Beat the Press

Beat the press por Dean Baker

Beat the Press is Dean Baker's commentary on economic reporting. He is a Senior Economist at the Center for Economic and Policy Research (CEPR). To never miss a post, subscribe to a weekly email roundup of Beat the Press. Please also consider supporting the blog on Patreon.

The April data on consumption expenditures left many people, including economics reporters, confused about consumer behavior. The basis of the confusion was a reported decline in the saving rate in April to 4.4 percent. It had been running over 8.0 percent in 2021.

However, this reported decline in the saving rate is deceptive. The saving rate is measure as the share of disposable income that is not spent. Disposable income, in turn, is defined as personal income (wages, government transfer payments, interest, dividends etc.) minus taxes.

The saving rate can fall either because consumption rises rapidly or disposable income falls. It turns out that the story we currently have of a declining saving rate is the latter, disposable income has been rising very slowly.

But the trick here is that the slow growth in disposable income is not due to slow growth in personal income. Rather, the slow growth in disposable income is the result of a big increase in taxes. In April, people paid taxes at an annual rate of $3,089 billion.[1] This is up by more than 40.0 percent from the $2,205 billion paid in taxes back in 2019, before the pandemic.

There has been no big increase in tax rates in the last three years, so that would not explain this huge jump in tax collections. The more likely explanation is that people have made large gains in the stock market over this period. They are cashing out some of these gains and paying capital gains taxes on them.

Capital gains income does not count as income in the national accounts. This means that when people sell stock at a gain, and then pay income tax on it, we would see this as a decline in disposable income. If consumption is unchanged, the GDP accounts would be showing a drop in the saving rate.

There is a simple way to adjust for this problem. We can just look at saving, plus taxes, as a percent of personal income. If we look at this figure for April of 2022, it comes to 19.2 percent. That is down from the 19.5 percent rate for the four years prior to the pandemic, but I’m not sure that drop would warrant a big story about people spending down their savings.  

[1] This refers to income and payroll taxes, it does not count taxes like sales taxes or excise taxes on items like alcohol and cigarettes.

 

Note: This piece has been edited to more accurately explain the calculation showing that the saving rate has not really declined to any substantial extent.

The April data on consumption expenditures left many people, including economics reporters, confused about consumer behavior. The basis of the confusion was a reported decline in the saving rate in April to 4.4 percent. It had been running over 8.0 percent in 2021.

However, this reported decline in the saving rate is deceptive. The saving rate is measure as the share of disposable income that is not spent. Disposable income, in turn, is defined as personal income (wages, government transfer payments, interest, dividends etc.) minus taxes.

The saving rate can fall either because consumption rises rapidly or disposable income falls. It turns out that the story we currently have of a declining saving rate is the latter, disposable income has been rising very slowly.

But the trick here is that the slow growth in disposable income is not due to slow growth in personal income. Rather, the slow growth in disposable income is the result of a big increase in taxes. In April, people paid taxes at an annual rate of $3,089 billion.[1] This is up by more than 40.0 percent from the $2,205 billion paid in taxes back in 2019, before the pandemic.

There has been no big increase in tax rates in the last three years, so that would not explain this huge jump in tax collections. The more likely explanation is that people have made large gains in the stock market over this period. They are cashing out some of these gains and paying capital gains taxes on them.

Capital gains income does not count as income in the national accounts. This means that when people sell stock at a gain, and then pay income tax on it, we would see this as a decline in disposable income. If consumption is unchanged, the GDP accounts would be showing a drop in the saving rate.

There is a simple way to adjust for this problem. We can just look at saving, plus taxes, as a percent of personal income. If we look at this figure for April of 2022, it comes to 19.2 percent. That is down from the 19.5 percent rate for the four years prior to the pandemic, but I’m not sure that drop would warrant a big story about people spending down their savings.  

[1] This refers to income and payroll taxes, it does not count taxes like sales taxes or excise taxes on items like alcohol and cigarettes.

 

Note: This piece has been edited to more accurately explain the calculation showing that the saving rate has not really declined to any substantial extent.

There is good reason for believing that the prices of many items that drove inflation higher in the last year have stopped rising and are may even be going in the opposite direction. Used cars are the best example. The CPI index for used vehicles rose 40.5 percent from January 2021 to January 2022. In the three months from January to April, the CPI index has fallen by 4.5 percent.

More generally, the supply shortages that drove prices higher in 2021 seem to be replaced by gluts, with major retailers like Amazon and Target complaining about stockpiles of unsold goods. With the stimulus measures from the pandemic fading into the past, and people no longer fearing to travel or go to restaurants, it is likely that we will be seeing serious downward pressure on the prices of many goods.

While inflation may be easing on the goods side, there are questions about prices in the service sector, most importantly rent. Rent accounts for more than 31.0 percent of the overall CPI, and almost 40 percent of the core index.

Rental inflation had been running at close to a 3.5 percent annual rate before the pandemic. It slowed in 2021, but is now running at almost a 5.0 percent annual rate. There are reasons for believing that it could go still higher. Home sales price growth has been in the double digits the last two years. Many indexes of market rents (units that change hands) have also shown double-digit growth. This raises the possibility that the CPI measure of rental inflation (which covers all units, not just those that change hands) will increase even more rapidly in the rest of 2022 and 2023.

Given its importance in the indexes, and people’s spending, it will be hard to contain inflation if rents are rising at a 5.0 percent, or higher, annual rate. Fortunately, there are some reasons for believing that we may be seeing downward pressure on rental inflation also.

First, the Fed’s interest rate hikes have had a huge impact on home sales. The interest rate for 30-year mortgages has risen by more than 2.0 percentage points, causing home sales to plummet. In recent weeks, purchase mortgage applications have been down by double-digit amounts from year ago levels. Other data, like pending home sales, also show a sharp drop off.

While the relationship between the ownership market and rental market is somewhat indirect, fewer homes being sold is likely to somewhat increase the supply available to renters. To see this point, consider three possibilities.

In the first, would be homebuyers deterred by higher interest rates were looking to move from either a rental or ownership unit of roughly the same size. In this case, the fact that they don’t buy a home has no impact on the overall demand for housing. They just would have occupied a different unit, leaving their current home vacant.

In a second case, imagine that the would be homebuyers were planning to occupy more space. Perhaps they would have moved from a one-bedroom apartment to a three-bedroom house. Alternatively, maybe they were sharing an apartment or house and would have instead have their own, if they bought. In this case, their decision not to buy frees up space that they otherwise would have occupied. That means, other things equal, downward pressure on rents.

It is important in this story to recognize both, that houses can be, and often are divided so that they are shared by multiple individuals or families. This can happen either because the owner formally divides a house explicitly into multiple units, or multiple individuals choose to share a house. Also, houses can be rented if they are not sold. Roughly 30 percent of rental units are single family homes.

The third case is where a would be homebuyer is looking to buy a second home. If higher interest rates make this impractical, then another unit is freed up for somewhat else to occupy.

While a large share, perhaps the majority, of would be homebuyers fall into the first category, people buying homes with comparable space to their current apartment or house, clearly a large number fall into the second and third categories. Therefore, it is reasonable to expect that higher mortgage rates will also help to lower rents.

It is worth mentioning that higher rates are likely to discourage construction and thereby have a negative effect on supply. This is true, but with the sharp run-up in prices over the last two years, homebuilders would have far more incentive to build even with higher interest rates, than they did at the start of the pandemic.

There is also reason to think that the supply of housing will be increasing simply due to the easing of supply chain problems.  During the pandemic, it became difficult for builders to get many items needed to finish a home. As a result, while housing starts rose to an annual pace of almost 1.8 million, completions rose little from their pre-pandemic pace of 1.3 million. With supply problems gradually being addressed, we should expect completions to rise to near the rate of housing starts. This will mean a substantial increase in the supply of housing over the next six months or year.

Finally, I should also add a somewhat morbid, but important point, to the rental picture. In an ordinary year there are close to 1 million evictions. We had around half this number in 2020 and 2021, due to eviction moratoriums. Thankfully, we have not seen the flood of evictions many predicted when these moratoriums ended, but we should expect to see evictions get back to their normal pace. This will also free up some units, putting downward pressure on rents.

Converting Office Space to Residential

As the pandemic has dragged on longer than most of us expected, the remote work arrangements that many companies adopted look to become permanent. Dates for returning to the office were continually pushed off, and now many companies are planning to live with a situation where a substantial share of their workers are expected to show up at the office either infrequently, or not at all.

As a result, many office buildings are now largely empty. The number of workers going into offices nationwide is still less than 40 percent of its pre-pandemic level. This huge amount of vacant office space offers the quickest route for increasing the supply of housing.

