused a big increase in backlogs, a shortage of inventory for manufacturers on both sides of the Pacific, and an increase in shipping costs. In fact, the Baltic Dry Index, a popular measure of shipping costs, is up about 200% since the start of this year and is significantly higher than the pre-pandemic level. Although the worst of this particular crisis is likely over, and although operations are beginning to go back to normal, it is expected to take several more weeks before the disruption is fully resolved.
Meanwhile, the troubles at Yantian have led to bottlenecks at other ports. The disruption at Yantian is, indeed, just one of many such crises driven by the continued presence of the virus. Many industry participants have said that the situation in southern China is far worse than what happened at the Suez Canal. This crisis is happening at a time when global demand for traded goods is surging as the world comes out of the pandemic. It is one of the factors contributing to an acceleration in inflation in many countries.
Not unexpectedly, retail sales in the United States declined from April to May as the impact of stimulus money waned. However, the headlines noted that the decline was sharper than analysts had anticipated, suggesting weakness in the economy at a time when inflation is accelerating. Hence, the term “stagflation” could re-enter the lexicon. Yet the retail sales report actually indicates that consumer demand is on fire, likely contributing to the temporary increase in inflation. In May, retail sales were 20.3% higher than in February 2020, just prior to the start of the pandemic. Thus, US consumers are spending at a level far above anything previously seen, at a new plateau far above the pre-pandemic path. This likely reflects the continued impact of stimulus money, pent-up demand, and a higher level of confidence fueled by rising vaccinations and declining infections. The modest decline in retail sales from April to May reflects the slowly diminishing impact of stimulus money.
Let’s look at the details: retail sales declined 1.3% from April to May and were up 28.1% compared to last year when the pandemic was in full force. Excluding the troubled automotive industry (where sales were down 3.7% from the previous month), retail sales were down a more modest 0.7%. The drop in automotive sales partly reflected the impact of a semiconductor shortage. There were also large decreases in spending at stores specializing in other consumer durable products. For example, sales were down 2.1% at furniture stores, down 3.4% at electronics stores, and down 5.9% at home improvement stores. On the other hand, sales were up 3.0% at clothing stores, up 1.6% at department stores, up 1.2% at grocery stores, up 1.8% at drugstores, and up 1.8% at restaurants. Sales at non-store retailers were down 0.8%. Investors were neither thrilled nor alarmed by the retail report. Equity prices and bond yields were relatively stable on the day of the report.
June 10 was a big day for investors and economists. The US government released the much-awaited and feared inflation numbers for May, and there was something for everyone. For those convinced that the United States is heading toward 1970s-style inflation, there was a big annual inflation number. For those who think high inflation is transitory and not related to monetary or fiscal stimulus, there was plenty of data to confirm their point of view. My own view is that the inflation report indicated two important things. First, it demonstrated that there is strong aggregate demand in the US economy, boding well for continued strong economic growth. This was reflected in the increase in equity prices, following release of the inflation report. Second, the report showed that big price increases took place in situations unrelated to stimulus. Rather, they were related to temporary supply chain issues that will likely abate over time. This view was reflected in a decline in bond yields. Evidently, the inflation report did not shock investors and seemed to confirm their adherence to the Federal Reserve’s view that inflation is not likely to become a problem.
Let’s look at the numbers. The consumer price index (CPI) was up 5.0% in May versus a year earlier, the sharpest increase since 2008. In part, this was due to the base effect of a very low number a year ago at the height of the pandemic crisis. In addition, the CPI was up 0.6% from April to May, lower than the 0.8% increase in the previous month. This was the first deceleration of monthly inflation since October 2020 and suggests that price pressure could be abating. When volatile food and energy prices are excluded, core prices were up 3.8% from a year earlier, the highest rate of core inflation since 1992. Core prices were up 0.7% from April to May, lower than the 0.9% increase in the previous month.
The most important thing is to look at the details. Some categories saw exceptional increases in prices while others were relatively muted. For example, the price of food eaten at home was up only 0.7% from a year earlier and up 0.4% for the month. Meanwhile, the price of food eaten away from home was up 4.0% from a year earlier and up 0.6% for the month. This variance reflects a sudden shift in consumer behavior that food merchants are struggling to accommodate. Apparel merchants are also struggling, with apparel prices up 5.6% from a year earlier and up 1.2% for the month.
