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This month marks the 50th anniversary of one of the signal events in post-war economic history. It was in August 1971 that then US President Richard Nixon closed the gold window and ushered in the era of floating exchange rates. Prior to that date, and under the Bretton Woods system that was negotiated at the end of World War II, there was a fixed price of gold against the US dollar. Other countries maintained a fixed exchange rate of their currencies versus the US dollar, and the United States bought and sold gold in order to maintain the system. Yet in the 1960s, the United States engaged in an expansive fiscal and monetary policy, leading to higher inflation and excess demand for imported goods. This led to a balance of payments deficit and downward pressure on the value of the dollar, forcing the United States to sell gold to maintain its price.
By 1971, the United States faced the prospect of not being able to meet the demand for gold. Hence, in August 1971, after a secret meeting with his advisors at Camp David, President Nixon shocked the world by ending the gold relationship, forcing a new era of floating currency values. In addition, Nixon attempted to boost US employment in anticipation of his reelection campaign in 1972 by cutting taxes and imposing an import tariff. To avoid the inflationary effects of this policy, he also imposed wage and price controls. This distortion of the economy contributed to the stagflation of the 1970s.
In any event, the Nixon shock led to widespread talk among investors that the era of dollar dominance was over. Without the United States effectively running the global financial system, it was expected that other currencies from lower inflation countries, such as the deutschmark and the yen, would gain in importance. This did not happen. Rather, the role of the dollar actually grew, and continues to grow even today. It turns out that the dominance of the dollar was not dependent on the United States acting as banker to the world. Rather, dollar dominance depended on the massive size of the US economy, the liquidity and transparency of its financial markets, and the perceived stability and reliability of the United States as a place to park funds. This has not changed, despite various intermittent shocks and crises.
Moreover, no suitable alternative to the dollar has emerged. Unlike the United States, the Eurozone lacks a centralized, broad, and liquid market for sovereign debt. It lacks fiscal and financial integration, making it more vulnerable to financial shocks. Meanwhile, the Chinese renminbi will not likely challenge the dollar so long as China retains capital controls and so long as China’s banking system and central bank remain relatively opaque and subject to government intervention.
Meanwhile, floating exchange rates have helped to avoid balance of payments crises that periodically afflicted affluent countries in the Bretton Woods era, especially the United Kingdom. Floating rates have also helped countries to adjust to external shocks and avoid the need for ruinous protectionism. In fact, the lack of floating rates within the eurozone likely contributed to the regional crisis in 2012–13. In addition, the expansion of global trade in the last 50 years might not have been so massive if not for the Nixon shock. And while various pundits periodically call for a return to the gold standard, this viewpoint is no longer considered respectable within the broad economics profession. Floating rates are likely here to stay. Although Richard Nixon was best known for his opening to China, it could be argued that the Nixon shock 50 years ago is his most enduring legacy.
Under US law, the Federal Reserve is charged with achieving price stability and maximum employment. These two goals are sometimes contradictory, so the Fed must find the right balance of policy. During the pandemic, the Fed has been more focused on its employment goal, even as inflation has soared in recent months. The Fed took the view, which it still maintains, that the uptick in inflation is transitory and that the economy requires support because employment remains far below the prepandemic level. That said, the Fed has made clear that, once the economy is on a path toward its goals, it will adjust policy.
This brings us to last Friday’s important event. Fed Chair Jay Powell gave a highly anticipated speech to the annual Jackson Hole meeting of central bankers which was once again held in cyberspace. In his speech, Powell reiterated that the rise in inflation is likely transitory, although he said that the Fed will continue to carefully monitor incoming data. He said that an important measure is market expectations of long-term inflation which, he noted, remain at a level consistent with the Fed’s goals. This indicates that market participants agree with the view that current high inflation is transitory.
With respect to policy, Powell said that, if the Fed were to tighten monetary policy too soon, it could have negative consequences for employment and growth. Alternatively, the Fed must be careful as transitory inflation could persist longer than anticipated. He noted that, in the 1970s, the Fed misread increases in food and energy prices as transitory. This led the Fed to keep policy too accommodative for too long, leading to a long period of high inflation. As such, the Fed must carefully monitor data on prices, employment, and the delta variant. It is a tough balancing act.
Since the pandemic began, the Fed has principally used two policy levers to support the economy. These are short-term interest rates and large asset purchases. There is no expectation that interest rates will be changed any time soon. But there has been much speculation regarding when the Fed will taper its program of monthly asset purchases. In fact, investors were eager to hear Powell address this issue. He did not disappoint. Powell said the following:
“We have said that we would continue our asset purchases at the current pace until we see substantial further progress toward our maximum employment and price stability goals, measured since last December, when we first articulated this guidance. My view is that the "substantial further progress" test has been met for inflation. There has also been clear progress toward maximum employment. At the FOMC's recent July meeting, I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year. The intervening month has brought more progress in the form of a strong employment report for July, but also the further spread of the Delta variant. We will be carefully assessing incoming data and the evolving risks.”
In other words, tapering will start later this year, although Powell was not specific about the timing or speed of tapering. He clearly left some wiggle room so that the Fed could react to changes in the business environment. However, the decision to start tapering is a signal that, despite the possibility of an economic setback due to the delta variant, Powell and his colleagues are largely confident that the economy is on a favorable path in terms of inflation and employment. With respect to the delta variant, he said that, “while the Delta variant presents a near-term risk, the prospects are good for continued progress toward maximum employment.”
As for interest rate policy, Powell said that the Fed will have a more stringent test. He said that the Federal Funds rate will remain at its current level “until the economy reaches conditions consistent with maximum employment, and inflation has reached 2% and is on track to moderately exceed 2% for some time. We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2% inflation on a sustainable basis.”
Investors reacted favorably to Powell’s comments, with equity prices rising and bond yields declining. Although Powell signaled an imminent end of asset purchases, investors appear to have been relieved by his strong defense of the argument that current inflation is transitory. This signals that the Fed will not overreact to inflation. The decline in bond yields is interesting in that, when the Fed begins to taper, the supply of bonds available to private investors will rise, which would normally lead to higher bond yields. Yet yields fell today. Perhaps this means that investors reduced their expectations for inflation following Powell’s remarks.
Meanwhile, the US government released the latest data on the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator (PCE-deflator). While inflation remains high, it appears that it might be decelerating. Specifically, the headline index was up 0.4% from June to July, slower than the 0.5% increase in the previous month. When volatile food and energy prices are excluded, core prices were up 0.3% from June to July, again slower than the 0.5% increase in the previous month. Prices were up 4.2% from a year earlier and core prices were up 3.6% from a year earlier. While it is too early to say that inflation is abating, it is reasonable to say that inflation is no longer accelerating and may have already peaked. Thus, the numbers appear to affirm the argument that Chair Powell made in his speech today.
In the face of a deceleration in economic activity, China’s central bank is taking steps to boost credit market activity. Last month it cut the required reserve ratio (RRR) for commercial banks. Later it provided direct low interest loans to banks to encourage them to boost lending. Last week Yi Gang, the Governor the People’s Bank of China (PBOC), urged banks to provide more credit to micro, small, and medium sized businesses that now face a “more severe and complex” business environment. Yi said that he wants banks to strengthen balance sheets and reduce lending rates. He wants them to lend more for the purpose of scientific and technological innovation as this tends to boost economic growth.