While it is true that many new office buildings cannot be easily converted to residential units, that is really beside the point. What we would expect is that as a glut of office space pushes down rents. Landlords in buildings that can be more easily converted will turn their space into apartments or condominiums. This would push tenants that had been using these buildings for offices into the buildings that are not easily converted to residential usage.

This is a straightforward market process, but it can be helped along by government. Unnecessary zoning barriers that make such conversions difficult can be relaxed. Governments can also inventory best practices, sharing examples of buildings that have been successfully converted. Low interest loans, to subsidize conversions, as well as the moves of tenants who need new space, can also be helpful.

There are undoubtedly many other policies that can hasten this process without large expenditures or bureaucracies, but governments have to agree that this is the route they want to follow. As it is, many politicians, most notably New York Governor Kathy Hochul and New York City Mayor Eric Adams, have been leaning on companies to bring their workers back to the office.

Hochul and Adams are responding to the thousands of businesses that are dependent on the throngs of commuters that used to come into Manhattan every day. With this figure slashed by more than 60 percent, many of these businesses cannot survive.

Their concern over these businesses is understandable, but we are seeing a permanent change in the economy, and New York and other cities will simply have to adapt. Most of the millions of workers newly given the opportunity to work remotely value this freedom. They can save thousands of dollars a year on commuting and other work-related expenses. In addition, they save the time needed for commuting, which can easily be ten hours a week in a major city like New York.

For these reasons, it is understandable that many workers do not want to return to the office. Employers that do not allow their employees to work remotely are likely to find themselves at a serious disadvantage in their efforts to attract and retain workers. In short, remote work is now a fact of life, we cannot turn back the clock.[1]

While this is bad news for the businesses that depended on a commuting workforce, it does not have to be bad news for cities. If the office space is converted to residential space, it will increase the number of people living in cities. The new residents will also require services from businesses, even though these may be different than the needs of the commuting population.

Also, additional residential space will put downward pressure on rents more generally. This is bad news for landlords, but it will mean more money for renters, who will now have more money to spend on things other than rent.

Even without large-scale conversion of office space, we have seen a sharp slowing of rental inflation in some of the highest cost cities. The CPI measure of rent has increased by close to 1.0 percent over the last year in New York, San Francisco, and Washington, DC. This likely reflects many people taking advantage of increased opportunities for remote work to move to lower cost parts of the country.

The flip side of this story is that rents in lower cost cities, like Detroit, Atlanta, and Phoenix, have far out-paced the national rate of rental inflation over the last year. This is fine for the renters who are moving from much higher cost cities. The resulting rise in house sale prices is also good news for homeowners in these places. However, it is bad news for those who were already renting in these lower cost cities, although the impact might be largely offset by increased job opportunities resulting from an influx of relatively affluent workers. In any case, this migration is almost certainly a net positive, even if there are likely to be some losers.

The Prospect of Lower Inflation Going Forward

Most of the new data that we have seen in the last few months supports the view that inflation is coming down, rather than spiraling upward. The Congressional Budget Office threw its lot in with this view in its latest budget and economic outlook. In many areas, the price declines will come about through the normal working of the market, however in the case of rent, the government can help to counter inflation by encouraging the conversion of vacant office space to residential units.

[1] Remote work is also great for the environment, since it means less carbon emissions from commuting.

There is good reason for believing that the prices of many items that drove inflation higher in the last year have stopped rising and are may even be going in the opposite direction. Used cars are the best example. The CPI index for used vehicles rose 40.5 percent from January 2021 to January 2022. In the three months from January to April, the CPI index has fallen by 4.5 percent.

More generally, the supply shortages that drove prices higher in 2021 seem to be replaced by gluts, with major retailers like Amazon and Target complaining about stockpiles of unsold goods. With the stimulus measures from the pandemic fading into the past, and people no longer fearing to travel or go to restaurants, it is likely that we will be seeing serious downward pressure on the prices of many goods.

While inflation may be easing on the goods side, there are questions about prices in the service sector, most importantly rent. Rent accounts for more than 31.0 percent of the overall CPI, and almost 40 percent of the core index.

Rental inflation had been running at close to a 3.5 percent annual rate before the pandemic. It slowed in 2021, but is now running at almost a 5.0 percent annual rate. There are reasons for believing that it could go still higher. Home sales price growth has been in the double digits the last two years. Many indexes of market rents (units that change hands) have also shown double-digit growth. This raises the possibility that the CPI measure of rental inflation (which covers all units, not just those that change hands) will increase even more rapidly in the rest of 2022 and 2023.

Given its importance in the indexes, and people’s spending, it will be hard to contain inflation if rents are rising at a 5.0 percent, or higher, annual rate. Fortunately, there are some reasons for believing that we may be seeing downward pressure on rental inflation also.

First, the Fed’s interest rate hikes have had a huge impact on home sales. The interest rate for 30-year mortgages has risen by more than 2.0 percentage points, causing home sales to plummet. In recent weeks, purchase mortgage applications have been down by double-digit amounts from year ago levels. Other data, like pending home sales, also show a sharp drop off.

While the relationship between the ownership market and rental market is somewhat indirect, fewer homes being sold is likely to somewhat increase the supply available to renters. To see this point, consider three possibilities.

In the first, would be homebuyers deterred by higher interest rates were looking to move from either a rental or ownership unit of roughly the same size. In this case, the fact that they don’t buy a home has no impact on the overall demand for housing. They just would have occupied a different unit, leaving their current home vacant.

In a second case, imagine that the would be homebuyers were planning to occupy more space. Perhaps they would have moved from a one-bedroom apartment to a three-bedroom house. Alternatively, maybe they were sharing an apartment or house and would have instead have their own, if they bought. In this case, their decision not to buy frees up space that they otherwise would have occupied. That means, other things equal, downward pressure on rents.

It is important in this story to recognize both, that houses can be, and often are divided so that they are shared by multiple individuals or families. This can happen either because the owner formally divides a house explicitly into multiple units, or multiple individuals choose to share a house. Also, houses can be rented if they are not sold. Roughly 30 percent of rental units are single family homes.

The third case is where a would be homebuyer is looking to buy a second home. If higher interest rates make this impractical, then another unit is freed up for somewhat else to occupy.

While a large share, perhaps the majority, of would be homebuyers fall into the first category, people buying homes with comparable space to their current apartment or house, clearly a large number fall into the second and third categories. Therefore, it is reasonable to expect that higher mortgage rates will also help to lower rents.

It is worth mentioning that higher rates are likely to discourage construction and thereby have a negative effect on supply. This is true, but with the sharp run-up in prices over the last two years, homebuilders would have far more incentive to build even with higher interest rates, than they did at the start of the pandemic.

There is also reason to think that the supply of housing will be increasing simply due to the easing of supply chain problems.  During the pandemic, it became difficult for builders to get many items needed to finish a home. As a result, while housing starts rose to an annual pace of almost 1.8 million, completions rose little from their pre-pandemic pace of 1.3 million. With supply problems gradually being addressed, we should expect completions to rise to near the rate of housing starts. This will mean a substantial increase in the supply of housing over the next six months or year.

Finally, I should also add a somewhat morbid, but important point, to the rental picture. In an ordinary year there are close to 1 million evictions. We had around half this number in 2020 and 2021, due to eviction moratoriums. Thankfully, we have not seen the flood of evictions many predicted when these moratoriums ended, but we should expect to see evictions get back to their normal pace. This will also free up some units, putting downward pressure on rents.

Converting Office Space to Residential

As the pandemic has dragged on longer than most of us expected, the remote work arrangements that many companies adopted look to become permanent. Dates for returning to the office were continually pushed off, and now many companies are planning to live with a situation where a substantial share of their workers are expected to show up at the office either infrequently, or not at all.

As a result, many office buildings are now largely empty. The number of workers going into offices nationwide is still less than 40 percent of its pre-pandemic level. This huge amount of vacant office space offers the quickest route for increasing the supply of housing.

While it is true that many new office buildings cannot be easily converted to residential units, that is really beside the point. What we would expect is that as a glut of office space pushes down rents. Landlords in buildings that can be more easily converted will turn their space into apartments or condominiums. This would push tenants that had been using these buildings for offices into the buildings that are not easily converted to residential usage.

This is a straightforward market process, but it can be helped along by government. Unnecessary zoning barriers that make such conversions difficult can be relaxed. Governments can also inventory best practices, sharing examples of buildings that have been successfully converted. Low interest loans, to subsidize conversions, as well as the moves of tenants who need new space, can also be helpful.

There are undoubtedly many other policies that can hasten this process without large expenditures or bureaucracies, but governments have to agree that this is the route they want to follow. As it is, many politicians, most notably New York Governor Kathy Hochul and New York City Mayor Eric Adams, have been leaning on companies to bring their workers back to the office.

Hochul and Adams are responding to the thousands of businesses that are dependent on the throngs of commuters that used to come into Manhattan every day. With this figure slashed by more than 60 percent, many of these businesses cannot survive.