The really big increases, which accounted for a sizable share of the reported inflation, were in a handful of categories, the most important of which was used cars. Prices of used cars were up 29.7% from a year earlier and up 7.3% from the previous month. This accounted for a third of overall inflation. It was largely due to a shortage of semiconductors that is hurting new car production, compelling consumers to seek used cars. The cost of renting a car increased 109.8% from a year earlier and was up 12.1% from the previous month as rental car companies struggle to rebuild their depleted fleets. Airline fares were up 24.1% from a year earlier and were up 7.0% from the previous month, as travelers suddenly hit the road again. Hotel prices are also up accordingly. With the housing market booming, the cost of hiring a moving company increased 16.2% from a year earlier and was up 5.5% from the previous month. The point is that, in industries that are suddenly thriving due to the removal of restrictions, businesses are having a hard time keeping up with demand as they have only begun to boost capacity and rehire workers. In some businesses, supply chain disruption is boosting prices. For example, the price of bicycles was up 10.1% from a year earlier and up 2.9% from the previous month. Home appliance prices were up as well. However, prices of computers were up only modestly. Prices of telephones dropped sharply.
The biggest danger now is not the strength of demand. Rather, it is the challenge of supply, especially the problem businesses are now facing in filling job vacancies in order to supply consumers with the goods and services they crave. Wages are rising in response to this pressure, albeit modestly. If a wage-price spiral emerges, then more persistent inflation would take place. From the perspective of the Federal Reserve, this would be the point at which a significant shift in monetary policy would likely be contemplated. For now, however, the Fed continues to say that there will be a temporary spike in inflation that will ultimately go away. Indeed, a criticism of the wage-price spiral narrative is that wage growth has so far been relatively modest, that US employment remains far below the prepandemic level, and that, by the Fall, there are reasons to expect a significant increase in labor force participation. These include the full return of children to school, the end of enhanced unemployment benefits, and greater confidence that the virus is no longer a threat.
Perhaps one of the biggest conundrum in the US economy is the sharp divergence between the comments of business leaders regarding inflation and the behavior of bond investors. From clients I repeatedly hear a drumbeat of fear about the coming of 1970s-style inflation. They complain about labor shortages leading to much higher wages and sharp increases in input costs being passed along to customers in the form of higher prices. Those old enough to remember say that they have not seen anything like this since the 1970s. They point to the CPI numbers for April and May. They worry that massive government stimulus, both in the form of fiscal spending and monetary policy easing, is overheating the US economy.
And yet, the bond market is not cooperating with this argument. Bond yields have dropped lately, which is not consistent with the high-inflation narrative. Bond yields reflect many things. They reflect expectations of inflation, supply and demand conditions in the bond market, and perceptions of risk. As for supply and demand conditions, the Federal Reserve continues to purchase bonds, thereby boosting demand and suppressing yields. As for expectations of inflation, this is precisely measured by the so-called breakeven rate (which I’ve explained on many occasions), demonstrating which part of a bond yield can be attributed to inflation expectations. The 10-year breakeven rate was 2.36% last week, down from 2.54% on May 17. That is, investors expect consumer price inflation to average 2.36% per year over the next 10 years—which is only slightly higher than the Federal Reserve’s target rate of inflation of 2.0%. The five-year breakeven rate was 2.47% compared to 2.72% on May 17. In other words, investors expect higher inflation in the next five years than in the next 10 years. This suggests that, like the Federal Reserve, investors expect a temporary surge in inflation, followed by a decline in the inflation rate. In other words, investors are evidently not worried about inflation getting out of control.
Of course, just because investors believe this does not mean it will come true. Investors, like economists, could be wrong. In any event, if inflation does become problematic, central banks will likely reverse course and tighten monetary policy. This would likely suppress economic recovery. Critics could argue that if the Fed acts too late, it will find it difficult to suppress inflation—as was the case back in the pesky 1970s. But back then, the inflation genie was long out of the bottle before the Fed acted. This time could be different. The Fed will clearly keep an eye on the breakeven rate (which didn’t exist in the 1970s). This will provide the Fed with an indication as to whether expectations are becoming unanchored.
As discussed before, there is a strong argument to be made that the current surge in inflation is transitory, driven by supply chain disruption and a sudden increase in demand that cannot easily be satisfied until companies return to normal operations. The argument is made that these factors will abate over the course of the coming year. That being said, an argument could be made that a wage-price spiral coming, as evidenced by the labor shortage now plaguing many companies. Wages are, indeed, rising in many industries. The problem is, in part, a reluctance to return to the labor force on the part of some potential workers. If businesses must pay more to compel people to work, does this imply that higher wages will be passed onto consumers in the form of higher prices? Or does it mean that the distribution of national income will shift away from business profits and toward wages? That distribution shifted sharply toward profits over the past half century, so it would not be entirely surprising to see a shift in a new direction, fueled in part by demographic and structural changes that make labor scarce.