Yi’s comments come following the release of data showing a deceleration of credit expansion, which often portends further weakening of economic activity. Already, the economy faces serious obstacles from COVID-19, supply chain disruption and shortages, fraught trading relations with the United States, and the lagged effect of previous tightening of credit market conditions. The PBOC is caught between a rock and a hard place. On the one hand, it has indicated concern about the rapid growth of business and household debt and the potential troubles this might create. On the other hand, it wants credit expansion to be sufficient to keep the economy growing. As such, many observers expect that the PBOC will walk a narrow path, not likely to implement a substantial easing of monetary policy, but keen to avoid a further tightening of credit market conditions.
Although China’s dependence on exports has waned in recent years, exports remain an important source of economic growth. Thus, the disruption of global supply chains and, especially, transport capacity is of considerable concern to Chinese authorities. In the past year, the cost of shipping a container from East Asia to the United States has risen 442%. The cost of shipping a container from East Asia to Europe is up about tenfold from a year ago.
A Chinese government spokesman said that “the tight transport capacity and high freight rates is a global phenomenon.” In response, he said that various ministries of the Chinese government will “actively take measures to increase container supply, enhance shipping capacity, and strengthen international cooperation. Local authorities have also stepped up shipping supporting services for small and medium-sized enterprises to help them reduce costs and losses.” He added that “we will continue to work with relevant departments and localities to further study targeted measures, stabilize the international logistics and strengthen cooperation with various trading partners to cope with the challenges together.” Many industry insiders expressed skepticism that Chinese government efforts will pay dividends any time soon. They expect that shipping costs will remain high for some time to come and that exporters in China will continue to face constraints.
Meanwhile, there is growing concern that the delta variant will prolong the shipping crisis. Already, isolated outbreaks of delta in China have led to two major temporary shutdowns of port facilities: one near Shenzhen; the other in Ningbo. The delta variant has also led to temporary shutdowns of factories and warehouses. Although China has had nowhere near as many infections per capita as many other countries, the government’s zero tolerance policy has meant the rapid closure of facilities and quarantining of hundreds of individuals each time an infection is spotted. Moreover, the spread of the delta variant in Southeast Asia has limited the ability of companies to shift supply chain processes out of China. The virus has disrupted supply chains in Vietnam, Indonesia, and Thailand.
Some industry participants have expressed the fear that, if the virus cannot be contained, then shortages and delays could become the new normal. Moreover, the fear of disruption has led to a big increase in hoarding of inputs and commodities, thereby contributing to rising costs and supply chain delays. This aspect of the market has already become the new normal.
The United States: The US economy continues to grow at a healthy pace, but clearly decelerated in August. This conclusion is based on the latest purchasing managers’ indices (PMIs) released by IHS Markit. PMIs are forward-looking indicators meant to signal the direction of activity in the broad manufacturing and services sectors. They are based on sub-indices such as output, new orders, export orders, employment, pricing, pipelines, and sentiment. A reading above 50 indicates growing activity; the higher the number, the faster the growth—and vice versa.
The manufacturing PMI for the United States fell from 63.4 in July to 61.2 in August, the lowest in four months. Still, this is a number indicating rapid growth. Although new orders continued to grow at a very strong pace, shortages of materials and capacity constraints had a negative impact on output. Moreover, difficulty in fulfilling orders led to a huge increase in backlogs. In addition, problems in attracting and retaining workers hurt capacity and led to relatively slow growth of employment. The disparity between strong demand and limited supply led to a record increase in input prices which, in turn, led to a record increase in selling prices.
The services PMI for the United States fell from 59.9 in July to 55.2 in August, an eight-month low. It is a number indicating a moderately strong rate of growth. The slowdown was attributed to the impact of the delta variant on demand for consumer-facing services, labor shortages, and supply chain disruption. The latter contributed to an acceleration in input prices and seller prices.
Overall, the latest PMIs for the United States suggest economic strength but significant challenges, especially those that influence inflation. However, Markit commented that “prices look set to continue to rise sharply due to the persistent upward pressure on costs arising from shortages of materials and labor, though if demand continues to cool due to rising case numbers this should alleviate some of the inflationary pressures.” As has been the case for the past 18 months, the virus remains the principal risk factor for the US economy.
Europe: In Europe, the economy of the 19-member eurozone continued to grow at a very strong pace in August, according to the latest PMIs. However, there was a slight deceleration, largely due to supply chain obstacles. The manufacturing PMI for the eurozone fell from 62.8 in July to 61.5 in August, a six-month low but still indicative of very rapid growth. Meanwhile, the services PMI was almost unchanged at 59.7 in August, a level indicating very rapid growth. Notably, the services PMI exceeded the manufacturing PMI for the first time since the recovery from the pandemic began. This was helped by the fact that containment measures were eased and that the infection rate has lately fallen sharply in response to previous containment measures. Moreover, vaccination continues to expand. As such, consumer interaction has improved.
Meanwhile, manufacturing activity continued to grow strongly, fueled by strong demand. However, supply constraints continued to restrain the growth of output. For both manufacturing and services, new orders were strong but decelerated moderately. Still, business leaders expressed strong optimism about the future given the improved outlook for the virus. Consequently, employment growth in the eurozone was very strong. Although backlogs were high, job growth helped to alleviate capacity constraints. On the other hand, supply chain problems contributed to accelerating prices. In fact, Markit commented that “we are seeing some upward movement on wage growth as a result of the job market gain, which could feed through to higher inflation, and supply delays from Asia in particular look likely to persist for some time to come.”
The PMIs for the United Kingdom suggest a significant deceleration of the British economy in August. Although the manufacturing PMI was largely steady (falling from 60.4 in July to 60.1 in August), the services PMI fell sharply from 59.6 in July to 55.5 in August, a six-month low. The sub-indices for output were down for both manufacturing and services. Companies reported that labor shortages and supply chain constraints held back output and led to massive backlogs. On the other hand, sentiment was very positive and job growth was strong, especially in the services sector.
Meanwhile, Markit commented that, “despite COVID-19 containment measures easing to the lowest since the pandemic began, rising virus case numbers are deterring many forms of spending, notably by consumers, and have hit growth via worsening staff and supply shortages.”
Japan: Business conditions in Japan deteriorated in August, based on the latest PMIs. The manufacturing PMI for Japan fell marginally from 51.8 in July to 51.0 in August, a level indicating very modest growth in activity. The services PMI, however, fell from 47.4 in July to 43.5 in August, a level indicating a sharp decline in activity. For both sectors, there was a decline in new orders and a weakening of output. Markit attributed the overall weakness to “weaker demand due to ongoing COVID-19 restrictions, coupled with sustained supply chain pressures.” Business sentiment weakened, largely because of concerns about the potential impact of the delta variant. On the other hand, sentiment remained positive on balance because of a high and growing rate of vaccination.
In recent years, there has been a significant increase in income and wealth inequality in China,1 partly the result of the market economy creating vast wealth for a relatively small number of entrepreneurial people. Deng Xiaoping, China’s paramount leader in the 1980s and 1990s, is alleged to have said that “to get rich is glorious” (although it is said that a better translation is “let some people get rich first”), which was a dramatic reversal of traditional Communist orthodoxy. Deng’s statement was meant to encourage people to seek riches as part of the development of the market-based economy. However, lately the government has taken steps to limit the growing power of China’s affluent. It has especially sought to limit the power of technology companies and to curtail their growing footprint in global capital markets. It has also sought to limit the power of private educational companies that are seen as providing an unfair advantage to the children of the affluent. Evidently, the rise in inequality is increasingly seen as a problem.
