The March CPI, the Inflation Picture, and the Fed

April 13, 2024

The higher than expected March CPI released on Wednesday freaked everyone out and got the markets convinced we will see fewer, if any, interest rate cuts this year. I have never been a Fed tea leaf reader, and am not about to change professions now, but it will be bad news if the Fed puts off rate cuts that can revitalize the housing market.

The big concern posed by the CPI, following higher-than-expected inflation numbers in January and February, is whether inflation is reaccelerating. We know that rental inflation is still high as an outcome of the surge in working from home at the start of the pandemic.

But we can be very confident that it will slow sharply over the course of the year due to the much slower inflation rate shown in indexes (including the BLS index) measuring rents in units that change hands. This means that rental inflation will not be an ongoing problem that the Fed has to worry about.

However, the recent data have shown an uptick in inflation, even pulling out rent. This is ostensibly the cause for concern.

There are two important points to be made about this uptick. First, it is not unusual to see large jumps, and falls, in CPI inflation excluding rent. Rent is a huge factor in the index, and since the pace of rental inflation changes slowly, it anchors the overall rate. Inflation is much more erratic when rent is excluded as shown below.



Note that there were many points at which inflation in the non-shelter CPI crossed 2.0 percent even in the low-inflation decade preceding the pandemic. In fact, year-over-year inflation in this index hit 2.1 percent in January of 2020, just before the pandemic started. It was at 2.5 percent in July of 2018. So a somewhat above-target reading for the non-shelter CPI should not be a major cause for concern by itself.

However, there is the question of whether the recent uptick reflects underlying trends. Here the story points in the opposite direction.

The day after the CPI report came out, we got a much more benign reading on the Producer Price Index (PPI). The overall figure for the month was 0.2 percent (0.154 to be more precise), with the core also at 0.2 percent. There are differences in coverage and methodology between the CPI and PPI, but inflation in the indexes still track each other closely.

The figure below shows the PPI for services, the PPI for goods, and the CPI.


What is perhaps most striking is how closely the CPI follows the PPI for services. That probably shouldn’t be surprising, since services account for almost two-thirds of the CPI. (It is important to note that the PPI does not include rent, so these are services minus rent.)

When the CPI goes substantially above or below the service component of the PPI it is following movements in the goods component. As can be seen the CPI has been well above the service component in the PPI since May of 2022. The cause here is the supply chain problems that sent goods inflation sky-rocketing a bit more than a year earlier.

The good news in this picture is that the goods component of the PPI has been far below the service CPI for a bit over a year, and for part of this period was even negative. This is just another way of showing the widely noted fact that the prices of supply chain goods have stabilized and in many cases are even falling. This looks likely to continue for the near-term future, especially if we don’t have a policy of blocking cheaper imports with higher tariffs as some presidential candidates are advocating.

The Wage Story

There is another part of the longer-term inflation picture that needs to be included, the slowing of wage growth. Our various wage indices show somewhat different figures for wage growth, but they tell basically the same story. Wage growth accelerated sharply as the economy reopened in the second half of 2020 and especially 2021 and 2022, as employers had to compete to hire and retain workers.

We saw record rates of quits, as workers left jobs that didn’t pay enough, offer advancement opportunities, had unsafe workplaces, or where the boss was a jerk. This is a great story, as workers saw gains in wages that outpaced inflation and workplace satisfaction hit a record high. The gains in wages were especially large for those at the bottom of the wage distribution.

While that is a very bright picture, we could not sustain nominal wage gains of the sort we were seeing in 2021 and the first half of 2022, and still hit the Fed’s 2.0 percent inflation target. Wage growth peaked at roughly 6.0 percent, 2.5 percentage points higher than the rates we were seeing before the pandemic.

To be clear, wages were not driving inflation. There was a shift from wages to profits at the start of the pandemic. It doesn’t make sense to say that wages are the cause of inflation when the profit share is increasing. But it is true that given current rates of productivity growth, we cannot have 6.0 percent wage growth and sustain anything close to a 2.0 percent rate of inflation. (FWIW, I am not a fan of the Fed’s 2.0 percent inflation target, but the Fed is.)

However, wage growth has slowed sharply over the last two years, getting close to its pre-pandemic pace. Again, there are differences by indices, but the pace of wage growth has fallen by roughly 2.0 percentage points, leaving it 0.5 percentage points above its pre-pandemic pace.