Amidst raging debate about the likelihood of much-higher inflation, US Treasury Secretary Yellen offered two important points of view. First, she said that the roughly US$4 trillion in additional spending being sought by the Biden administration will not be inflationary because it will be spread over a decade and, on an annual basis, is not that big compared to the size of the economy. However, it should benefit growth by boosting productivity and labor force participation. Moreover, the impact of the very large US$1.9 trillion spending bill passed earlier this year will abate sometime next year. She continues to believe that the current surge in inflation will prove to be transitory and not due to stimulus but due to supply chain disruption.
Second, she said that a boost to inflation and interest rates is actually welcome. She said, “if we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view and the Fed’s point of view.” She noted that, in the past decade, US policymakers have struggled—without success—to boost inflation and borrowing costs. She said that, if the current mix of policy boosts inflation, then “that’s not a bad thing, that’s a good thing.” In an interview she recalled that, after the last recession in 2008-09, the Federal Reserve waited for inflation to surge and it never happened. Many economists believe that a bit of inflation helps to grease the wheels of commerce. Moreover, interest rates that are significantly above zero encourage businesses to make better investment choices. Artificially low borrowing costs distort capital allocation.
Yellen’s comments may be in line with the thinking of the Federal Reserve. However, Fed leaders simply cannot say what Yellen has said for fear of disrupting financial markets. Normally, the Fed would rather not have a Treasury Secretary opine on such matters. However, given that Yellen used to lead the Fed and maintains a close relationship with Fed Chair Powell, this time is likely different.
The US job market is operating at an exceptional level. The latest Job Openings and Labor Turnover Survey (JOLTS) from the US government suggests a historically high level of job openings. Specifically, there were 9.3 million job openings in April, a record high and up from 8.3 million in the previous month. This means that there is roughly one job available for everyone unemployed—although it is likely that there remains a significant skills mismatch. The job openings rate, which is the share of available jobs that are unfilled, was 6.0% in April, also a record. This was up from 5.4% in March, 3.4% a year ago, and 4.6% just prior to the start of the pandemic. The increase in job openings was heavily concentrated in leisure and hospitality. Of the roughly one million increase in job openings from March to April, nearly 400,000 were in leisure and hospitality, where the job openings rate hit a staggering 10.1%. Other industries with high job openings rates include nondurable manufacturing (7.5%), professional services (6.8%), health care and social assistance (6.2%), and retail trade (6.0%).
The government also releases data on the number of hires, which was unchanged in April. In addition, it released data on separations (quits, layoffs, and discharges). The number of separations increased moderately, entirely due to a surge in quits, which hit a record high of 2.7% of jobs. The number of quits increased by roughly 400,000 from March to April. Layoffs and discharges were down, with the rate of layoffs and discharges at a record low. Thus, it appears that there are plenty of jobs available and that people are comfortable quitting jobs in the knowledge that other jobs are readily available. The number of quits in April was high in retail trade (up 106,000), professional services (up 94,000) and transportation, warehousing, and utilities (up 49,000). The quits rate in leisure and hospitality was 5.3%. This means one in 20 employees in this industry quit their jobs in April alone. That indicates a high degree of confidence that another job is just around the corner, or that employment is simply not needed. Indeed, there is evidence from the most recent jobs report that older workers are quitting the labor force in droves as they choose to retire.
This JOLTS report, along with the recently released report on employment growth in May, suggests that the job market is a seller’s market and that workers have greater bargaining power than at any time in recent history. Indeed, wages increased at a good pace in May as businesses struggled to fill empty slots. Still, the relatively high unemployment rate and the sharp decline in labor force participation in the past year suggest that there remains plenty of room for noninflationary labor market growth. In the coming year, three factors are likely to cause either an increase in labor force participation or a further increase in demand for labor. These are the return to full-time school and daycare, the end of enhanced unemployment insurance, and the resolution of temporary supply chain disruption. Still, the labor market is likely to see sustained disruption emanating from a skills mismatch.
In China, producer prices, also known as factory gate prices, increased 9.0% in May versus a year earlier, the fastest gain since 2008. This reflected the fact that strong domestic and foreign demand for China’s factory goods fueled increases in global commodity prices. This, in turn, led to higher producer prices. The biggest increases were for extraction (up 36.4% from a year earlier) and raw materials (up 18.8%). Many observers worry that this could lead to higher consumer price inflation in China as well as in the rest of the world. If not, will companies selling consumer goods take a hit to their profit margins?