Last week, authorities indicated that, going forward, promoting income equality will be a key policy. At a Communist Party leadership meeting, a statement was released vowing to “strengthen the regulation and adjustment of high income, protect legal income, reasonably adjust excessive income, and encourage high-income groups and enterprises to give back to society more.” Communist Party leadership said that it will seek a balance between “efficiency and fairness.” This sentiment was promoted at the highest levels of the Chinese government.
What this means in practice is still hard to say. It could mean further efforts to limit the power of private enterprise, especially in the technology sector. That, in turn, could have a negative impact on entrepreneurship and innovation. The result could be a slower economic growth in the future. Nonetheless, the new policy could entail more social spending aimed at levelling the playing field for those with lower levels of skill, education, and income. If so, it could have a positive effect on the consumer economy, which the authorities are keen to expand. In recent years, a disproportionate share of economic growth stemmed from investment and exports rather than consumer spending.2 The government has indicated a desire to reverse this trend.
A perfect storm of rising infections, new restrictions on mobility, supply chain bottlenecks, natural disasters (mainly flooding around Henan Province), and decelerating global demand for Chinese-made goods led to a deceleration in Chinese economic activity in July. New data on retail sales, industrial production, and fixed asset investment indicates healthy growth, but at a significantly slower pace than previously and slower than investors had anticipated. In response, Asian equity markets performed poorly. Moreover, China’s central bank last week unleashed the equivalent of US$92 billion in medium-term loans to financial institutions to offset an evident slowdown. The central bank expressed the hope that banks will use these funds to boost lending now that the required reserve ratio for commercial banks has been reduced. Let’s look at the data.
Retail sales in China were up 8.5% in July versus a year earlier, slower than the 12.1% growth clocked in June. This was the slowest growth in retail sales since December 2020. Retail sales fell on a month to month basis. The government acknowledged that restrictions imposed to fight the spread of the virus had undermined consumer mobility and spending. China’s zero-tolerance policy toward the virus has meant severe restrictions in many locations in response to even modest outbreaks. In addition, a shortage of semiconductors, which has slowed production of automobiles, likely contributed to the 1.8% decline in consumer purchases of automobiles.3
Meanwhile, Chinese industrial production increased 6.4% in July versus a year earlier, slower than the 8.3% growth clocked in June and the slowest pace of growth since August 2020. A combination of higher commodity prices, supply chain bottlenecks, the shutdown of some factories and port facilities due to the virus, and weakening overseas demand contributed to this deceleration. Some categories of production saw a decline in output. These included motor vehicles (down 15.8%), cement (down 6.6%), ferrous metals (down 2.6%), and textiles (down 1.0%). Even then, production of machinery and chemicals was up 6.6%, while production of general equipment was up 7.6%.
Fixed asset investment in China was up 10.3% in the first seven months of the year versus a year earlier, a slowdown from earlier months. This included a 12.7% increase in property investment, a deceleration from recent months. Public sector investment was up 7.1% while private sector investment was up 13.4%. Both numbers were lower than previously clocked. It has been suggested that the slowdown in investment is related to the recent tightening of credit market conditions as well as a regulatory crackdown on some Chinese industries.
Going forward, the most important factor driving China’s recovery is likely to be the virus. Indeed, a government spokesman said, “Given the combined impact of sporadic local outbreaks of COVID-19 and natural disasters on the economy of some regions, the economic recovery is still unstable and uneven.” The Delta variant is wreaking havoc around the world, including in China. While there is not reliable data as to the size of the outbreak in China, we do know that the government has taken significant steps to quell the outbreak in numerous locations around the country. These measures are affecting economic activity.
Although there has been a sharp increase in the number of people vaccinated in China, it is reported that the Chinese vaccines are less effective than those offered in North America or Europe. Thus, the ability to quell the outbreak through vaccination is in question. It seems likely that severe measures to suppress transmission of the virus will continue, especially given the government’s hope to host a successful Winter Olympics in early 2022. Meanwhile, it appears that the government is responding by easing monetary policy, but with an eye toward avoiding a further build-up of debt.4
As I recently wrote in the weekly update, high-frequency credit and debit card data lately suggested a decline in US consumer spending, although the level of spending remains above the prepandemic level. Last week, the US government released retail sales data for July that confirmed this trend. Retail sales declined (vs. June) more sharply than investors had anticipated. Market commentary indicates that investors view the decline as resulting from the recent surge of Delta variant infections and hospitalizations. Evidently Delta is having a negative impact on the US economy. But that is not the whole story. Sales at automotive dealers fell very sharply, likely due to the semiconductor shortage that has limited the availability of new cars and caused a sharp increase in the prices of both new and used cars.
Let’s take a look at the numbers. In July, retail sales in the United States were down 1.1% from the previous month, but up 15.8% from a year earlier. In addition, sales were 18.7% above the prepandemic level from February 2020. They were, however, down 3.0% from the peak reached in April 2021, which immediately followed the distribution of stimulus money. The fact that sales have fallen from April, while remaining far above the prepandemic level, should not cause alarm.
There was a 3.9% decline in retail sales at automotive dealers. In fact, excluding this, overall retail sales fell only 0.4%. Given that prices of both new and used cars were rising sharply, a decline in nominal sales suggests a very significant decline in the number of vehicles sold. We’ll know more about that soon when data on unit sales is released. The shortage of semiconductors appears to be the principal culprit in the automotive drama.
Also, sales at nonstore retailers (mainly online retailers) fell 3.1%, suggesting a shift back to store-based spending. Notably, sales at food and beverage retailers (restaurants and bars) were up 1.7%, indicating a modest continuation of the trend toward eating out. Indeed, sales at grocery stores were down 0.4%. At the same time, several categories of spending experienced a significant decline, likely reflecting negative effects from the outbreak of the Delta variant. For example, sales at clothing stores fell 2.6%, sales at home improvement retailers fell 1.2%, and sales at furniture stores fell 0.6%. It could be the case that these declines are partly due to shortages of key merchandise, itself the result of supply chain and transport disruption in East Asia.
In response to the news about retail sales, equity prices fell sharply while bond yields fell modestly. My view is that investors saw the report as the first clear indication that the Delta variant is having a negative impact on the economy—and they reacted accordingly. Going forward, the path of retail sales will likely depend on the path of the Delta variant. This cannot easily be predicted as it depends on vaccination rates and consumer willingness to engage in social distancing and mask wearing. Moreover, the US government is now suggesting that vaccinated people take a booster shot eight months after their initial shots. If many people are unwilling to do this it could exacerbate the outbreak.
Although retail sales disappointed in July, industrial production performed quite well. Output was up 0.9% from the previous month, the fastest monthly growth since March. In addition, output was up 6.6% from a year earlier. This means that, in July, industrial production was just 0.2% below the prepandemic level of February 2020. That is, output has roughly returned to where it had been.
The manufacturing component of industrial production was up 1.4% from the previous month and was up 7.4% from a year earlier. It was 1.2% above the prepandemic level. Notably, output of business equipment was up 2.8% from the previous month and was up 9.7% from a year earlier. This bodes well for business investment in equipment in the coming months.
The troubled automotive industry was interesting. In July, production of motor vehicles was up 19.3% from the previous month. However, output of motor vehicles was down 12.9% from a year earlier. It was 3.7% below the prepandemic level of February 2020. Thus, it is not surprising that spending on cars has been suppressed. Not only is domestic production down, imports have been negatively affected by limits to transport capacity and production weakness overseas.
Output of semiconductors in the United States was up 0.4% in July versus a year earlier and up 10.6% from a year earlier. In addition, the energy industry is ramping up in expectations of a continued increase in demand. Oil/gas well drilling was up 6.1% from the previous month and up 79.4% from a year earlier.