One index, the Indeed Wage Tracker, has fallen back to its 2019 rate of wage growth. This index is noteworthy because it measures wages in job postings for new hires. In this sense it can be thought of as being analogous to the new tenant rent indexes that measure the rents of units that turn over.

Just as most people don’t move every month, most people don’t change jobs every month, but we expect the rents of units that don’t turn over to roughly follow the rents of units that do change hands. In the same way, it is reasonable to think that wage patterns of workers who stay in their jobs will roughly follow wage patterns for newly hired workers. The Indeed Wage Tracker is telling us that wage growth has fallen back to a non-inflationary pace. This may take some time to show up in the other wage series, but we can be pretty confident of the direction of change.

Profit Shares and Productivity

There are two other reasons we can be reasonably confident inflation is now under control. The first is that the rise in profit shares at the start of the pandemic has not gone away. In fact, profit shares increased somewhat in the fourth quarter, indicating we are going in the wrong direction.

It is not clear why profit shares continue to rise, and not fall back towards pre-pandemic levels. (Yeah, corporations are greedy, but they have always been greedy.) The increase during the supply-chain crisis was understandable, companies have much more market power when supply is constrained. But unless conditions of competition were permanently altered by the pandemic, it’s hard to see why they would stay elevated, and we certainly should not expect them to continue to rise.

In any case, the rise in the profit share in the fourth quarter, suggests that a lower pace of inflation would be consistent with the wage growth we are now seeing, if the profit share were to remain stable. If the profit share were to fall back towards its pre-pandemic level (which was already well above its level at the start of the century), we could sustain considerably lower inflation with the current pace of wage growth.

In other words, there seems little basis for believing that the current rate of wage growth is inconsistent with the Fed’s 2.0 percent inflation target. In this respect, the Biden administration is on exactly the right track in going after abuses of market power that allow for higher margins, such as attempting to block the merger of the nation’s two largest supermarket chains, Albertson’s and Safeway. Similarly, cracking down on drug companies abusing their government-granted patent monopolies will also have the effect of reducing profit margins.

The other big wildcard in this story is productivity growth. Productivity growth soared in the last three quarters of 2023, averaging 3.7 percent over this period. Productivity growth is notoriously erratic and the data are subject to large revisions. We also have to note that growth was horrible in 2022, actually falling for the year. So, it is far too early to claim we are on a faster growth path. Nonetheless, the recent data are encouraging and it looks like we will have respectable numbers again for the first quarter, although not above 3.0 percent.

Given advances in AI and other technologies, it hardly seems absurd to think we may be seeing a productivity uptick. We are clearly at the very beginning of the uses of many of these technologies, so there will be many gains that we will see down the road.

If we can sustain a faster pace of productivity growth, then we can have faster nominal wage growth and still hit the Fed’s 2.0 percent inflation target. To be clear, I am not talking about a wildly rapid pace of growth, if we can just sustain a 2.0 percent rate, well below the rates we saw in the upturn from 1995 to 2005 and the long Golden Age from 1947 to 1973, then 4.0 percent wage growth would be consistent with 2.0 percent inflation, even after a period in which profit margins shrank somewhat.

Time to Declare Victory and Lower Rates

The long and short here is that it is really time for the Fed to declare victory in its war on inflation and start lowering interest rates. One problem that seems to be delaying rate cuts is that the economy remains strong, leaving Chair Powell and other Fed officials to talk about the situation as a one-sided choice. They see a risk of inflation if they lower rates too much or too soon, but there is little basis for concern about a recession or rising unemployment.

However, that leaves other negative effects of high interest rates out of the equation, most notably their impact on the housing market. The number of existing homes being sold in the last year is down by almost a third from its 2020-21 pace. This means that millions of people who would otherwise be looking to move are being kept in place by the Fed’s high interest rate policy.

Higher interest rates are also a drain on people’s budgets insofar as they have credit card debt or other forms of short-term debt. And it makes it more expensive to buy new or used cars. The rise in interest rates also creates stress on the financial system. This stress led to the failure of Silicon Valley Bank last year, along with several other smaller banks. With luck we won’t see another major round of bank failures this year, but higher rates unambiguously increase the risk.

In short, even if the economy does not need lower rates to sustain a healthy growth path right now, there is a real cost to keeping rates high. It’s time for the Fed to change course.  


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