Their concern over these businesses is understandable, but we are seeing a permanent change in the economy, and New York and other cities will simply have to adapt. Most of the millions of workers newly given the opportunity to work remotely value this freedom. They can save thousands of dollars a year on commuting and other work-related expenses. In addition, they save the time needed for commuting, which can easily be ten hours a week in a major city like New York.

For these reasons, it is understandable that many workers do not want to return to the office. Employers that do not allow their employees to work remotely are likely to find themselves at a serious disadvantage in their efforts to attract and retain workers. In short, remote work is now a fact of life, we cannot turn back the clock.[1]

While this is bad news for the businesses that depended on a commuting workforce, it does not have to be bad news for cities. If the office space is converted to residential space, it will increase the number of people living in cities. The new residents will also require services from businesses, even though these may be different than the needs of the commuting population.

Also, additional residential space will put downward pressure on rents more generally. This is bad news for landlords, but it will mean more money for renters, who will now have more money to spend on things other than rent.

Even without large-scale conversion of office space, we have seen a sharp slowing of rental inflation in some of the highest cost cities. The CPI measure of rent has increased by close to 1.0 percent over the last year in New York, San Francisco, and Washington, DC. This likely reflects many people taking advantage of increased opportunities for remote work to move to lower cost parts of the country.

The flip side of this story is that rents in lower cost cities, like Detroit, Atlanta, and Phoenix, have far out-paced the national rate of rental inflation over the last year. This is fine for the renters who are moving from much higher cost cities. The resulting rise in house sale prices is also good news for homeowners in these places. However, it is bad news for those who were already renting in these lower cost cities, although the impact might be largely offset by increased job opportunities resulting from an influx of relatively affluent workers. In any case, this migration is almost certainly a net positive, even if there are likely to be some losers.

The Prospect of Lower Inflation Going Forward

Most of the new data that we have seen in the last few months supports the view that inflation is coming down, rather than spiraling upward. The Congressional Budget Office threw its lot in with this view in its latest budget and economic outlook. In many areas, the price declines will come about through the normal working of the market, however in the case of rent, the government can help to counter inflation by encouraging the conversion of vacant office space to residential units.

[1] Remote work is also great for the environment, since it means less carbon emissions from commuting.

Inflation is persisting at rates far higher than most of us consider acceptable. The future path continues to be the focus of the debate on economic prospects. On one side, many of us continue to believe inflation is a temporary phenomenon caused by the reopening from the pandemic and the war in Ukraine. On the other side are those who see inflation spiraling upward to more dangerous levels, with a severe recession the only factor that can stop it.

In its latest report on the budget and the economy, the Congressional Budget Office (CBO) sided clearly with those arguing the case for inflation being temporary. The report projected that inflation, as measured by the Consumer Price Index, would fall to 2.7 percent next year and 2.3 percent in 2024. That is somewhat higher than in the pre-pandemic period, but certainly not spiraling inflation.

This drop in the inflation rate is not accomplished by a surge in unemployment. It projects that unemployment in the fourth quarter of this year will be 3.7 percent this year. It will be 3.6 percent in the fourth quarter of next year, and 3.8 percent in 2024. If this projection proves to be true, this would be the lowest three-year stretch for unemployment in the post-World War II era.

CBO also projects that the profit share of national income will fall back to its pre-pandemic level. This will allow wage growth to outpace productivity growth for this three-year period.

These projections show an outstanding picture of the economy for this period. CBO can be wrong, but these are serious projections from a non-partisan source. If they prove true, we will have much to celebrate.   

Inflation is persisting at rates far higher than most of us consider acceptable. The future path continues to be the focus of the debate on economic prospects. On one side, many of us continue to believe inflation is a temporary phenomenon caused by the reopening from the pandemic and the war in Ukraine. On the other side are those who see inflation spiraling upward to more dangerous levels, with a severe recession the only factor that can stop it.

In its latest report on the budget and the economy, the Congressional Budget Office (CBO) sided clearly with those arguing the case for inflation being temporary. The report projected that inflation, as measured by the Consumer Price Index, would fall to 2.7 percent next year and 2.3 percent in 2024. That is somewhat higher than in the pre-pandemic period, but certainly not spiraling inflation.

This drop in the inflation rate is not accomplished by a surge in unemployment. It projects that unemployment in the fourth quarter of this year will be 3.7 percent this year. It will be 3.6 percent in the fourth quarter of next year, and 3.8 percent in 2024. If this projection proves to be true, this would be the lowest three-year stretch for unemployment in the post-World War II era.

CBO also projects that the profit share of national income will fall back to its pre-pandemic level. This will allow wage growth to outpace productivity growth for this three-year period.

These projections show an outstanding picture of the economy for this period. CBO can be wrong, but these are serious projections from a non-partisan source. If they prove true, we will have much to celebrate.   

The New York Times ran a piece discussing why innovations in cloud computing and artificial technology have not led to more rapid increases in productivity. It raises a number of possibilities, but leaves out an obvious one, increasing waste associated with rent-seeking. We clearly see an increase in waste associated with rent-seeking, the only question is whether it is large enough to have a notable effect on productivity growth.

The piece actually touches on, without commenting on it, one of the major sources of waste. It discusses the practices of a major health insurer.

Health insurance does not directly contribute to GDP. Health care (actually health) is what we care about. Health insurers determines who has access to health care. In principle we want as few people employed in the health insurance industry as possible, we want people to be able to get health care, not to have insurers block their path.

However, we have over 900,000 people employed in health and life insurance companies. Much of what they do is made profitable by the fact that patent monopolies make many drugs and medical equipment expensive. In the absence of these monopolies, no insurer would look to block patients from getting the drugs or medical care recommended by their physician.

There are similar stories in many other sectors. The financial industry employs hundreds of thousands of people shuffling assets in ways that contribute nothing to GDP. The same is true with the lawyers and accountants devoting their efforts to help rich people and corporations avoid paying taxes.

Eliminating, or at least reducing, this waste would be a great way to increase productivity. Unfortunately, the people get rich and richer off this waste prevent it from being addressed politically, or even discussed in the New York Times.

The New York Times ran a piece discussing why innovations in cloud computing and artificial technology have not led to more rapid increases in productivity. It raises a number of possibilities, but leaves out an obvious one, increasing waste associated with rent-seeking. We clearly see an increase in waste associated with rent-seeking, the only question is whether it is large enough to have a notable effect on productivity growth.

The piece actually touches on, without commenting on it, one of the major sources of waste. It discusses the practices of a major health insurer.

Health insurance does not directly contribute to GDP. Health care (actually health) is what we care about. Health insurers determines who has access to health care. In principle we want as few people employed in the health insurance industry as possible, we want people to be able to get health care, not to have insurers block their path.

However, we have over 900,000 people employed in health and life insurance companies. Much of what they do is made profitable by the fact that patent monopolies make many drugs and medical equipment expensive. In the absence of these monopolies, no insurer would look to block patients from getting the drugs or medical care recommended by their physician.

There are similar stories in many other sectors. The financial industry employs hundreds of thousands of people shuffling assets in ways that contribute nothing to GDP. The same is true with the lawyers and accountants devoting their efforts to help rich people and corporations avoid paying taxes.

Eliminating, or at least reducing, this waste would be a great way to increase productivity. Unfortunately, the people get rich and richer off this waste prevent it from being addressed politically, or even discussed in the New York Times.

Sorry folks, I’m back!!!! Anyhow, I was following the news the last few weeks and was struck by a couple of items that seem to have gotten little attention.

First, on inflation, we have seen a sharp fall in the break-even inflation rate for inflation-indexed 10-year Treasury bonds compared with conventional Treasury bonds. This break-even rate had been rising through the fall and winter, peaking at just over 3.0 percent on April 21.

Anyhow, it has since fallen sharply, and stood at 2.6 percent on Monday. This is still somewhat higher than the Fed’s 2.0 percent inflation target, but not by much, since everyone expects higher inflation in 2022 and there is around a 0.3 percentage point gap between the CPI, which is the basis of the index and the PCE deflator than the Fed targets.

The drop in this break-even rate deserves more attention than it’s getting. As someone who warned of both the stock bubble in the 1990s and the housing bubble in the ‘00s, I am well aware that markets can be wrong, but it is still worth paying attention to what they are telling us.

Rather than seeing a story of spiraling inflation, actors in financial markets seem to be expecting that the inflation rate will quickly fall back to more moderate levels. That is worth noting.

The other issue is the plunge in the stock market that has upset many people, including some self-identified liberals. There all sorts of factors, both rational and irrational, that can explain stock market movements, but in principle, the stock market is supposed to represent the discounted value of future corporate profits.