Overall, the report on industrial production indicates that, despite the Delta outbreak in July, the industrial part of the US economy performed well. However, further weakening of domestic demand in response to the outbreak could have a negative impact on industrial output.
Since the pandemic began, the Federal Reserve has engaged in massive monthly asset purchases meant to suppress bond yields and, therefore, keep credit markets functioning during the crisis. The Fed has previously signaled that this policy will be sustained until the Fed’s goal of stable inflation and maximum employment is met. Lately, given the sudden surge in inflation, the decline in unemployment, and the existence of a labor shortage, many Fed leaders have started to discuss the possibility of reducing or ending the asset purchase program. Last week, the Fed released the minutes of the last meeting of the Federal Open Market Committee (FOMC), the principal policymaking body of the Fed. The minutes indicate that most FOMC members now favor tapering asset purchases later this year, while some want to wait until next year. Here is the relevant text of the minutes.
“Most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s ‘substantial further progress’ criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum employment goal. Various participants commented that economic and financial conditions would likely warrant a reduction in coming months. Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee’s ‘substantial further progress’ standard or because of uncertainty about the degree of progress toward the price-stability goal.”
The FOMC members debated about the potential pace of tapering, about which assets should be the focus of an initial tapering (Treasury bonds or mortgage-backed securities), and about how to coordinate tapering with interest rate policy. In addition, the members discussed how investors would likely interpret its actions, especially in light of the Fed’s relatively new policy of targeting an average inflation rate of 2.0% rather than a maximum rate. Some members were concerned that initiating a tapering of asset purchases would send the wrong signal about the Fed’s inflation targeting. Meanwhile, there appears to be consensus that the current surge in inflation is transitory. Thus, any decision to taper asset purchases will be meant to suppress future inflationary impulses, not to address the current situation.
Finally, FOMC members discussed the potential impact of the Delta outbreak on the economic outlook and the Fed’s decision-making. Members noted that the outbreak could lead to economic weakness and the need to delay tapering. They also discussed the impact of supply chain disruption and labor market shortages. Here is the relevant text from the minutes.
“Rising COVID-19 cases associated with the spread of the Delta variant could cause delays in returning to work and school and so damp the economic recovery. Several participants also remained concerned about the medium-term outlook for inflation and the possibility of the reemergence of significant downward pressure on inflation, especially in light of the recent decline in longer-term inflation compensation. In addition, several participants emphasized that there was considerable uncertainty about the likely resolution of the labor market shortages and supply bottlenecks and about the influence of pandemic-related developments on longer-run labor market and inflation dynamics. Those participants stressed that the Committee should be patient in assessing progress toward its goals and in announcing changes to its plans on asset purchases.”
In response to the release of the Fed’s minutes, equity prices and bond yields fell. This suggests that the minutes were a surprise, which they should not have been. After all, Fed leaders have been signaling a shift in this direction for a while. In any event, I believe that investors interpreted the Fed’s statement as auguring a rise in bond yields in the coming year. A higher rate at which expected future profits are discounted implies lower equity values. Thus, the decline in equities makes sense. The decline in bond yields, however, suggests a downward revision of inflation expectations on the view that the Fed’s future tapering will reduce the likelihood of much higher inflation. In any event, growing concern about the Delta variant is also affecting markets, making it difficult to identify the impact of the Fed announcement.
The Gallup Organization conducted a poll in the United States in late July to determine public attitude toward the pandemic. The poll data revealed that 29% of respondents believe that the pandemic is already over. A majority of self-identifying Republicans (57%) say that the pandemic is over, while only 4% of Democrats believe the pandemic is over. This is consistent with other indicators pointing to political identification as the main point of division on attitudes toward the pandemic, the vaccine, social distancing, and mask wearing. In addition, the poll found that people who have been vaccinated are worried about the Delta variant while the unvaccinated say that they are not worried and, consequently, are not adjusting behavior. This is worrisome in that the unvaccinated are clearly far more at risk than the vaccinated. Moreover, if the unvaccinated are not worried, it could be difficult to convince them to get vaccinated.
Meanwhile, the number of daily infections in the United States is now at the highest level since early February and, unlike in Europe, shows no sign of slowing. The highest rates of infection are in Louisiana and Florida. In fact, Florida accounts for roughly 17% of daily infections, even though it accounts for about 6% of the US population. One in five US hospitalizations for COVID-19 are in Florida. In addition, the daily number of vaccinations in the country has risen lately, increasing to the highest level since early June, but still only about 25% of the level in mid-April. The United States now lags all major European countries in the share of the population that is fully vaccinated; it was the leader as recently as early June. Since early June, the share of the US population that is vaccinated increased very slowly, while that of Europe increased rapidly.
As the Delta variant has surged, an important question has been whether it will have a negative impact on the economy as happened during previous outbreaks. So far, there has not been a large impact. This may reflect the fact that most state and local governments have not imposed significant restrictions. In addition, more than half the adult population is fully vaccinated. Moreover, as the Gallup Poll showed, even many of the unvaccinated are not worried about the outbreak and, consequently, are not likely changing their behavior.
Nevertheless, there are now indications that the current outbreak is starting to have an economic impact, likely due to the fact that vaccinated people (who tend to be higher income) are increasingly worried and, therefore, might be adjusting their mobility and spending behavior. In fact, an index of consumer confidence issued by the University of Michigan has dropped to its lowest level since April 2020. This was likely due to fears of the Delta variant. In addition, an index of daily consumer spending, based on credit and debit card transactions, has been falling gradually since June, although it remains almost 10% above the prepandemic level. Spending has mainly fallen with respect to transport services and entertainment. If this continues, it could have a measurable impact on economic activity in August and beyond.
Inflation in the United States remains high compared to recent history. However, it appears to be abating—at least based on the July data. The Consumer Price Index increased 5.4% from a year earlier, the same as in the previous month and the biggest annual increase since 2008. However, prices were up 0.5% from June to July, far lower than the 0.9% increase in the previous month and the smallest monthly increase since February. When volatile food and energy prices are excluded, core prices were up 4.3% from a year earlier, lower than the 4.5% increase in the previous month. Core prices were up 0.3% from June to July, lower than the 0.9% increase in the previous month and the smallest increase since March. This data suggests that the worst may be over. Still, one month does not make a trend and it remains too early to say with certainty.
The categories that caused the surge in inflation in recent months mostly continued to experience strong price gains from a year earlier, but not necessarily from the previous month. In other words, some of these prices are starting to stabilize or even fall. That, in turn, bodes well for a reduction in inflation, especially given that recent inflation has been heavily concentrated in a relatively small number of merchandise and service categories. For example, the price of used cars was up 41.7% in July from a year earlier, but up only 0.2% from the previous month. The latter figure was dramatically lower than what transpired in the most recent two months. The price of car rental services was up 73.5% from a year earlier but was down 4.6% from the previous month. And airline fares were up 19.0% from a year earlier but were down 0.1% from the previous month. Moreover, airline fares remain, on average, significantly lower than prior to the pandemic. These examples suggest a stabilization in the prices of these categories—even though prices have not necessarily returned to prepandemic levels.
Some prices fell sharply in July. For example, the price of fruits and vegetables was down 0.9% from the previous month. The price of coffee was down 0.6%. The price of furniture was down 0.6% from the previous month, likely reflecting the decline in lumber prices. The price of footwear was down 0.8%, jewelry was down 0.7%, and the price of cosmetics was down 1.0%. This suggests either a lessening of demand and/or a lessening of supply chain disruption.