First, it appears that the surge in producer prices has not yet been passed through to Chinese consumers. Chinese consumer prices were up 1.3% in May versus a year earlier, up from an increase of 0.9% in April. This was the fastest gain since September 2020. Notably, prices were down 0.2% from the previous month. The biggest year-over-year increase was in transportation and communications equipment, which was up 5.5% in May versus a year earlier. There were also big increases for airline tickets and fuel. The price of pork, however, fell very sharply. China’s leaders have expressed concern about the potential impact of rising producer prices on consumer prices. In fact, the Premier has called for increased coal production in order to suppress the surge in coal prices. The weakness of food prices, which account for a large share of the CPI, may help to avoid ruinous inflation.
What about the impact of China’s rising costs on global inflation? The rise in prices in China, combined with continued disruption of transportation of traded goods, could lead to a much bigger increase in import prices in the United States and Europe. If these price increases are passed on to local consumers, it could be inflationary. However, this could be transitory if the surge in global demand abates in the coming year. Government stimulus in the United States and Europe will, in fact, subside by 2022, potentially reducing consumer impetus to spend with abandon. Moreover, by then it could be the case that pent-up demand will be satisfied and that the growth of demand will subside. Finally, it should be noted that the Chinese renminbi has been rising in value. This could help to reduce the rise in import prices in the United States and Europe. It could also mean a profit squeeze for Chinese producers.
Job growth accelerated in the United States in May, although it remained below analyst expectations. More than half the jobs created were in the leisure and hospitality sector. Participation in the labor force declined while employment increased. The result was a sharp decline in the unemployment rate. Investors greeted the jobs report favorably, pushing up equity prices while pushing down bond yields. They evidently saw the report as an indication of continued strong economic growth but mild inflationary pressure. Let’s look at the details.
The US government produces two reports on the job market—one based on a survey of establishments, the other based on a survey of households. The establishment survey found that 559,000 new jobs were created in May, far more than the upwardly revised 278,000 jobs created in April, but less than the 785,000 jobs created in March. While this is up about 12 million jobs from a year earlier, it remains about 7.6 million jobs below the prepandemic level of February 2020. Thus, the job market remains somewhat depressed.
The manufacturing sector saw 23,000 new jobs, entirely due to job growth in the automotive sector. Meanwhile, construction employment declined sharply, likely reflecting shortages of key inputs as well as skilled labor. The construction industry has long relied on migrant workers from Mexico. Cross-border movement of labor has been severely disrupted by the pandemic.
As for employment in services, 292,000 jobs were created in the leisure and hospitality sector, less than in April but more than in March. This included 186,000 jobs at restaurants and bars, 35,000 at hotels, and 72,000 at arts, entertainment, and recreation facilities. This surge reflected the reopening of the economy across the country as well as greater confidence owing to increased vaccination. In addition, there were 87,000 new jobs in education and health services. However, the retail sector saw a net loss of almost 6,000 jobs, including a 26,000 decline in jobs at grocery stores. This likely reflected the shift of consumer spending away from meals at home and toward restaurants. Even large general merchandise stores saw a decline of nearly 5,000 jobs. However, clothing stores boosted employment by more than 10,000, possibly indicating that people are increasingly concerned with their appearance now that they are going out again. Also, because there continues to be growth of online commerce, employment in transportation and distribution increased by 23,000. Finally, employment in state and local governments increased by 78,000, possibly due to the impact of stimulus money provided by the Federal government.
The establishment survey also provides data on average hourly wages. It found that the May average hourly compensation was up 1.9% from a year earlier, a relatively mild number. However, there were big differences by industry. Compensation was up 6.1% in financial services, even though employment in the sector was stagnant. Compensation was up 4.3% in retail, possibly indicating a struggle to attract people to work in stores. And compensation was up 3.7% in the thriving leisure and hospitality sector that’s working hard to ramp up capacity. That said, compensation was up only 1.0% in manufacturing. The overall modest boost to wages suggests that the economy is not yet facing the kind of wage-price spiral that would ignite sustained inflation. Thus, it is no wonder that bond yields fell following release of this report.
The separate survey of households indicated that, although the working-age population grew by 107,000 in May, labor force participation fell by 53,000. Participation means people who are either working or actively seeking employment. The decline suggests that some people became discouraged because of a skills mismatch. Meanwhile, employment grew strongly. The result was that the unemployment rate fell from 6.1% in April to 5.8% in May, the lowest level in 14 months. The unemployment rate among those aged 16 to 19 fell dramatically, indicating the likely return of younger workers to the retail and hospitality sectors. There was also a sharp decline in the number of people unemployed for more than six months.