Many of us have noted that the pandemic inflation has been associated with a sharp shift from wage income to profit income, with the latter rising by roughly 2 percentage points of corporate income. The immediate trigger for the latest plunge was reports from Target and Amazon that they are seeing increasing pricing pressure, and therefore lower profit margins, on a wide range of goods.

Let’s suppose that this is the beginning of a reversal in profit shares, with the possibility that they will return to their pre-pandemic level. This is what many of us had been hoping for.

But what would be the predicted effect on stock prices of a drop in profit shares of roughly 2 percentage points, or 10 percent of current profits? That’s right, we would expect a plunge in stock prices. The good news for workers here (lower prices mean high real wages) is bad news for the stock market.

Too early to say if this is in fact the story, but if it is, progressives should be happy.

Sorry folks, I’m back!!!! Anyhow, I was following the news the last few weeks and was struck by a couple of items that seem to have gotten little attention.

First, on inflation, we have seen a sharp fall in the break-even inflation rate for inflation-indexed 10-year Treasury bonds compared with conventional Treasury bonds. This break-even rate had been rising through the fall and winter, peaking at just over 3.0 percent on April 21.

Anyhow, it has since fallen sharply, and stood at 2.6 percent on Monday. This is still somewhat higher than the Fed’s 2.0 percent inflation target, but not by much, since everyone expects higher inflation in 2022 and there is around a 0.3 percentage point gap between the CPI, which is the basis of the index and the PCE deflator than the Fed targets.

The drop in this break-even rate deserves more attention than it’s getting. As someone who warned of both the stock bubble in the 1990s and the housing bubble in the ‘00s, I am well aware that markets can be wrong, but it is still worth paying attention to what they are telling us.

Rather than seeing a story of spiraling inflation, actors in financial markets seem to be expecting that the inflation rate will quickly fall back to more moderate levels. That is worth noting.

The other issue is the plunge in the stock market that has upset many people, including some self-identified liberals. There all sorts of factors, both rational and irrational, that can explain stock market movements, but in principle, the stock market is supposed to represent the discounted value of future corporate profits.

Many of us have noted that the pandemic inflation has been associated with a sharp shift from wage income to profit income, with the latter rising by roughly 2 percentage points of corporate income. The immediate trigger for the latest plunge was reports from Target and Amazon that they are seeing increasing pricing pressure, and therefore lower profit margins, on a wide range of goods.

Let’s suppose that this is the beginning of a reversal in profit shares, with the possibility that they will return to their pre-pandemic level. This is what many of us had been hoping for.

But what would be the predicted effect on stock prices of a drop in profit shares of roughly 2 percentage points, or 10 percent of current profits? That’s right, we would expect a plunge in stock prices. The good news for workers here (lower prices mean high real wages) is bad news for the stock market.

Too early to say if this is in fact the story, but if it is, progressives should be happy.

Taking May Off

I will be vacationing for the month, so it is unlikely that I will post anything until the end of the month. See you then.

I will be vacationing for the month, so it is unlikely that I will post anything until the end of the month. See you then.

Many people were struck by the 1.4 percent drop in GDP in the first quarter, with some reports suggesting this was the beginning of a recession. This is not the real story of the first quarter GDP, instead it looks like growth is continuing at a healthy rate. To understand this point, it is important to recognize how imports are counted in GDP, since the increase in imports subtracted 2.53 percentage points from GDP growth in the quarter.[1]

Imagine that the sum of consumption spending, investment, and government spending increased at 2.7 percent annual rate in the quarter (which they did). Now suppose that we offloaded $60 billion of goods from boats sitting offshore, increasing our imports by this amount. On an annual basis, this additional $60 billion in imports would be $240 billion, or roughly 1.0 percent of GDP. This would reduce GDP by this amount, even though our purchases for consumption, investment, and the government had not changed.

Okay, that story is not exactly right. The goods that we offloaded from the ships are now sitting in warehouses at the ports or on their way to the retail outlets where they will eventually be sold. This increase in inventories would raise GDP by an amount equal to the growth in imports, offsetting the drag that imports otherwise would have been on growth. However, inventories were actually a drag on growth in the quarter, subtracting 0.84 percentage points from GDP.

These two facts can be reconciled by looking at the actual amount that inventories increased in the first quarter. The report showed that inventories increased at a $158.7 billion annual rate. (Non-farm inventories rose at an even more rapid $185.3 billion annual rate. Farm inventories shrank at a $35.8 billion rate, continuing a pattern that has been going on for sixteen years, but that is another story.)

This is an extremely fast pace of inventory accumulation. By comparison, in the years of 2016-2018, three normal years of economic growth, inventory accumulation averaged $45 billion. The reason inventories were a negative factor in growth in the first quarter, in spite of this extraordinary rate of accumulation, is that inventories grew at an even more rapid $193.2 billion annual rate in the fourth quarter of 2021. That rise added 5.32 percentage points to the fourth quarter’s growth.

So how do we think about first quarter growth? It probably makes the most sense to focus on the measure of final demand to domestic purchasers, which rose at a very healthy 2.6 percent annual rate. This is measuring the growth in consumption, fixed investment, and government expenditures. If we want the fullest picture, we can combine the fourth quarter’s 6.9 percent growth rate with the first quarter’s 1.4 percent decline to get a 2.8 percent average growth rate for the last two quarters.

In addition to recognizing that the economy is still growing at very healthy pace, inventories have been largely rebuilt, in spite of supply chain problems. Real non-farm inventories at the end of the first quarter were just 0.1 percent below their pre-pandemic levels. (Farm inventories are now at just 53.0 percent of their level of 16 years ago.) This is a very positive sign, in that it should be mean that the prices of many items that rose sharply in the last year will be leveling off, and quite likely coming down.

In short, rather than being a bad report with a drop in GDP, this report is overwhelming good news. It shows that the main components of final demand, consumption, investment, and government expenditures, are growing at a healthy pace. And, it shows that inventories have been largely rebuilt, meaning that supply chain problems are being alleviated. Inflation is of course a problem, but this rise in inventories is exactly what we want to see if inflation is to be slowed.    

[1] A drop in exports subtracted another 0.68 percentage points. This is likely also due to supply chain issues, as exporters can’t arrange for shipping containers.

Many people were struck by the 1.4 percent drop in GDP in the first quarter, with some reports suggesting this was the beginning of a recession. This is not the real story of the first quarter GDP, instead it looks like growth is continuing at a healthy rate. To understand this point, it is important to recognize how imports are counted in GDP, since the increase in imports subtracted 2.53 percentage points from GDP growth in the quarter.[1]

Imagine that the sum of consumption spending, investment, and government spending increased at 2.7 percent annual rate in the quarter (which they did). Now suppose that we offloaded $60 billion of goods from boats sitting offshore, increasing our imports by this amount. On an annual basis, this additional $60 billion in imports would be $240 billion, or roughly 1.0 percent of GDP. This would reduce GDP by this amount, even though our purchases for consumption, investment, and the government had not changed.

Okay, that story is not exactly right. The goods that we offloaded from the ships are now sitting in warehouses at the ports or on their way to the retail outlets where they will eventually be sold. This increase in inventories would raise GDP by an amount equal to the growth in imports, offsetting the drag that imports otherwise would have been on growth. However, inventories were actually a drag on growth in the quarter, subtracting 0.84 percentage points from GDP.

These two facts can be reconciled by looking at the actual amount that inventories increased in the first quarter. The report showed that inventories increased at a $158.7 billion annual rate. (Non-farm inventories rose at an even more rapid $185.3 billion annual rate. Farm inventories shrank at a $35.8 billion rate, continuing a pattern that has been going on for sixteen years, but that is another story.)

This is an extremely fast pace of inventory accumulation. By comparison, in the years of 2016-2018, three normal years of economic growth, inventory accumulation averaged $45 billion. The reason inventories were a negative factor in growth in the first quarter, in spite of this extraordinary rate of accumulation, is that inventories grew at an even more rapid $193.2 billion annual rate in the fourth quarter of 2021. That rise added 5.32 percentage points to the fourth quarter’s growth.

So how do we think about first quarter growth? It probably makes the most sense to focus on the measure of final demand to domestic purchasers, which rose at a very healthy 2.6 percent annual rate. This is measuring the growth in consumption, fixed investment, and government expenditures. If we want the fullest picture, we can combine the fourth quarter’s 6.9 percent growth rate with the first quarter’s 1.4 percent decline to get a 2.8 percent average growth rate for the last two quarters.

In addition to recognizing that the economy is still growing at very healthy pace, inventories have been largely rebuilt, in spite of supply chain problems. Real non-farm inventories at the end of the first quarter were just 0.1 percent below their pre-pandemic levels. (Farm inventories are now at just 53.0 percent of their level of 16 years ago.) This is a very positive sign, in that it should be mean that the prices of many items that rose sharply in the last year will be leveling off, and quite likely coming down.