Going forward, the Federal Reserve will likely view this data as confirming its view that inflation is likely to be transitory. Consequently, my expectation is that the Fed will feel quite comfortable with its currently expected policy path. Evidently many investors agree. Last week, equity prices were up and bond yields were down following the inflation news.
In the United States, the principal policymaking body of the Federal Reserve system is the Federal Open Market Committee (FOMC). It consists of the seven governors of the Federal Reserve Board as well as a rotating group of five of the 12 regional Federal Reserve Bank presidents. Lately, several regional Fed presidents have started to speak publicly about the possibility of scaling back monetary stimulus. Mary Daly, President of the Federal Reserve Bank of San Francisco, said, “I remain very optimistic and positive about the [autumn] and ongoing improvements in the key variables we care about. That for me means it’s appropriate to start discussing dialing back the level of accommodation that we’re giving the economy on a regular basis, and the starting point for that is of course asset purchases.” Daly’s comment is notable given that she is seen as one of the Fed’s more dovish leaders. In addition, she currently serves on the FOMC.
Daly is not alone. In addition, Esther George, President of the Kansas City Fed, said, “While recognizing that special factors account for much of the current spike in inflation, the expectation of continued strong demand, a recovering labor market, and firm inflation expectations are consistent, in my view, with the committee’s guidance regarding substantial further progress toward its objectives. I support bringing asset purchases to an end under these conditions.” George will join the FOMC in 2022.
Other similar comments have recently been made by the presidents of the Fed banks in Dallas, Atlanta, St. Louis, Richmond, and Boston. Meanwhile, Federal Reserve Board Chairman Powell has not yet indicated a similar point of view, and his point of view matters a great deal. Still, if enough regional Fed bank presidents express a strong view in support of a new direction, it will likely have an impact. The growing view that tapering is just around the corner evidently reflects confidence in the strength of the recovery and the potential for a return to full employment and a true surge in inflation—even if the current surge is considered to be transitory and related to one-off events. That being said, if the current outbreak of the virus worsens and has negative economic consequences, it could delay a shift in Fed policy. In fact, this is a scenario to which Powell has alluded.
When the Federal Reserve ultimately starts to taper bond purchases, as several Fed leaders have suggested, the effect will likely be an increase in bond yields. However, with government stimulus expenditures waning, the US Treasury intends to issue a smaller volume of bonds in the coming months than in recent months. This decline in government borrowing is expected to help offset the impact on yields if the Fed chooses to taper asset purchases. In addition, if consumer price inflation abates in the coming months, as now seems likely, there would likely be downward pressure on yields as well. In fact, the 10-year breakeven rate, which is a good measure of investor expectations of inflation, has remained relatively steady since mid-May. The five-year rate has actually fallen, suggesting that investors think the current surge in inflation will not last very long. Thus, it seems likely that bond yields will remain suppressed for the foreseeable future. If so, this will mean continued low borrowing costs for businesses and home buyers.
One of the factors that have contributed to an acceleration in inflation in major economies in recent months has been a sharp increase in the cost of transporting containers. The cost of shipping a container from East Asia to the West Coast of the United States has increased by more than 50% since April. The cost of shipping a container from East Asia to Europe has increased by roughly 75% over the same period. The Baltic Dry Index (BDI), which is the most popular measure of the cost of shipping nonliquid bulk commodities, such as coal, wheat, and iron ore, has hit the highest level since June 2010, although it remains far below the peak reached prior to the 2008-09 global financial crisis. The increase began early this year as the global economy appeared to be on a path toward recovery.
The increase in recent days likely reflects the impact of the closure of one of China’s largest port facilities, a terminal at Ningbo-Zhoushan. This closure was in response to the rising Delta outbreak. As companies have attempted to shift transport logistics, that closure has led to congestion and delays at other ports, such as that of Shanghai, one of the world’s busiest. The closure has affected both exports and imports. Moreover, September is generally the peak month for Chinese exports. That is when goods are shipped for the holiday season in the United States, Europe, and elsewhere. If the port remains closed, this will exacerbate the existing problem. Even if the port reopens soon, it will likely take several weeks to work through the accumulated congestion. Thus, the BDI is likely to remain elevated for the foreseeable future. Meanwhile, shares in shipping companies have increased sharply.
There are several explanations for the stunning increase in shipping costs. First, the recent outbreak of the virus in several southern Chinese markets as well as in Southeast Asia has disrupted not only factories but also port facilities. Second, fear of shortages has led some customers of shipping companies to oversupply products to avoid future disruption. Such hoarding has become a common characteristic of the recovery from the pandemic. With many companies doing this, the net effect is to create shortages and boost shipping costs. Third, as the pandemic appeared to abate a few months ago, global demand accelerated, creating increased stress for the shipping industry.
At the same time, the current outbreak could ultimately put downward pressure on shipping costs. That is, the outbreak could ease the growth of demand in major markets if it has a negative impact on employment. In addition, the outbreak is already wreaking havoc with factories in parts of Asia. This could reduce the availability of products for shipping. The end result could be upward pressure on the prices of goods in short supply, but downward pressure on the cost of shipping. It is too early to say with certainty what will happen.
After having declined in the first quarter, largely due to the impact of the virus, the British economy came roaring back in the second quarter as economic restrictions were lifted. Real GDP increased 4.8% from the first to the second quarter, or at an annualized rate of 20.6%. Despite such rapid growth, real GDP remained 4.4% below the prepandemic level. The strong increase in the second quarter was largely driven by consumer spending which increased 7.3% from the first to the second quarter, or at an annualized rate of 32.6%. This was driven by purchases of restaurant meals, hotel stays, transport services, and automobiles. On the other hand, fixed asset investment declined 0.5% from the first to the second quarter after having fallen in the previous quarter as well. This was mainly due to a decline in government investment while business investment grew at a healthy pace. Still, business investment remains 15.3% below the prepandemic level.
In addition to measuring the expenditure components of GDP such as consumer spending and business investment, the British government measures the supply side as well. It found that the three major components (services, production, and construction) all increased in the second quarter. The biggest contributors to the rebound were wholesale and retail trade, accommodation (hotels), food service (restaurants), and education. Output by the accommodation and food service industries nearly doubled from the first to the second quarter due to reopening. In addition, the education sector increased at a blistering pace as schools reopened.
Nonetheless, there was a sharp decline in output by the financial sector in the second quarter. Also, although output in the manufacturing sector increased at a decent pace, there was a very sharp reduction in output by the automotive sector. The government attributed this to the global shortage of semiconductors. As a result, output of motor vehicles is 24.6% below the prepandemic level of 2019 Q4. Interestingly, purchases of cars increased sharply and is now higher than the prepandemic level. This was facilitated by a surge in imported vehicles as well as a shift toward used vehicles, the prices of which increased sharply.
Of the G7 countries, Britain had the fastest second-quarter growth of GDP. This was needed, given that Britain’s real GDP had fallen very sharply in the second quarter of 2020 and then again in the first quarter of 2021. There is much catching up to do. Meanwhile, given the outbreak of the Delta variant during the summer, there is reason to expect that growth will have slowed in the third quarter.
In 2007, just prior to the start of the global financial crisis, household debt in the United States was roughly 130% of disposable income, having grown rapidly on the back of a surging housing market. At the same time, household debt in China was only about 40% of disposable income. Today, however, things are somewhat reversed. In China, household debt is now estimated to be about 130% of disposable income while, in the United States, the figure has dropped to about 100%. Moreover, as in the United States two decades ago, the surge in Chinese household debt is mostly related to the housing market. In addition, nonfinancial corporate debt in China has also increased dramatically in the past decade. In fact, from 2014 to 2019, overall nongovernmental debt in China increased by roughly US$10 trillion, of which about 45% was household debt. The increase in household debt was comparable to what happened in the United States between 2003 and 2008.
