August 25, 2023
When I read Jerome Powell’s Jackson Hole speech this morning, I was more than a bit scared. The tone was very hawkish as he reiterated the Fed’s commitment to get inflation down to its 2.0 percent target. He also said that if the inflation rate is above the target, it would be necessary to have growth somewhat below potential (meaning unemployment rises) for a period of time in order to get inflation back down to its target.
Both parts of this story worried me. In the good old days, before the pandemic, Jerome Powell repeatedly said that the 2.0 percent target was an average, not a ceiling. A ceiling is clear enough. That means that inflation above 2.0 percent is above the target. But an average means that we will have periods that are both above and below 2.0 percent.
Inflation was below the Fed’s 2.0 percent target for most of the decade before the pandemic. No one at the Fed seemed to view that as a crisis. The desire was to raise the inflation rate, but there was no panic that the Fed was undershooting its target.
Inflation is now clearly moving down towards its target. There will be some month-to-month turbulence, but we know that rental inflation, a huge component of the core Personal Consumption Deflator (the Fed’s key index) is definitely heading lower and quite likely falling to rates below the pre-pandemic pace.
Inflation in goods continues to slow as supply chains return to normal. The big question mark is non-housing services. This is largely labor costs, but there is also a substantial goods component. Items like auto insurance and auto repair depend to a substantial extent on the prices of cars and parts. Restaurant prices depend on food prices. Anyhow, as the price of goods stabilizes or declines, it will slow service sector inflation.
The story on wages is ambiguous. Some measures, the Employment Cost Index and Hourly Compensation series in the Bureau of Labor Statistics Productivity and Cost data, show rates of compensation growth that are close to the pre-pandemic pace. This is also true of Indeed’s new hire’s wage index. However, the Average Hourly Earnings (AHE) series has shown an uptick in recent months to a pace that is more than a percentage point above the pre-pandemic pace.
We will get new data on the AHE series next Friday, both an August reading and possible revisions to the prior two months’ data. But in any case, there is enough ambiguity on the course of inflation that it seems that Powell should not be able to rule out the mission accomplished story, that we will soon have an inflation rate consistent with the Fed’s 2.0 percent target.
The second part of Powell’s story, that we need to have a growth rate below the economy’s potential, is also cause for concern. The reality is that we don’t have that good an idea of what the economy’s potential is at this point.
In July of 2022, the unemployment rate was at 3.5 percent, which most consider close to full employment. Yet we were able to add more than 3.3 million jobs over the last year because the labor force increased by more than 3.1 million people. Can we see a comparable increase in the labor force next year? I wouldn’t bet on it, but I wouldn’t have bet on it last summer either.
There is a similar story on the productivity side. Since the start of the pandemic productivity growth has averaged 1.3 percent, pretty much in line with the pre-pandemic pace. However, it is plausible it could pick up. After all, we have ostensibly knowledgeable people telling us that AI will make work obsolete.
We don’t have to take their wildest claims at face value to think that AI will provide a substantial boost to productivity growth. How much and how quickly is very much up in the air, but it would be reckless for the Fed to pursue a policy that effectively assumes no productivity gains from AI.
In short, we have good reasons for believing that the economy’s potential growth rate could be above the 2.0 percent pace in the Fed’s projections. If that’s the case, deliberately holding growth below this pace will be needlessly choking off growth, including the green transition, and raising unemployment.
Those are my fears, but I have been told by some of my economist friends that I shouldn’t worry. Powell just needs to talk tough to humor the inflation hawks. Perhaps that’s right, after all, Powell did not commit the Fed to further rate hikes. But I would sleep better tonight if Powell’s speech had been less hawkish.
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