In short, rather than being a bad report with a drop in GDP, this report is overwhelming good news. It shows that the main components of final demand, consumption, investment, and government expenditures, are growing at a healthy pace. And, it shows that inventories have been largely rebuilt, meaning that supply chain problems are being alleviated. Inflation is of course a problem, but this rise in inventories is exactly what we want to see if inflation is to be slowed.    

[1] A drop in exports subtracted another 0.68 percentage points. This is likely also due to supply chain issues, as exporters can’t arrange for shipping containers.

It is amazing how frequently policy types talk about “free trade” as though it is actually a policy anyone is interested in promoting. The reality is that what passes for free trade is a policy of removing barriers to allow low cost manufactured goods to enter the United States without restrictions. This puts downward pressure on the pay of manufacturing workers. Since manufacturing had historically been a source of high paying jobs for workers without college degrees (it is no longer), the loss of these jobs out downward pressure on the pay of non-college educated workers more generally.

A policy of genuine free trade would mean eliminating barriers that limit trade in physicians’ services as well as the services of highly paid professionals more generally. It would also mean weakening or eliminating patent and copyright monopolies, which can raise the price of protected items by many thousand percent above the free market price.

There is no political constituency for removing these protectionist barriers, as can be clearly seen by the fact that no major political figure is advocating this path. Instead, there is a strong political constituency, which includes many self-described liberals, for a trade policy designed to reduce the pay of non-college educated workers.

It is politically more salable to describe this policy as “free trade,” but it is a lie. Reporters should not describe it that way if they are trying to be objective.  

It is amazing how frequently policy types talk about “free trade” as though it is actually a policy anyone is interested in promoting. The reality is that what passes for free trade is a policy of removing barriers to allow low cost manufactured goods to enter the United States without restrictions. This puts downward pressure on the pay of manufacturing workers. Since manufacturing had historically been a source of high paying jobs for workers without college degrees (it is no longer), the loss of these jobs out downward pressure on the pay of non-college educated workers more generally.

A policy of genuine free trade would mean eliminating barriers that limit trade in physicians’ services as well as the services of highly paid professionals more generally. It would also mean weakening or eliminating patent and copyright monopolies, which can raise the price of protected items by many thousand percent above the free market price.

There is no political constituency for removing these protectionist barriers, as can be clearly seen by the fact that no major political figure is advocating this path. Instead, there is a strong political constituency, which includes many self-described liberals, for a trade policy designed to reduce the pay of non-college educated workers.

It is politically more salable to describe this policy as “free trade,” but it is a lie. Reporters should not describe it that way if they are trying to be objective.  

It has become popular among the “Let’s Go Brandon” crowd, and major news outlets, to blame President Biden for the high price of gas. While this might excite the right, it literally has no foundation in reality.

The basic story is that gas is expensive because the world price of oil is high. There are small differences in oil prices across countries due to transportation costs, but if the world price of oil goes up sharply, as it has, then we will pay more for gas in the United States.

The U.S. can at best have a very limited impact on the world price of oil. When the U.S. economy grows rapidly, as it did in 2021, it increases world demand for oil. However, the impact of U.S. growth, by itself, is very limited. If the U.S. economy grew 2.0 percent in 2021, instead of its actual 5.5 percent rate, then perhaps the price of a barrel of oil would be $1 to $2 a barrel lower. That would save U.S. consumers 2.5 to 5.0 cents a gallon.

That might be helpful to people, but would not qualitatively change the story of high gas prices. So, if the unemployment rate was 1-2 percentage points higher (meaning another 1.5-3.0 million unemployed), and GDP was 3.5 percent smaller, car owners might be saving 5 cents on a gallon of gas.

There is even less of a story on the supply side. Biden has been pushing for measures that would promote the development and use of clean energy. To date these have had at best a very limited effect in moving us away from dependence on fossil fuels. But, insofar as they have had any impact, these measures would lower gas prices, not raise them.

He has proposed limiting drilling on government land, but he has opened up huge tracts for leasing to oil and gas developers. Furthermore, the oil and gas industries already have access to far more land than they are currently using. In short, there is no case that Biden’s efforts to reduce greenhouse gas emissions have had any noticeable effect on U.S. production of oil and gas.

Some right-wingers have highlighted Biden’s decision to nix the Keystone pipeline, which would bring oil from Canada to the United States. This pipeline was nowhere close to completion in any case. Furthermore, this oil is already making it to the world markets, meaning that any redirection due to the Keystone pipeline would have a trivial impact on world prices.

There is an important way in which Biden’s actions have lowered world oil prices. He is drawing down the U.S. strategic oil reserves by 1 million barrels a day. This has the same impact on world oil prices as if we increased U.S. production by 1 million barrels a day. An increase of this size would get production roughly back to the pre-pandemic level. The actual impact on world prices is even somewhat larger, since Biden also arranged for several of our allies to release oil from their reserves.

If there is a president to blame for high oil prices it would be Donald Trump. He actually boasted about arranging for OPEC to reduce its production of oil during the pandemic. OPEC still has not returned to its pre-pandemic levels of oil production. Apart from concerns over the Ukraine war leading to a reduction in world oil supplies, the reduction in oil production arranged by Donald Trump is by far the most important reason that gas prices are above their pre-pandemic level.

That reality may not fit the “let’s go Brandon” story, but as the Republicans always say, “reality has no place in politics.”

It has become popular among the “Let’s Go Brandon” crowd, and major news outlets, to blame President Biden for the high price of gas. While this might excite the right, it literally has no foundation in reality.

The basic story is that gas is expensive because the world price of oil is high. There are small differences in oil prices across countries due to transportation costs, but if the world price of oil goes up sharply, as it has, then we will pay more for gas in the United States.

The U.S. can at best have a very limited impact on the world price of oil. When the U.S. economy grows rapidly, as it did in 2021, it increases world demand for oil. However, the impact of U.S. growth, by itself, is very limited. If the U.S. economy grew 2.0 percent in 2021, instead of its actual 5.5 percent rate, then perhaps the price of a barrel of oil would be $1 to $2 a barrel lower. That would save U.S. consumers 2.5 to 5.0 cents a gallon.

That might be helpful to people, but would not qualitatively change the story of high gas prices. So, if the unemployment rate was 1-2 percentage points higher (meaning another 1.5-3.0 million unemployed), and GDP was 3.5 percent smaller, car owners might be saving 5 cents on a gallon of gas.

There is even less of a story on the supply side. Biden has been pushing for measures that would promote the development and use of clean energy. To date these have had at best a very limited effect in moving us away from dependence on fossil fuels. But, insofar as they have had any impact, these measures would lower gas prices, not raise them.

He has proposed limiting drilling on government land, but he has opened up huge tracts for leasing to oil and gas developers. Furthermore, the oil and gas industries already have access to far more land than they are currently using. In short, there is no case that Biden’s efforts to reduce greenhouse gas emissions have had any noticeable effect on U.S. production of oil and gas.

Some right-wingers have highlighted Biden’s decision to nix the Keystone pipeline, which would bring oil from Canada to the United States. This pipeline was nowhere close to completion in any case. Furthermore, this oil is already making it to the world markets, meaning that any redirection due to the Keystone pipeline would have a trivial impact on world prices.

There is an important way in which Biden’s actions have lowered world oil prices. He is drawing down the U.S. strategic oil reserves by 1 million barrels a day. This has the same impact on world oil prices as if we increased U.S. production by 1 million barrels a day. An increase of this size would get production roughly back to the pre-pandemic level. The actual impact on world prices is even somewhat larger, since Biden also arranged for several of our allies to release oil from their reserves.

If there is a president to blame for high oil prices it would be Donald Trump. He actually boasted about arranging for OPEC to reduce its production of oil during the pandemic. OPEC still has not returned to its pre-pandemic levels of oil production. Apart from concerns over the Ukraine war leading to a reduction in world oil supplies, the reduction in oil production arranged by Donald Trump is by far the most important reason that gas prices are above their pre-pandemic level.

That reality may not fit the “let’s go Brandon” story, but as the Republicans always say, “reality has no place in politics.”

Inflation has stayed higher longer than I expected. I got that one wrong. I am happy to acknowledge my mistake, but I also want to know the reason why. This is not a question of finding excuses, I want to know why the economy is acting differently than I thought it would.

The most obvious reason is the supply chain disruptions that led to the original jump in prices have lasted longer and been more far-reaching than I expected. Part of this is due to the persistence of the pandemic, with the delta and omicron strains disrupting economies around the world.