Historically, excessive debt is a precursor to financial instability. In addition, too much debt and debt servicing costs can have a negative impact on economic growth. This situation is new for China, a country in which households have historically saved a great deal and avoided debt. Although we know that the increase in debt creates risk, we don’t know at what point that risk becomes serious. In other words, we don’t know if we’ve reached the tipping point. For the government, which is evidently concerned about excessive debt, there is a careful balancing act that must be undertaken. On the one hand, it can restrict credit growth in order to avoid further accumulation of debt. On the other hand, it likely wants to avoid a sharp decline in property prices, which would undermine household financial stability. Moreover, the government likely recognizes that a sharp curtailment of debt accumulation will have a negative impact on economic growth and, therefore, employment. As has been true for many countries in the past, a situation of high debt leaves few good options for policymakers.
As the global economy recovers from the pandemic-induced recession, a combination of surging demand and disrupted supply chains has led to a sharp rise in inflation in many countries. This, in turn, has fueled fears among many business leaders that a new era of much higher inflation is imminent. However, financial indicators suggest that the investment community remains unworried about inflation, at least in the world’s major developed economies. Rather, it sees the current surge as transitory and likely to be quickly reversed, a view held by many central bankers.
This brief article attempts to answer several questions, among which are:
We will examine data mostly from the United States. There are many reasons for this—among major industrial countries, the United States has lately seen the biggest surge in inflation after experiencing the biggest government stimulus; greater availability of detailed data; and the huge footprint that the country has in the global economy. What happens in the United States will influence global currency values, capital flows, trade flows, and economic growth. What the US central bank does will influence other central banks.
Inflation is a general increase in prices that results in a decline in the purchasing power of money. It is not simply a rise in some prices, which merely results in a change in the relative prices of different goods and services. Serious inflation is when most prices are rising rapidly at the same time, as happened in many developed economies in the 1970s. Governments measure inflation by looking at prices in a broad basket of goods and services that consumers purchase on a regular basis. The basket is weighted according to how people spend their money.
There are several factors that can drive inflation. The great Nobel Prize-winning economist Milton Friedman wrote,5 “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” However, if the quantity of money rises and people don’t spend it, then it might not be inflationary.
Another factor, which is the source of the current debate, is fiscal policy. If governments borrow and spend money that is otherwise being saved, it can cause the economy to overheat if the spending exceeds the difference between actual and potential output. Inflation can also be increased by a depreciating currency, which boosts import prices, and by rising commodity prices, as happened in the 1970s when the price of oil skyrocketed.
Finally, inflation is susceptible to psychology. That is, if people expect high inflation, they will behave in ways that reinforce high inflation—and vice versa. For example, if workers expect high inflation, they will be more likely to demand big wage increases. If businesses expect high inflation, they will be more likely to pass cost increases on to their customers in the form of high prices. And if consumers expect high inflation, they will be more amenable to paying higher prices. Thus, from the perspective of central banks, it is critically important to act and communicate in ways that properly anchor expectations of inflation.
If wages rise in line with inflation, then purchasing power remains unchanged. Therefore, why do we even care about inflation? While the answer to this question could fill several books, here is a brief explanation of why inflation is considered a problem.
First, when inflation is endemic, it creates uncertainty for investors. They, in turn, require a risk premium to part with their money. Some countries with histories of high inflation have unusually high borrowing costs that, in turn, suppress business investment. This hurts economic growth.
Second, inflation makes it more difficult for consumers to discern price differences, thereby reducing their price sensitivity. That, in turn, reduces the need for businesses to be efficient or to invest in improvements in productivity. It is no accident that the inflationary 1970s were a period of low productivity growth.
That being said, a little bit of inflation is seen as greasing the wheels of commerce. Deflation (falling prices) is considered damaging. It results in high inflation-adjusted borrowing costs. In addition, because wages tend to be sticky, deflation results in rising inflation-adjusted wages that can suppress job growth and business profitability.
In the United States, Europe, and many other countries, both developed and emerging, there has lately been a sharp increase in inflation. Moreover, some pundits are concerned that recent policy initiatives are setting the stage for a return to sustained high inflation. Others see today’s high inflation as transitory and likely to soon be reversed.
Proponents of the high-inflation argument largely point to the impact of fiscal policy, especially in the United States. There, former US Treasury Secretary Lawrence Summers has argued that recent government stimulus expenditures were far more than was needed to return the United States to full employment. The result, according to Summers, is likely to be an overheated economy with rising inflation. In addition, previous rounds of stimulus money were largely saved. This sets the stage for a sudden burst of future spending as consumers respond to pent-up demand. If businesses cannot quickly meet that demand, prices will rise.
The counterargument is that much of the recent stimulus money was, indeed, saved. Thus, demand is not rising enough to overheat the economy. Moreover, some of the money that is being spent is draining out of the United States in the form of imports. Finally, the savings accumulated over the course of the pandemic, in both the United States and Europe, will not necessarily be quickly spent even after the pandemic ends. After all, how many laptops, televisions, fitness machines, or restaurant meals can one purchase?
Another argument in favor of ruinous inflation is that the money supply in major countries has accelerated sharply. In the United States, money supply growth has taken place at a historic pace during the pandemic. However, much of that money has been saved. This means that the velocity of money, which is the number of times a dollar changes hands in a period of time, has fallen sharply during the pandemic. Consequently, the surge in money supply has not been inflationary, at least not yet. The same has been true in Europe.
Also, those worried about inflation note the recent disruption of global supply chains, suggesting it is due, in part, to excess demand driven by government stimulus. They fear that global businesses will not be able to boost production and transport capacity sufficiently to meet sustained higher demand—at least not within a suitable time frame. Others, however, expect that the current disruption will quickly be resolved, especially as demand is likely to lessen as the impact of stimulus abates. Plus, there are already substantial efforts under way to increase global transport capacity as well as capacity to produce goods in short supply, such as semiconductors. Moreover, prices of some commodities, such as lumber, have already fallen sharply.
Finally, inflation hawks fear that, in many countries, labor shortages are likely to persist, thereby causing upward pressure on wages. That, in turn, could create a wage-price spiral that would cause sustained high inflation. This is especially worrisome in the United States where the number of unfilled jobs is now at a record high level. The shortage of labor reflects many factors, such as fear of the virus, the need to care for children who are not in school full time, and a skills mismatch between the existing labor force and the jobs on offer. Normally, a labor shortage would lead to a surge in wages. Yet, although US wages have accelerated, they have actually fallen after accounting for inflation. Only in consumer-facing industries, such as restaurants and hotels, have there been a substantial inflation-adjusted increase in compensation. Thus, the labor shortage is not creating inflationary pressures—at least not yet.
Inflation has risen sharply around the world, but especially in the United States where consumer prices were up 5.4% in June from a year earlier. It was the biggest increase since August 2008 and a considerable gain since the 5.0% increase in May. Prices were up 0.9% from May to June, the biggest increase since June 2008. When volatile food and energy prices are excluded, core prices were up 4.5% from a year earlier, the biggest increase since November 1991, and core prices were up 0.9% from the previous month.