The relatively moderate pace of job growth, combined with limited wage gains, suggests that the Federal Reserve is likely to leave monetary policy unchanged. The decline in participation suggests continued reluctance on the part of some potential workers to engage in the labor force. When, later this year, children go back to school and daycare full time, it is possible that many hesitant workers will reenter the labor force. If herd immunity is reached later this year due to mass vaccination, those fearful of the virus will likely return as well. Plus, once supply-chain disruptions are resolved, businesses will be in a better position to boost hiring further. Thus, there are reasons for optimism. On the other hand, another surge in infections later this year could set the clock back substantially. Experts in the field of public health have said that this is not a trivial risk, especially in states with low rates of vaccination and high rates of mobility and social interaction.
Despite an elevated unemployment rate and the number of employed being 7.6 million below the prepandemic level, it appears that the US job market is relatively tight. For example, the National Federation of Independent Businesses says that 44% of businesses surveyed report having job openings that they are unable to fill. This is the highest percentage in the history of the survey. The number of online advertisements for jobs has surged, especially for those jobs that involve interaction with people.
Meanwhile, many businesses are boosting wages and offering signing bonuses in order to attract reluctant workers. While some people are reluctant to work because of enhanced unemployment insurance benefits, this clearly does not apply to jobs that offer decent compensation. Instead, a survey by the US Census Bureau found that, in March, over six million people were not looking for work because they were caring for children who were not in school or daycare. Another four million were fearful of catching or spreading the virus.
The hope is that, by September, most children will return to school and daycare and a sufficient share of the population would have been vaccinated to make fear of the virus a thing of the past. There is, however, no guarantee that this will be the case, especially given continued vaccine reluctance on the part of many people.
Another factor causing a tight job market is demographics. Many older workers have chosen to drop out of the labor force, given concern about the virus. The participation rate among those over 65 fell dramatically in the past year. At the same time, the number of young entrants to the labor force has been low compared to the number who have exited. Older households have seen a surge in the value of their assets, including homes. They have also boosted saving in the past year. Thus, many don’t necessarily see the need to work, given their favorable financial situation.
What does this labor shortage mean for inflation and for Federal Reserve policy? The President of the Federal Reserve Bank of St. Louis, James Bullard, said, “I’m evolving toward a judgment where labor markets should be interpreted as fairly tight, and you’re certainly seeing that in firms saying that they’re just going to go ahead and raise wages for these types of workers. They’re going ahead and saying, ‘let’s pay some signing bonuses to get to get workers in the door,’ you’re seeing some businesses actually just staying shuttered because they can’t find enough workers.” However, he indicated that he was not yet ready to think about changing monetary policy, at least not until the pandemic was truly over. If wages do indeed accelerate sharply due to labor shortages over a long period of time, this could be inflationary. However, if the wage gains are offset by productivity gains due to implementation of labor-saving technology, then unit labor costs will be stable and inflation will not be a problem. Moreover, the shortage of labor could abate soon if the pandemic ends, children return to school, and workers gain confidence.
Labor productivity is measured as the ratio of output to hours worked. In recent years, productivity growth in the United States has been modest. Yet as the US economy comes out of the pandemic, productivity is increasing rapidly, in part a reflection of the shift in the types of work taking place and the mix of skills and capital being used. The government reports that, in the first quarter of 2021, labor productivity grew at an annualized rate of 5.4% over the previous quarter. This reflected an increase in output of 8.6% and an increase in hours worked of 3.0%. Quarterly changes are often volatile, which has been especially true during the pandemic. Thus, it is useful to look at the change from a year earlier. The government reports that, in the first quarter, productivity was up 4.1% from a year earlier. This reflected a 1.1% rise in output and a 2.9% drop in hours worked. To put these numbers in a prepandemic perspective, productivity grew 1.7% in 2019, with output up 2.4% and hours worked up 0.7%.
Why do we care about productivity? One answer is that, in the long run, it drives economic growth—and consequently, growth in the size of the labor force. If productivity rises faster, the economy will grow more rapidly. Another answer is that productivity can influence the level of inflation. That is, if wages increase rapidly, but are offset by productivity gains, then the labor cost of producing a unit of output would not increase, thereby not requiring any price increase. This brings us to unit labor costs (ULC), which is a measure of the labor cost of producing a unit of output. The change in ULC is measured by dividing compensation growth by productivity growth. If wages rise faster than productivity, then ULC rises and inflationary pressures are present—and vice versa.