The other major source of disruption is Russia’s invasion of Ukraine. This has blocked the supply of many items manufactured in Ukraine, but more importantly, the war reduces its ability to grow and sell wheat and other crops on world markets. There is also the risk of losing Russia’s oil and gas, which propelled oil prices to levels not seen in more than a decade.[1] 

The idea that inflation would spike under such circumstances should not be surprising. As has been widely noted, the jump in inflation was worldwide, not just in the United States. The increase in the inflation rate was comparable in the European Union and the United Kingdom, so it obviously was not just a story of excessive stimulus in the United States. The break-even inflation rate on German 10-year government bonds are now essentially the same as in the United States, indicating that investors expect inflation in the two countries to be roughly the same over this period.

The logic here should not be hard to understand. The normal delivery of goods and services was disrupted by the pandemic. Since overall demand did not drop to anywhere near the same extent (due to various stimulus measures), we had shortages of many items, leading to sharp increases in prices.

While there were jumps in demand at various points during the pandemic, associated with the timing of stimulus payments, overall growth has not been extraordinary. Real consumption expenditures for February of 2022 (the most recent month for which we have data) were 4.6 percent higher than they were two years ago, a 2.3 percent annual rate of growth.

The problem has been, and still is, a huge shift from consumption of services to consumption of goods, due to the pandemic. While service consumption was still slightly below its pre-pandemic level in February of 2022, consumption of nondurable goods was up 11.8 percent, a 5.9 percent annual rate of growth. Consumption of durable goods grew even more rapidly, rising 22.6 percent, a 10.7 percent rate of growth.

This jump in demand would have been difficult for the economy to meet even without pandemic-related, and now war-related, supply issues, but definitely overstretched capacity given where the economy is at present. If the pandemic continues to wane, it should mean that consumption will continue to switch back towards services. It should also mean a reduction in pandemic-related supply disruptions, although disruptions associated with the war may continue and could grow worse.

The Optimistic Route to Lower Inflation

It is important to recount the route to the surge in inflation, since it matters for our prospects for reducing inflation. Recounting our historical track record in bringing inflation down after surges that came from fundamentally different sources is not necessarily useful in describing our prospects for bringing down the current inflation spike.

The optimistic path for lowering inflation would be for an end to the supply chain issues that pushed inflation higher. This means an end to the backlogs at ports, an end to the shortage of truckers, and an end to COVID-19-related shutdowns in China and other manufacturing locations. Also, the shift back to services will reduce the extent to which demand for goods is exceeding the economy’s ability to supply them.[2]

The story would be that when these disruptions are ended, or at least ameliorated, the prices of many items would stop rising and even come back down. This should not sound far-fetched. Televisions provide a great example. The price of televisions had been falling gradually for decades. It suddenly surged 8.7 percent in the five months from March of 2021 until August. The index then turned around and fell sharply, so that it’s now lower than it had been in March of last year.

We may also be seeing this story now with used cars and trucks. Used vehicles prices rose 41.2 percent from February 2021 to February 2022, adding 1.1 percentage points to the overall inflation rate. (New vehicle prices rose 12.4 percent over this period, adding 0.5 percentage points to the inflation rate over the year.) Used vehicle prices fell 3.8 percent in March, after dropping 0.2 percent in February. A private index shows an even sharper drop in used vehicle prices, dropping 6.3 percent since its peak in January.

If we don’t see another resurgence of the pandemic, and the war in Ukraine doesn’t escalate further, these sorts of price reversals may be the norm. A wide range of goods that saw sharp increases in price during the pandemic may experience rapid price declines as the economy normalizes further and supply chain problems are overcome.

Apart from the small number of cases where prices are now falling, there is a more general reason why we might expect these price reversals to be common. Prices have hugely outpaced costs during the pandemic. This has led to a large shift from wages to profits, with the profit share of corporate income rising by more than two percentage points since the pandemic began.

If we think that the conditions of competition have not changed in most sectors since the start of the pandemic, it is reasonable to think that the labor and capital shares will return to their pre-pandemic level. Of course, this is not a given. Inertia is a powerful economic force, so it may be the case that even if we return to roughly pre-pandemic conditions, the profit share will remain elevated. But it is still plausible that we would return to pre-pandemic shares. That would increase the likelihood of price reversals like what we have already seen with televisions and may be now seeing with used vehicles.

There is one other point that has been largely neglected in the comparisons with the 1970s inflation. In the 1970s, there was a sharp slowdown in productivity growth. Productivity had been growing at close to 2.5 percent annually in the quarter century from 1947 to 1972. This allowed for rapid wage growth, with wages rising roughly in step with productivity for most workers. This changed in the seventies, with productivity growth falling to just over 1.0 percent annually from 1972 to 1980.

By contrast, we have seen a rise in productivity growth in the last three years, with the rate of growth increasing from just over 0.7 percent annually, between the fourth quarter of 2010 and the fourth quarter of 2018, to a 2.3 percent pace in the years from the fourth quarter of 2018 to the fourth quarter of 2021. This acceleration in productivity growth should allow for healthy real wage growth without inflation.

Trends in productivity growth are notoriously unpredictable, with few economists having expected the major breaks in trend in the post-war era. But it is encouraging that we have seen strong productivity growth through the pandemic, with businesses finding ways to innovate around unpredictable disruptions to supply chains, as well as their workforce. In this respect, it is worth noting that real output is now higher in restaurants than before the pandemic, even though aggregate hours worked in the sector is 7.2 percent lower than before the pandemic.

Rent and House Prices

While we may be getting some good news on price trends with a wide range of goods, in recent months we have been seeing an acceleration in the rate of rent increases. This could be a big factor increasing inflation since the rental components accounts for more than 31 percent of the overall CPI and almost 40 percent of the core CPI.

The underlying issue in higher rents and house sales prices (house prices have been rising at more than double-digit rates since the start of the pandemic), is a dozen years of extraordinarily weak construction following the collapse of the housing bubble in 2006 to 2009. The economy recovered very slowly from the collapse of the bubble, but when the labor market began to look more normal in the five years prior to the pandemic, rent began to outpace the overall rate of inflation. The rise in rents and sales prices did lead to an increase in housing construction, but the pace of construction was likely still below the growth of demand.

The pandemic aggravated the imbalance in the housing market through several different channels. First, and most obviously, the plunge in mortgage interest rates made it far cheaper for people to buy homes. With the mortgage rate bottoming out at under 3.0 percent, prospective home buyers could afford to pay far more for a house.

Another factor pushing house prices higher was the increase of remote work. Tens of millions of people began to work from home during the pandemic. This meant that they needed more space in their house to accommodate a home office. They also had additional money to pay for rent or a mortgage, since they were saving a large amount of money on commuting costs.  It’s not clear how enduring the increase in remote work will be, but it is virtually certain that millions of additional workers will be working remotely, at least part-time, even after the pandemic.

A third factor that boosted housing demand was the eviction moratorium that went in place in April of 2020 and lasted until September, 2021. In an ordinary year, there are close to 1 million evictions. This number fell by more than half during the moratorium. While there were warnings of an explosion in evictions when the moratorium ended, there was no huge surge, even as the rate of evictions moved closer to normal.

It is not good to see people evicted from their home, but keeping tenants in their home does reduce the number of units that are coming on the market. The moratorium helped increase the demand for housing over the last two years.

In the four years from the fourth quarter of 2017 to the fourth quarter of 2021, the number of occupied units increased by more than 7.2 million. By contrast, in the prior four years the number of occupied units increased by only 5.2 million units. This is likely a big part of the story of the run-up in both sales prices and rents, as vacancy rates fell to near record low levels.

However, we may be reaching a turning point in the housing market as well. The Fed’s moves on interest rates have the most direct impact on the housing market. Even though the federal funds rate has risen by just 0.25 percent, the interest rate on 30-year mortgages has already gone up by more than 2.0 percentage points from its pandemic low.

It is still early to get good data on the impact of this rise mortgage rates, but there is evidence that it has already substantially slowed the housing market. Applications for purchase mortgages are down by double-digit amounts from their year ago level. There is also considerable anecdotal evidence of realtors reporting a qualitative shift in the market, with many sellers now making cutting prices from their original listing price.

Another factor that can put downward pressure on sales prices and rents would be an increase in the rate of housing completions. The rate of housing construction rose sharply in the pandemic, rising from less than 1.3 million in 2019, to close to 1.8 million in recent months. However, there has been no comparable increase in the rate of housing completions, which is still running at just over 1.3 million annual rate.

The gap is another aspect of the supply chain crisis. Builders are finding it difficult to get the materials they need to complete a home. There are shortages of everything from lumber to garage doors. If we can resolve supply chain issues, the gap between starts and completions should close quickly. It will take several years to make up the shortfall in supply resulting from more than a decade of severe under building, but increasing completions by 500,000 to 600,000 a year should help to alleviate the severe shortages being seen in many areas.