The gap between the headline number and the core inflation rate reflected a big increase in energy prices, which were up 24.5% from a year earlier and up 1.5% from the previous month. The category with the biggest price increase continued to be used cars, with prices up 45.2% from a year earlier and up a staggering 10.5% from the previous month. Thus, although used cars only account for 3.2% of the consumer price index, used car prices accounted for a third of the monthly increase in the index. Moreover, the surge in used car prices is not related to growth in the money supply. Rather, it reflects unique conditions in the market for used cars that are driven by the semiconductor shortage and strong demand by rental car companies. As US Federal Reserve Chair Powell recently stated, “Used car prices are going up because of sort of a perfect storm of very strong demand and limited supply. It’s going up at just an amazing annual rate. But we do think that it makes sense that would stop, and that in fact it would reverse over time.”
Notably, the price of renting a car was up 87.7% from a year earlier and up 5.2% from the previous month. This reflects a shortage of rental cars after companies sold a substantial share of their fleets at the height of the pandemic. Another category that saw a big price increase was airline fares, up 24.6% from a year earlier and up 2.7% from the previous month. This reflects a sudden surge in demand that the airlines have been slow to accommodate, in part because of regulatory requirements. It is worth noting, however, that the index of airline fares remains below the prepandemic level. Thus, although fares are up sharply, they have not yet made up for the decline during the pandemic. The cost of staying at a hotel was up 17% from a year earlier and up 7.9% from the previous month. A surge in demand fueled by the perception that the pandemic is ending is the likely cause.
At the same time, there were significant decreases in the prices of many merchandise and service categories, including electricity, some types of furnishings, nonelectric cookware, household cleaning products, men’s apparel, girl’s apparel, jewelry, medicine, audio equipment, pet supplies, sports equipment, books and magazines, toys, computer software, tobacco products, domestic services, health insurance, sporting events, and internet services. In other words, very large increases in a small number of categories were partially offset by moderate decreases in the prices of many other categories. This pattern is not indicative of a general inflationary trend.
In fact, the degree to which inflation has been concentrated in a small number of categories can be measured. The Federal Reserve Bank of Cleveland has developed a novel approach to determining underlying inflation. The usual method is to subtract the impact of volatile food and energy prices, rendering so-called core inflation. Yet the Cleveland Fed takes a different approach. They exclude the outliers. As they state on their website, their measure “is a weighted average of one-month inflation rates of components whose expenditure weights fall below the 92nd percentile and above the 8th percentile of price changes.” This measure, knowns as the “16% trimmed mean,” indicates a relatively modest level of underlying inflation.
Here are the numbers: The government’s headline annual rate of inflation for June was 5.4%, up from 5.0% in May. Their “core” rate of inflation in June was 4.5%, up from 3.8% in May. However, the Cleveland Fed’s measure was 2.9% in June, up from 2.6% in May. This suggests that, when a small number of categories are excluded, underlying inflation only increased modestly and remained at a level that should not generate heartburn.
Recall that the outliers included the prices of used cars, the cost of renting a car, the prices of major appliances, the prices of airline tickets, and the price of hotel stays. Each of these categories saw a big surge in prices that was not reflective of stimulus spending or wage pressures. Rather, they reflected changed behavior on the part of consumers and businesses related to the pandemic abating. They also reflected supply chain constraints that will likely be resolved in the next few months. As such, it seems premature to worry about ruinous inflation.
Although much has been written and spoken about the dangers of persistent inflation, and although many business leaders are trying to understand what an inflationary environment might mean to them, fear of inflation has simply not been reflected in the bond market. Rather, bond investors in the United States and Europe appear to accept the argument of central bankers that the current inflation is transitory.
A bond yield effectively consists of two components—expected inflation and the real (inflation-adjusted) yield, which reflects supply and demand conditions in the bond market. These components are measurable. Some governments issue bonds in which the principal value moves in line with inflation. In the United States, this is the Treasury Inflation Protected Security (TIPS). The yield on TIPS is, effectively, the real yield. Therefore, the difference between the yield on the Treasury bond and the TIPS bond is the expected rate of inflation. It is also known as the “breakeven” rate.
In the United States and Europe, breakeven rates have risen this year as economies have recovered and investors expected that rising demand would lead to accelerating inflation. However, breakeven rates remain relatively muted, especially compared to current inflation. In the United States, for example, the 10-year breakeven rate, at roughly 2.5% in early August, was far below the most recently reported inflation rate of 5.4%. Moreover, after having risen for much of this year, the US breakeven rate fell during most of the summer of 2021, indicating that bond investors were downwardly revising their expectations of future inflation. Why? This was likely due to an increasing realization that the impact of stimulus will soon abate, supply chain disruptions are likely to be resolved, the recent outbreak of the virus might cause the economy to slow, and because the Federal Reserve hinted that it might tighten policy sooner rather than later.
In addition, it is notable that the five-year breakeven rate has lately exceeded the 10-year rate. This is unusual. It likely means that investors expect a short burst of inflation followed by a decline in the rate of inflation over time. In other words, investors accept the argument made by the Federal Reserve that inflation is transitory and will decelerate in the next year or two.
For businesses worried about what will happen with inflation, there are serious reasons to expect that the current inflation will abate within the next year to year and a half. If so, and if central banks do not dramatically shift policy within that time frame, then businesses can plan to simply manage a temporary shock while awaiting a return to normalcy. For many companies, this has already entailed a sharp rise in commodity and input prices, some upward pressure on wages, and the choice of whether to pass cost increases on to customers. However, the decision map in this situation is different than dealing with persistent high inflation. The principal difference involves wage negotiations.
In an inflationary environment, such as what transpired in the 1970s, workers expect wages to rise sharply each year and often insist that this be included in contracts. Likewise, suppliers expect persistent inflation and prefer it be a regular feature of negotiations. At the same time, inflation often entails complacent consumers, ready to accept price increases. That, in turn, can allow companies to easily boost profit margins by raising prices and not be compelled to invest in greater efficiency.
Last week the US government released data on personal income and expenditures in June. The principal inference that can be drawn from the data is that the consumer economy appears to be returning to normal. Real (inflation-adjusted) income and spending are both above prepandemic levels. In June, even as government stimulus payments to households fell sharply, nominal income grew as more people worked and earned wages. However, relatively high inflation ate into wages and led to a decline in real disposable income. Still, real household spending increased strongly as consumers saved less to spend more. The personal savings rate fell to the lowest level since the pandemic began, although it remained relatively high.
Here are the details: In June, wage and salary income grew 0.8% from the previous month while government transfers to households declined 2.0%. The net result was that nominal income grew a modest 0.1%. After accounting for inflation and taxes, real disposable personal income was down 0.5% from May to June. However, it was 3.3% above the prepandemic level of February 2020. Moreover, as the impact of waning stimulus recedes, and as wage income continues to expand, real disposable income should grow at a healthy pace in the months to come.
Meanwhile, the personal savings rate fell from 10.3% of disposable income in May to 9.4% in June, the lowest level since the pandemic began. This decline in savings facilitated an increase in household expenditures. Real spending increased 0.5% from May to June and was 2.7% above the prepandemic level. Real spending on durable goods declined 2.5%. However, real spending on nondurables increased 1.2% while real spending on services increased 0.8%. Evidently, consumers shifted the focus of spending toward categories consistent with greater social interaction. As economic restrictions were eased, and as consumers felt more comfortable engaging in interaction due to vaccination and low infection rates, they spent more on apparel, restaurant meals, and travel to name a few.