The latest data shows that, in the first quarter of 2021, ULC was up at an annualized rate of 1.9% from the previous quarter. It was up 4.1% from a year earlier, reflecting an 8.3% increase in hourly compensation and a 4.0% increase in productivity. This suggests the possibility of inflationary pressures. However, the much slower rate of quarterly increase suggests that ULC pressure is abating. Moreover, the surge in compensation from a year earlier partly reflects a shift in the mix of jobs. That is, there are fewer lower-paid workers in retail stores and more high-paid workers in technology companies. Thus, the average compensation has increased accordingly, but not necessarily because of general inflationary pressure. Finally, to put things in their prepandemic perspective, it is worth noting that ULC increased 1.9% in 2019, a year during which there was low inflation. In the quarters to come, it will be interesting to observe the trend in these numbers in order to better gauge the degree of inflationary pressure and the likely speed of economic growth. For now, the numbers are too volatile to draw robust inferences.
The weakness in the global economy in the past year was mainly due to a decline in activity in the services industry. The necessity of avoiding social contact led consumers to shun restaurants, bars, theatres, airplanes, hotels, and other venues that involve interaction with other human beings. The global economy will only return to the prepandemic path once services fully recover. The good news is that this is starting to happen in key parts of the world.
The latest purchasing managers’ indices (PMIs) for services were released by IHS Markit and they indicate rapid expansion of the services sectors in the United States and Western Europe, healthy growth in China, and declining activity in India and Japan. Overall, the global PMI indicates rapid global growth in services. PMIs are forward-looking indicators meant to signal the direction of activity. They are based on sub-indices such as output, new orders, export orders, employment, pipelines, pricing, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa.
The global PMI for services hit 59.4 in May, a 15-year high and a number indicating very rapid growth in activity. This was driven by strength in new orders, business sentiment, and a surge in input prices. The most stunning report was from the United States, where the services PMI jumped from 64.7 in April to 70.4 in May, a record high. This was driven by a record increase in output and new orders. The continued reopening of the economy as well as consumer confidence, driven by increased vaccination and reduced rates of infection, helped to propel the sector. This led to a surge in input prices due to shortages of key supplies. Employment growth in the sector was strong, but likely held back by reluctance of some people to return to work.
In Europe, the services PMI for the United Kingdom increased from 61.0 in April to 62.9 in May, the highest in 24 years. United Kingdom’s reopening had a big positive impact as did the strong pace of vaccination. As elsewhere, the surge in activity led to a surge in input prices, creating new inflationary pressures. In the Eurozone, the services PMI increased from 50.5 in April to 55.2 in May. This meant that, after stagnating due to economic restrictions, the lifting of restrictions led to an acceleration in activity. There was a big increase in new orders, backlogs, and employment. Service activity grew especially strongly in Ireland, Spain, and France. Growth was slower in Germany.
In Asia, the picture was not as spectacular as in North America and Europe. India’s services PMI fell sharply, from 54.0 in April to 46.4 in May, indicating a decline in activity. This reflected the sudden closure of businesses due to the massive outbreak. In contrast, growth in China remained steady and strong with the PMI at 55.1 in May. Finally, Japan’s services PMI fell from 49.5 in April to 46.5 in May, indicating declining activity, likely due to new economic restrictions meant to stifle the virus.
Going forward, the health of the large services sector will be determined by the rate of vaccination, the rate of infection, the easing of travel restrictions, and the willingness of consumers to interact with other people. It will also be influenced by the ability of businesses to quickly boost capacity through hiring. It might require significantly higher wages and/or investments in labor-saving technology.
It is increasingly clear that the European Central Bank (ECB) does not intend to scale back asset purchases any time soon. Some analysts had begun to question whether it makes sense for the ECB to change policy. This discussion was driven by the expectation of faster economic growth this year as well as rising inflation in the Eurozone. These factors have already led to an increase in bond yields. However, the expectation of a shift in policy was dampened this week when several leaders of the ECB indicated that it is not yet time to adjust policy. For example, Fabio Panetta, a member of the ECB executive board from Italy, said, “A premature withdrawal of policy support would risk suffocating the recovery before it becomes self-sustained. From my viewpoint, the conditions that we see today do not justify reducing the pace of purchases.” He added, “We should not extrapolate from what is happening in the United States. We don't expect the same kind of surging demand and tight labor markets that would generate stronger lasting price pressures." The US Federal Reserve has left policy unchanged. However, it did indicate amenability to shifting policy sometime in the future. Canada’s central bank, however, has started to ease asset purchases. Meanwhile, ECB President Lagarde said that it is “far too early” to discuss longer-term issues for the Eurozone.
In response to the comments by Panetta and Lagarde, bond yields in Europe fell. The yield on the German government’s 10-year bond fell four basis points in one day after a month of rising. Yields on bonds issued by France, Italy, and Spain fell by a similar amount. The extent of the decline in yields reflected, in part, investor surprise at the ECB commitment to maintain asset purchases. Given the evident strengthening of the Eurozone economy and the rise in inflation, many investors had expected a different attitude on the part of ECB leaders.