In short, there are important factors on both the demand and the supply side that should alleviate the upward pressure on rents and house sale prices. There is always a considerably amount of inertia in the housing market, but we may not see as a high rate of rental inflation as many analysts are now expecting.

In sum, there is a plausible story whereby inflation begins to come down in the not distant future. In this scenario, instead of seeing a wage-price spiral, we see inflation gradually fall back to levels that most of us would feel comfortable with.

The Bad Inflation Story

We can hope for the good inflation story, but there is also the bad one that needs to be taken seriously. In this view, we are already seeing a wage-price spiral. High inflation is changing people’s expectations, with workers now looking to get higher wage increases to compensate for the high inflation of the prior year. A round of wage increases that compensate for last year’s inflation will put more upward pressure on prices. This sequence continues, with inflation rates getting to ever more unacceptable levels.

The seventies inflation was eventually broken by the Fed pushing its overnight interest rate to more than 20.0 percent. This led to a steep recession in 1981-1982, with the unemployment rate peaking at just under 11.0 percent.

The recession brought down inflation by forcing workers to take pay cuts. With double-digit unemployment, few workers had the bargaining power to secure wage gains that kept pace with inflation. This reduced cost pressure and led to a rapid drop in the inflation rate to a more moderate pace.

It is important to recognize that this is a process involving enormous pain for tens of millions of people. The media have been full of reports of people who have trouble paying for gas and food with the recent rise in prices. In fact, most workers have had pay increases that have roughly kept pace with inflation since the pandemic, with pay for most workers at the bottom end of the wage distribution actually outpacing inflation.

However, if the Fed brings on a serious recession to combat inflation, many of the people in these news stories, who are now struggling to pay for food and gas, will be unemployed, or at least will have endured a stretch of unemployment. (Most spells of unemployment are relatively short.) Those who have jobs will likely not be getting pay increases that keep pace with whatever rate of inflation the economy is seeing at the time. Their ability to demand higher pay from their employer, or to seek a new job, will be severely limited by high unemployment. In other words, the process whereby inflation is brought down, will not be good news for them.

This point is important to keep in mind. There is not a simple and painless way to bring down the inflation rate through interest rate hikes by the Fed. It is not just a matter of turning down the thermostat a few notches. The rate hike put in place in March, coupled with a commitment to further hikes over the course of the year, has cooled down the housing market in a way that was necessary. It will also have a modest impact in slowing inflation in other sectors.

But the sort of rate hikes put in place by the Volcker Fed at the start of the 1980s would, at least in the short-term, make life far worse for the bulk of the population, even if there may be longer term benefits in the form of a lower and stable inflation rate. Everyone should be very clear on this point.

The Pandemic and the War Created Inflation and There Is No Simple Way to Bring it Down

The main points here are that the rise in the inflation rate as the economy reopened from the pandemic was overwhelmingly the result of inherent problems with reopening, and now disruptions created by the war in Ukraine. We can see this by virtue of the fact that most of Europe is now seeing comparable inflation rates. The stimulus provided by the Biden administration undoubtedly increased the inflation rate somewhat, but we would still be seeing uncomfortably high rates of inflation, along with higher unemployment, even without this stimulus.

There are reasons for thinking that the inflation rate will slow sharply as supply chain problems get resolved. We have already seen this sort of price reversal with some items, most notably televisions, where a sharp price last summer has been completely reversed in the last seven months. While the Biden administration can try to help in working through supply chain bottlenecks, there is no simple way to resolve this problem.

There is also no happy alternative path to lowering inflation. The route pursued by the Fed under Volcker subjected tens of millions of workers to unemployment. The mechanism was to undermine workers’ bargaining power, so that they would be forced to take real wage cuts. If people are struggling now to pay for gas and milk, their situation will not be improved if they lose their jobs and/or get lower real wages when they are working.

 

[1] FWIW, it seems unlikely that much Russian oil would be removed from world markets. Even if European countries join the United States in boycotting Russian oil, it would most likely be sold to other countries, most importantly India and China. The net effect on world supplies is likely to be limited.

[2] It is worth noting that demand for cars and other big-ticket items is to some extent self-limiting. People who bought a car or refrigerator in 2020 or 2021 are unlikely to buy another one in 2022.

Inflation has stayed higher longer than I expected. I got that one wrong. I am happy to acknowledge my mistake, but I also want to know the reason why. This is not a question of finding excuses, I want to know why the economy is acting differently than I thought it would.

The most obvious reason is the supply chain disruptions that led to the original jump in prices have lasted longer and been more far-reaching than I expected. Part of this is due to the persistence of the pandemic, with the delta and omicron strains disrupting economies around the world.

The other major source of disruption is Russia’s invasion of Ukraine. This has blocked the supply of many items manufactured in Ukraine, but more importantly, the war reduces its ability to grow and sell wheat and other crops on world markets. There is also the risk of losing Russia’s oil and gas, which propelled oil prices to levels not seen in more than a decade.[1] 

The idea that inflation would spike under such circumstances should not be surprising. As has been widely noted, the jump in inflation was worldwide, not just in the United States. The increase in the inflation rate was comparable in the European Union and the United Kingdom, so it obviously was not just a story of excessive stimulus in the United States. The break-even inflation rate on German 10-year government bonds are now essentially the same as in the United States, indicating that investors expect inflation in the two countries to be roughly the same over this period.

The logic here should not be hard to understand. The normal delivery of goods and services was disrupted by the pandemic. Since overall demand did not drop to anywhere near the same extent (due to various stimulus measures), we had shortages of many items, leading to sharp increases in prices.

While there were jumps in demand at various points during the pandemic, associated with the timing of stimulus payments, overall growth has not been extraordinary. Real consumption expenditures for February of 2022 (the most recent month for which we have data) were 4.6 percent higher than they were two years ago, a 2.3 percent annual rate of growth.

The problem has been, and still is, a huge shift from consumption of services to consumption of goods, due to the pandemic. While service consumption was still slightly below its pre-pandemic level in February of 2022, consumption of nondurable goods was up 11.8 percent, a 5.9 percent annual rate of growth. Consumption of durable goods grew even more rapidly, rising 22.6 percent, a 10.7 percent rate of growth.

This jump in demand would have been difficult for the economy to meet even without pandemic-related, and now war-related, supply issues, but definitely overstretched capacity given where the economy is at present. If the pandemic continues to wane, it should mean that consumption will continue to switch back towards services. It should also mean a reduction in pandemic-related supply disruptions, although disruptions associated with the war may continue and could grow worse.

The Optimistic Route to Lower Inflation

It is important to recount the route to the surge in inflation, since it matters for our prospects for reducing inflation. Recounting our historical track record in bringing inflation down after surges that came from fundamentally different sources is not necessarily useful in describing our prospects for bringing down the current inflation spike.

The optimistic path for lowering inflation would be for an end to the supply chain issues that pushed inflation higher. This means an end to the backlogs at ports, an end to the shortage of truckers, and an end to COVID-19-related shutdowns in China and other manufacturing locations. Also, the shift back to services will reduce the extent to which demand for goods is exceeding the economy’s ability to supply them.[2]

The story would be that when these disruptions are ended, or at least ameliorated, the prices of many items would stop rising and even come back down. This should not sound far-fetched. Televisions provide a great example. The price of televisions had been falling gradually for decades. It suddenly surged 8.7 percent in the five months from March of 2021 until August. The index then turned around and fell sharply, so that it’s now lower than it had been in March of last year.

We may also be seeing this story now with used cars and trucks. Used vehicles prices rose 41.2 percent from February 2021 to February 2022, adding 1.1 percentage points to the overall inflation rate. (New vehicle prices rose 12.4 percent over this period, adding 0.5 percentage points to the inflation rate over the year.) Used vehicle prices fell 3.8 percent in March, after dropping 0.2 percent in February. A private index shows an even sharper drop in used vehicle prices, dropping 6.3 percent since its peak in January.

If we don’t see another resurgence of the pandemic, and the war in Ukraine doesn’t escalate further, these sorts of price reversals may be the norm. A wide range of goods that saw sharp increases in price during the pandemic may experience rapid price declines as the economy normalizes further and supply chain problems are overcome.

Apart from the small number of cases where prices are now falling, there is a more general reason why we might expect these price reversals to be common. Prices have hugely outpaced costs during the pandemic. This has led to a large shift from wages to profits, with the profit share of corporate income rising by more than two percentage points since the pandemic began.

If we think that the conditions of competition have not changed in most sectors since the start of the pandemic, it is reasonable to think that the labor and capital shares will return to their pre-pandemic level. Of course, this is not a given. Inertia is a powerful economic force, so it may be the case that even if we return to roughly pre-pandemic conditions, the profit share will remain elevated. But it is still plausible that we would return to pre-pandemic shares. That would increase the likelihood of price reversals like what we have already seen with televisions and may be now seeing with used vehicles.