Going forward, the big question is whether the current surge in infections will have a negative impact on spending in July, August, and beyond. So far, high frequency credit and debit card data does not yet indicate a shift in spending. Even though infections have increased sharply and hospitalizations have increased somewhat, state governments have mostly not imposed new mobility restrictions, although some have returned to mask mandates. Moreover, more than half the adult population is vaccinated. Such people are not getting infected in large numbers and evidently feel comfortable leading their lives. Thus, it is possible that, absent a dramatic surge in infections, the impact on consumer spending will be mild at most. Meanwhile, employment is growing, wages are rising, both contributing to greater spending capacity. On the other hand, the recent surge in inflation has damaged consumer confidence.
Along with data on income and spending, the government released the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator, or PCE-deflator. This, rather than the consumer price index (CPI), is the inflation measure the Fed follows as it deliberates on policy. The PCE-deflator was up 4.0% in June versus a year earlier and up 0.5% from the previous month. When volatile food and energy prices are excluded, core prices were up 3.5% from a year earlier and up 0.4% from the previous month. The monthly increase in both headline and core prices have decelerated in the past few months, suggesting that the recent surge in inflation is starting to abate. From the perspective of the Federal Reserve, this justifies its intention to retain a relatively easy monetary policy.
Meanwhile, the Fed last week announced that it has chosen to leave interest rates and the asset purchase program unchanged for now. However, the Fed hinted that it might be getting closer to the day when it will choose to scale back, or taper, the asset purchasing program. Specifically, its statement indicated that, “with progress on vaccinations and strong policy support, indicators of economic activity and employment have continued to strengthen. The sectors most adversely affected by the pandemic have shown improvement but have not fully recovered. Inflation has risen, largely reflecting transitory factors. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to US households and businesses.” Consequently, the Fed said that “the economy has made progress” toward the Fed’s goals regarding inflation and unemployment and that it will “continue to assess progress in coming meetings.” This means that, if all goes well, the Fed might decide to taper asset purchases sooner than previously expected.
That said, the Fed noted that downside risks to the economy remain. Specifically, it said that “the path of the economy continues to depend on the course of the virus. Progress on vaccinations will likely continue to reduce the effects of the public health crisis on the economy, but risks to the economic outlook remain.” It said that, among the various types of data it will examine as it deliberates on policy, will be public health information. Thus, the virus remains front and center.
For the Fed, this is a difficult time. After all, the current surge in COVID-19 infections, both in the United States and around the world, could have countervailing effects on the inflation outlook. On the one hand, a sharp surge in infections in the coming months could theoretically have a negative impact on US economic activity, especially the recovery of the services sector. This, in turn, would likely reduce some of the inflationary pressure we are now seeing. On the other hand, a surge in infections in Asia could have a disruptive effect on global supply chains, especially if it leads to reduction in capacity at Asian factories and ports. That, in turn, could exacerbate the problem of shortages of key components and goods, thereby causing further inflationary pressure in the United States and elsewhere.
Thus, it can be argued that the outbreak might lead to a kind of stagflation. That is, it could cause economic stagnation along with higher inflation. For the Fed, that would be the worst of all possible worlds and would make it that much more difficult to choose the optimal policy. Moreover, the issues of supply chain disruption and potential weakening of US demand are not just US issues. They are global. As such, it is not surprising that global bond yields have fallen lately as investors reassess their expectations for growth in the world’s major markets. In any event, the downward movement of US bond yields suggests that investors are not expecting an imminent shift in Fed policy, and that they are increasingly worried more about growth than about inflation.
With respect to the impact of the virus on global supply chains, a few things have happened that are worth noting:
A bipartisan group of US Senators has agreed on an infrastructure bill that will authorize about US$1.2 trillion in spending over eight years on hard infrastructure such as transportation. Some of that money has already been authorized, so the amount of new spending is less. The Senate voted 67-32 to begin the process for moving the bill.
The Biden Administration was keen to get a bipartisan bill, in large part because of pressure from moderate Democrats such as Joe Manchin of West Virginia and Kyrsten Sinema of Arizona who helped negotiate the bill along with moderate Republicans. Biden’s team likely hopes that, once the infrastructure bill is passed in a bipartisan manner, Manchin and other moderate Democrats will be amenable to voting for a larger US$3.5 trillion bill that many Democrats hope to pass through the reconciliation process, requiring the support of only 50 Senators. That bill will be focused on other spending priorities including healthcare, childcare, education, and climate. It would likely be partially financed by higher taxes on corporations and high-income households, as well as a potential carbon tax on imports. Through negotiations, that bill may wind up somewhat below US$3.5 trillion. However, it will still be a major spending initiative. Passage will require unanimity among Democrats in the Senate.
If both bills pass, there are three potential impacts: the impact on the budget deficit, which could influence bond yields and inflation; the impact on taxes, which could influence investment and growth; and the impact on labor force participation, which could influence employment and growth.
First, consider the deficit. These bills will spend a lot of money, but over an extended period. Moreover, the increased spending will be partly offset by higher taxes. Thus, the overall impact of increased annual borrowing will be modest compared to the size of the economy. Therefore, a major impact on bond yields or inflation is not expected, especially if some of the measures lead to increased labor force participation.
Second, taxes. All other things being equal, increased taxes have a negative impact on economic activity. But not all things are equal, and the increased spending will offset the negative impact of higher taxes. A bigger question is whether a higher corporate tax rate will adversely affect corporate investment. We do know that, when the corporate rate was reduced in 2018, there was no significant boost to investment. Instead, the added cashflow of corporations was heavily spent on share repurchases, which boosted equity prices. It is possible that raising the corporate rate will not cut investment. Rather, it might have a negative impact on equity prices.
Finally, and perhaps most importantly, the increased spending is meant to have a positive impact on productivity and labor force participation. Historically, infrastructure spending has accelerated productivity growth by improving the efficiency of the economy. Thus, the infrastructure bill could, theoretically, cause economic growth to accelerate, thereby helping to pay for itself. The other larger spending bill includes subsidies for childcare, meant to enable parents of small children to participate in the labor force. The experience of other countries suggests that such subsidies do, in fact, have a positive impact on labor force participation, especially among women. If so, this will mean that the bill will partly pay for itself. The spending on education is meant to improve the quality of the labor force, potentially boosting productivity. Naturally, the devil is in the details, and success of these programs depends on design and execution.
The US government has lately increased the number of Chinese companies to which US companies cannot sell—mostly involving technology products. The goal is to punish China for alleged human rights violations as well to prevent China from making technological leaps that might be detrimental to US economic and national security. At the same time, China is now reducing the number of technology products that cannot be imported from 126 to 24. That is because China is keen to enable domestic companies to acquire the resources needed to become more self-sufficient. In fact, China’s government just urged domestic companies to increase overseas investments in such technologies as artificial intelligence and 5G. The government said that Chinese companies should “seize overseas market opportunities in digital infrastructure.” It said that it wants to encourage “technological self-reliance” and that it is good for Chinese companies to participate in “reshaping the global industrial chain, and to consolidate the country’s development advantage.”
Given the US government’s concerns over technology symbiosis with China, it is more likely that Chinese overseas investments will take place in other countries such as in Europe, East Asia, or India. For US-based companies that are eager to take advantage of the vast Chinese market, this geopolitical situation creates a conundrum. On the one hand, they must abide by US sanctions. On the other hand, China now has rules that punish companies that abide by US sanctions. Moreover, if US companies start to reduce their dependence on Chinese supply chains, they risk offending China’s government and thereby hurting their position in the vast Chinese market. For Chinese companies that want to be globally competitive and world class, restrictions on interaction with US companies are problematic. Thus, the likely search for alternative sources of intellectual capital. Companies not based in the United States or China are caught in the middle, and must navigate a challenging path, not wanting to offend either side.