Meanwhile, breakeven rates in the Eurozone indicate an increase in expectations of inflation in Europe. First, the breakeven rate is calculated by subtracting the yield on an inflation-protected security from the headline yield. In the case of an inflation-protected security, the principal moves in line with inflation. As such, the yield is the real (inflation-adjusted) return on the bond. The difference between the two yields is, therefore, the expected rate of inflation.
In Germany, the 10-year breakeven rate was 0.48% a year ago. It then reached 0.91% in early January. Now it is 1.4%—even though the headline yield on the 10-year bond remains below zero. Thus, the real (inflation-adjusted) bond yield is substantially negative. This is likely due to continued massive bond purchases by the ECB. That policy, along with expectations of a robust economic recovery, explains the rise in inflation expectations.
Meanwhile, the breakeven rate in the other major economies of the Eurozone has moved roughly in line with that of Germany. For example, the 10-year breakeven rate for Italy increased from 0.381% a year ago, to 0.849% in early January, to 1.36% now—slightly lower than that of Germany. The lower expectation for inflation in Italy than Germany reflects an expectation that the German economy will be stronger in the coming years, with less slack in the labor market. The headline yield in Italy, 0.96%, means that the real rate, while negative, is substantially higher than that of Germany. That partly reflects a perceived higher risk of default in Italy. Finally, the 10-year breakeven rates in France and Spain are currently 1.36% and 1.47%, respectively. Thus, most investors have relatively consistent expectations about inflation across the Eurozone. In all cases, the expectation remains below the ECB’s target rate of inflation of 2.0%. Meanwhile, the 10-year breakeven rate in the United States is around 2.4%, higher than the Federal Reserve’s target of 2.0%.
The Chinese renminbi has appreciated recently, hitting a three-year high against the US dollar, having risen about 10% in the past year. The increase reflects relatively high bond yields in China, which have generated strong inflows of portfolio foreign investment. It also reflects expectations that China’s economy will grow strongly in the coming year, with high returns on portfolio assets. The Chinese authorities are concerned that a higher valued renminbi will hurt the competitiveness of Chinese exports, especially at a time when the profitability of many of China’s smaller manufacturers is at risk. That, in turn, is due to the rise in the cost of imported commodities. Global commodity prices have surged due to a rapid expansion in global demand, combined with supply chain constraints as global companies struggle to adjust to a new normal.
Although the renminbi has risen in value, the rise has been constrained by the fact that the central bank places limits on how far the exchange rate can move. Recall that a senior central bank official recently called for allowing the currency’s value to be fully determined by market forces. However, such flotation of the currency does not appear to be in the cards. Liu Guoqiang, deputy governor of the central bank, recently said that there are no plans to change the exchange rate regime. He said that the managed floating exchange rate is “an institutional arrangement fit for China at present and in the foreseeable future.” Even if China intended to float the currency, it would likely not say so at this time. Meanwhile, in order to prevent a larger appreciation, the central bank must engage in purchases of foreign currency.
China’s central government is strongly considering introducing a national tax on residential property. This is a controversial issue. Many local governments oppose this move as they expect it will result in lower property prices. Local governments often rely on property sales to generate revenue. So lower property values would be a problem for them. At the same time, experimental property taxes introduced in Shanghai and Chongqing did not, evidently, result in a decline in property prices. Rather, property prices continued to rise due to reduced land sales and an easy monetary policy.
There are two major reasons why a property tax could make sense. First, it would generate a reliable stream of government revenue, eliminating the need for unpredictable property sales. Second, it would encourage economically sensible use of land and would discourage the kind of speculative purchases that are currently popular. It has been widely reported that there is a very large number of unoccupied homes in China. One reason is that people purchase newly built unoccupied homes as a speculative investment, hoping that the value will eventually rise in the long term. Given the low yield on bank deposits and the casino-like quality of equity markets, property is seen as a favorable and reliable investment. Yet massive construction of unused property is a waste of resources and is environmentally damaging. A property tax would discourage this kind of investment. It would enable a shift of resources toward investments that have a positive return in the short term.
One problem is that, in China, people own their homes but not the land on which they are built. Instead, all land is owned by the government and is leased to homeowners on a long-term basis. While some critics worry that this will create a problem in implementing a property tax, there are several countries in which the value of homes is taxed even though the land is owned by the government. This is true in Singapore, for example.