There is one other point that has been largely neglected in the comparisons with the 1970s inflation. In the 1970s, there was a sharp slowdown in productivity growth. Productivity had been growing at close to 2.5 percent annually in the quarter century from 1947 to 1972. This allowed for rapid wage growth, with wages rising roughly in step with productivity for most workers. This changed in the seventies, with productivity growth falling to just over 1.0 percent annually from 1972 to 1980.

By contrast, we have seen a rise in productivity growth in the last three years, with the rate of growth increasing from just over 0.7 percent annually, between the fourth quarter of 2010 and the fourth quarter of 2018, to a 2.3 percent pace in the years from the fourth quarter of 2018 to the fourth quarter of 2021. This acceleration in productivity growth should allow for healthy real wage growth without inflation.

Trends in productivity growth are notoriously unpredictable, with few economists having expected the major breaks in trend in the post-war era. But it is encouraging that we have seen strong productivity growth through the pandemic, with businesses finding ways to innovate around unpredictable disruptions to supply chains, as well as their workforce. In this respect, it is worth noting that real output is now higher in restaurants than before the pandemic, even though aggregate hours worked in the sector is 7.2 percent lower than before the pandemic.

Rent and House Prices

While we may be getting some good news on price trends with a wide range of goods, in recent months we have been seeing an acceleration in the rate of rent increases. This could be a big factor increasing inflation since the rental components accounts for more than 31 percent of the overall CPI and almost 40 percent of the core CPI.

The underlying issue in higher rents and house sales prices (house prices have been rising at more than double-digit rates since the start of the pandemic), is a dozen years of extraordinarily weak construction following the collapse of the housing bubble in 2006 to 2009. The economy recovered very slowly from the collapse of the bubble, but when the labor market began to look more normal in the five years prior to the pandemic, rent began to outpace the overall rate of inflation. The rise in rents and sales prices did lead to an increase in housing construction, but the pace of construction was likely still below the growth of demand.

The pandemic aggravated the imbalance in the housing market through several different channels. First, and most obviously, the plunge in mortgage interest rates made it far cheaper for people to buy homes. With the mortgage rate bottoming out at under 3.0 percent, prospective home buyers could afford to pay far more for a house.

Another factor pushing house prices higher was the increase of remote work. Tens of millions of people began to work from home during the pandemic. This meant that they needed more space in their house to accommodate a home office. They also had additional money to pay for rent or a mortgage, since they were saving a large amount of money on commuting costs.  It’s not clear how enduring the increase in remote work will be, but it is virtually certain that millions of additional workers will be working remotely, at least part-time, even after the pandemic.

A third factor that boosted housing demand was the eviction moratorium that went in place in April of 2020 and lasted until September, 2021. In an ordinary year, there are close to 1 million evictions. This number fell by more than half during the moratorium. While there were warnings of an explosion in evictions when the moratorium ended, there was no huge surge, even as the rate of evictions moved closer to normal.

It is not good to see people evicted from their home, but keeping tenants in their home does reduce the number of units that are coming on the market. The moratorium helped increase the demand for housing over the last two years.

In the four years from the fourth quarter of 2017 to the fourth quarter of 2021, the number of occupied units increased by more than 7.2 million. By contrast, in the prior four years the number of occupied units increased by only 5.2 million units. This is likely a big part of the story of the run-up in both sales prices and rents, as vacancy rates fell to near record low levels.

However, we may be reaching a turning point in the housing market as well. The Fed’s moves on interest rates have the most direct impact on the housing market. Even though the federal funds rate has risen by just 0.25 percent, the interest rate on 30-year mortgages has already gone up by more than 2.0 percentage points from its pandemic low.

It is still early to get good data on the impact of this rise mortgage rates, but there is evidence that it has already substantially slowed the housing market. Applications for purchase mortgages are down by double-digit amounts from their year ago level. There is also considerable anecdotal evidence of realtors reporting a qualitative shift in the market, with many sellers now making cutting prices from their original listing price.

Another factor that can put downward pressure on sales prices and rents would be an increase in the rate of housing completions. The rate of housing construction rose sharply in the pandemic, rising from less than 1.3 million in 2019, to close to 1.8 million in recent months. However, there has been no comparable increase in the rate of housing completions, which is still running at just over 1.3 million annual rate.

The gap is another aspect of the supply chain crisis. Builders are finding it difficult to get the materials they need to complete a home. There are shortages of everything from lumber to garage doors. If we can resolve supply chain issues, the gap between starts and completions should close quickly. It will take several years to make up the shortfall in supply resulting from more than a decade of severe under building, but increasing completions by 500,000 to 600,000 a year should help to alleviate the severe shortages being seen in many areas.

In short, there are important factors on both the demand and the supply side that should alleviate the upward pressure on rents and house sale prices. There is always a considerably amount of inertia in the housing market, but we may not see as a high rate of rental inflation as many analysts are now expecting.

In sum, there is a plausible story whereby inflation begins to come down in the not distant future. In this scenario, instead of seeing a wage-price spiral, we see inflation gradually fall back to levels that most of us would feel comfortable with.

The Bad Inflation Story

We can hope for the good inflation story, but there is also the bad one that needs to be taken seriously. In this view, we are already seeing a wage-price spiral. High inflation is changing people’s expectations, with workers now looking to get higher wage increases to compensate for the high inflation of the prior year. A round of wage increases that compensate for last year’s inflation will put more upward pressure on prices. This sequence continues, with inflation rates getting to ever more unacceptable levels.

The seventies inflation was eventually broken by the Fed pushing its overnight interest rate to more than 20.0 percent. This led to a steep recession in 1981-1982, with the unemployment rate peaking at just under 11.0 percent.

The recession brought down inflation by forcing workers to take pay cuts. With double-digit unemployment, few workers had the bargaining power to secure wage gains that kept pace with inflation. This reduced cost pressure and led to a rapid drop in the inflation rate to a more moderate pace.

It is important to recognize that this is a process involving enormous pain for tens of millions of people. The media have been full of reports of people who have trouble paying for gas and food with the recent rise in prices. In fact, most workers have had pay increases that have roughly kept pace with inflation since the pandemic, with pay for most workers at the bottom end of the wage distribution actually outpacing inflation.

However, if the Fed brings on a serious recession to combat inflation, many of the people in these news stories, who are now struggling to pay for food and gas, will be unemployed, or at least will have endured a stretch of unemployment. (Most spells of unemployment are relatively short.) Those who have jobs will likely not be getting pay increases that keep pace with whatever rate of inflation the economy is seeing at the time. Their ability to demand higher pay from their employer, or to seek a new job, will be severely limited by high unemployment. In other words, the process whereby inflation is brought down, will not be good news for them.

This point is important to keep in mind. There is not a simple and painless way to bring down the inflation rate through interest rate hikes by the Fed. It is not just a matter of turning down the thermostat a few notches. The rate hike put in place in March, coupled with a commitment to further hikes over the course of the year, has cooled down the housing market in a way that was necessary. It will also have a modest impact in slowing inflation in other sectors.

But the sort of rate hikes put in place by the Volcker Fed at the start of the 1980s would, at least in the short-term, make life far worse for the bulk of the population, even if there may be longer term benefits in the form of a lower and stable inflation rate. Everyone should be very clear on this point.

The Pandemic and the War Created Inflation and There Is No Simple Way to Bring it Down

The main points here are that the rise in the inflation rate as the economy reopened from the pandemic was overwhelmingly the result of inherent problems with reopening, and now disruptions created by the war in Ukraine. We can see this by virtue of the fact that most of Europe is now seeing comparable inflation rates. The stimulus provided by the Biden administration undoubtedly increased the inflation rate somewhat, but we would still be seeing uncomfortably high rates of inflation, along with higher unemployment, even without this stimulus.

There are reasons for thinking that the inflation rate will slow sharply as supply chain problems get resolved. We have already seen this sort of price reversal with some items, most notably televisions, where a sharp price last summer has been completely reversed in the last seven months. While the Biden administration can try to help in working through supply chain bottlenecks, there is no simple way to resolve this problem.

There is also no happy alternative path to lowering inflation. The route pursued by the Fed under Volcker subjected tens of millions of workers to unemployment. The mechanism was to undermine workers’ bargaining power, so that they would be forced to take real wage cuts. If people are struggling now to pay for gas and milk, their situation will not be improved if they lose their jobs and/or get lower real wages when they are working.

 

[1] FWIW, it seems unlikely that much Russian oil would be removed from world markets. Even if European countries join the United States in boycotting Russian oil, it would most likely be sold to other countries, most importantly India and China. The net effect on world supplies is likely to be limited.

[2] It is worth noting that demand for cars and other big-ticket items is to some extent self-limiting. People who bought a car or refrigerator in 2020 or 2021 are unlikely to buy another one in 2022.

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