Dismal inflation and real earnings numbers

Bureau of Labor Statistics (BLS) data on consumer price inflation and real earnings printed some dismal numbers today. CPI was up 5.6% year-on-year, a 17 year high. The month-over-month change came in at 0.8% versus expectations of 0.4%, and the core rate came in higher than expected at 0.3% versus 0.2%. A core rate around 3.6% is not something to cheer about, especially given its continued upward trajectory.

Real average weekly earnings provided further evidence for our ongoing stagflation thesis. While average hourly earnings rose 0.3% month-over-month, average hours worked fell by the same amount. Thus, the entire CPI reading ate into real hourly earnings–that’s not good for wage earners, nor is it good for future economic performance.

There is widespread hope that  the recent pullback in commodity prices will pull down the hot headline inflation rate. That should prove true in the short term, but feed through effects are still in the pipeline. We also think that commodity prices are going to stay stubbornly high despite their recent pullback. Why? Because policymakers in the U.S. have fallen into the same flawed thinking that got them into trouble in the 1960s and 70s, i.e., that monetary policy and tax/fiscal/trade/regulatory policies are interchangeable. In other words, if tax or regulatory burdens increase (thereby lowering the expected rate of growth in the economy), monetary policy can be used to pick up the slack without causing inflation. If the U.S. were a closed economy, that would be true. But there’s a global economy out there that is financed heavily by U.S. dollars, and that is still growing at a relatively healthy clip. That means that the Fed’s target rate is still too low.

Of course, we’re not blind to the pain that a ‘neutral’ (non-inflationary) fed funds rate would cause. Domestic money supply and credit would contract further, and domestic unemployment would increase at a faster rate. The only way to dampen the negative domestic effects of a sounder monetary policy is with well designed, pro-growth policies at the federal, state, and local levels. Policymakers learned this lesson in the late 1970s and early 1980s, and it was embraced by JFK in the early 1960s. Apparently it needs to be learned again.

However, government policies currently appear to be headed in the opposite direction. Taxes in the U.S. are almost certain to rise in 2009 and beyond. We may see a cut in the corporate tax rate, which is good, but at 25-30% it would merely help us catch up to the rest of the world (ex-Japan). And it will be neutral at best if the overall tax burden increases as much as expected and if trade and regulatory barriers are raised. Government spending is likely to rise too in the coming years in the name of "stimulus".

Higher taxes and massive public spending are key characteristics of Japan’s economic stagnation since 1989. In fact, things got so bad that the Bank of Japan ran into a "zero bound" problem–it could not lower its interest rate target below zero, even though trend growth was negative (there are ways around this, such as the "quantitative easing" measures the BoJ took a few years back, but those are highly unusual and somewhat risky measures for central bankers to take). A key difference between Japan and the U.S. is that the USD is the primary global reserve currency, which is not true for the Yen. Thus, even if the Fed is neutral or hawkish for the U.S. economy at a 2% fed funds rate target, we don’t expect a long deflationary recession (or depression) like the one Japan experienced. The price of many U.S. goods, services, and assets that are not highly tradeable will fall–for example, today’s real earnings report shows that the price of hourly labor is falling, and home prices have been falling for some time. But global inflation is going to persist until the Fed becomes more hawkish, even with Jean-Claude Trichet’s ECB doing what it can to push down on global inflationary pressures at the expense of the European economy. 

The bottom line? We expect continuing stagnation and stubborn inflation; stagnation + inflation = stagflation. Again, at this point we don’t expect it to be as bad as in the 1970s, but it ’s still going to feel pretty crummy. Today’s numbers help drive that point home.