The path of personal income and consumer spending in the United States over the past year has been volatile, largely due to the periodic dispensation of government stimulus payments. April was no exception. The US government reports that, after a sharp increase in personal income in March due to the massive US$1,400 payments made to about 85% of Americans, personal income fell sharply in April, returning to a normal level. However, after a big increase in spending in March, spending stabilized in April at a high level. Thus, it is clear that the stimulus payments continued to have a positive impact on economic activity. Meanwhile, although the savings rate fell in April, it remained historically high. The volume of money saved by American households over the past year is massive and possibly sets the stage for a further revival of spending on services later this year, provided that the country continues to have success in quelling the COVID-19 outbreak.
Here are the details. After rising 20.9% from February to March, total personal income fell 13.1% from March to April. Notably, wage income was up a robust 1.0% in April as employment and wages continued to rise. However, government transfers fell 41.4% after having risen 95.2% in the previous month. After accounting for inflation and taxes, real disposable personal income was down 15.1% from March to April. However, real consumer spending fell only 0.1% from March to April after having risen 4.1% in the previous month. In other words, after rising sharply to a new plateau in March, spending stayed roughly at that level in April as consumers dipped into the money they had saved in the previous month. In fact, the savings rate fell from 27.7% in March to 14.9% in April, roughly where it had been in February. The data on consumer spending is consistent with data on retail sales that was released earlier.
As for categories of spending, Americans spent less on goods and more on services. Specifically, real (inflation-adjusted) spending on durable goods fell 0.9% from March to April, spending on nondurable goods fell 1.6%, and spending on services increased 0.6%. This implies, for example, that households spent less at grocery stores and more at restaurants. People are going out again, fueled by a reduction in economic restrictions and fewer mask mandates. The number of new infections is down sharply and, although the rate of vaccination has slowed, the share of the population that is fully vaccinated is higher than in most other developed nations. Still, the threat of new variants remains.
The latest report on personal income included data on the personal consumption expenditure deflator, which is the Federal Reserve’s favorite measure of inflation. While not as dramatic as the recent consumer price index report, it did indicate an acceleration in inflation. Specifically, the report noted that the deflator was up 0.6% from March to April and was up 3.6% from a year earlier. Excluding the impact of volatile food and energy prices, core prices were up 0.7% from March to April and were up 3.1% from a year earlier. In addition, the greatest annual inflation was seen for durable goods and the least was for services. This is consistent with the surge in demand for durable goods and the supply chain constraints in meeting that demand.
There was no new information in the report on inflation. Consequently, bond yields fell following the report on inflation. If investors had been surprised by the high level of inflation, yields would have increased. Most investors evidently appear comfortable with the Fed’s analysis that the increase in inflation is temporary and related to transitory factors that will abate by next year. The next big piece of news will be the May employment figures which will be released one week from today.
For much of the pandemic, spending on consumer-facing services, such as restaurants, has been suppressed in the United States, keeping economic activity below the prepandemic path. For many months, there was an expectation that, once a large number of people are vaccinated, there will be greater confidence that the virus is less of a threat and that, as a result, spending on consumer-facing services would rebound strongly. We now have evidence as to what is happening. Indeed, spending on consumer-facing services is up as consumer mobility has increased. And yet this revival cannot be explained by vaccination. In fact, evidence suggests that, in states with relatively low rates of vaccination, mobility has increased significantly faster than in states with higher rates of vaccination.
Specifically, a survey conducted by Cardify revealed that, in April, spending at entertainment venues increased 20% since January for consumers reporting no intention of being vaccinated. For those intending to be vaccinated, the increase was only 10%. In addition, Cardify found that, in states with greater vaccine reluctance, visits to airports and hotels was 71.2% of the prepandemic level in April. In states, with more vaccine enthusiasm, the number was 52.7%. Cardify found other examples in which mobility and spending increased more for vaccine-reluctant consumers than for vaccine enthusiasts. How can we explain this anomaly?
One possible explanation is that people are less likely to be vaccinated or intend to be vaccinated in states that opened earlier and that have removed mask mandates. In those states, it is likely that consumers are less fearful of the virus than in other states, leading to a greater degree of mobility and spending. This explains what has happened in recent months, but might not explain what will happen in the months to come. In fact, as vaccination proceeds, the overall level of fear will likely diminish, perhaps leading to strong growth of mobility and spending in states that, heretofore, were home to a larger number of immobile consumers.
Interestingly, the pattern found by Cardify is consistent with political affiliation. That is, the states with more vaccine reluctance and faster increases in mobility are largely those that supported Donald Trump in the 2020 election. Meanwhile, states with greater vaccine enthusiasm and slower increases in mobility tended to support Joe Biden. For many months, political affiliation has been strongly correlated with attitudes toward vaccination.
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