Inflation in G20 Countries

Most recent annual rates, compiled by Trading Economics. The US is right in the middle:

Argentina 109%
Turkey 43.7%
United Kingdom 8.7%
Italy 8.2%
Germany 7.2%
Australia 7%
Euro Area 7%
South Africa 6.8%
Mexico 6.3%
France 5.9%
Singapore 5.7%
Netherlands 5.2%
United States 4.9%
India 4.7%
Canada 4.4%
Indonesia 4.3%
Brazil 4.2%
Spain 4.1%
South Korea 3.7%
Japan 3.5%
Saudi Arabia 2.7%
Switzerland 2.6%
Russia 2.3%
China 0.1%

Regulation and Delayed Updates: Why Services Inflation Will Likely Stay High

Apart from some possible geopolitical upset (and theater with the debt ceiling), the Big Issue for the larger economy, and for investing decisions, remains how fast inflation will decline – since that governs how soon the Fed can relent on keeping interest rates high. Those high interest rates are having all kinds of knock-on effects, including bank failures and suppressed home sales.

The investing market seems to be pricing in expectations of significant Fed rate cuts before the end of 2023, which in turn presupposes that inflation will have ratcheted downwards far enough by then to allow the Fed to declare victory. Goods inflation (= mainly stuff made in China) has declined nicely, but services (which comprise the majority of household spending) remains high. It is coming down, but too slowly to realistically hit the Fed’s 2% target this year.

In an article in the Seeking Alpha site title Services Inflation Is Stuck, the investment firm Blackrock notes some technical factors that will likely keep services inflation high for at least the remainder of this year. I will paste in their text in italics:

Core Services ex-Shelter inflation is a bit of a hodgepodge that includes things like medical care services, video and audio services, tuition, and insurance. It comprises roughly a quarter of the CPI basket and, importantly for the Fed, is very domestically oriented.

A key insight from this article is that nearly two-thirds of this key “Core Services ex-Shelter” component consists of:

(1) Service prices that are regulated (especially insurance), and

(2) Services with infrequent price resets (such as tuition and especially medical services):

There are technical factors that make it likely that these particular items will see ongoing, sticky inflation:

Impact of Regulated Prices

Regulated prices tend to be more discrete and more lagged in their changes due to bureaucratic delays and their negotiated nature. Some types of regulated prices, like postage or water and sewage fees, are easily recognizable as subject to government regulation. Somewhat less intuitive is the degree to which insurance in the United States is a regulated price. Insurance comprises the largest share of Core Services ex-Shelter basket and state-level insurance commissioners play important roles in negotiating auto, property, and casualty insurance price changes.

The underwriting costs of insurance have been surging globally – a combination of higher reinsurance premiums, inflated asset values, and more natural disasters. These rising costs have only just begun to flow through into consumer prices; auto insurance costs were an upside surprise within March’s CPI report.

Jumps in Medical and Education Prices Will Appear Later

Though the market has been fixated on the painstaking details of the month-over-month inflation prints, many of the sub-components of the CPI do not update monthly. Two of the more important items within the core services basket – medical care services and tuition – only update their prices annually. Coincidentally, updates for both of these categories take place in the autumn, and both are set to rise strongly.

Medical care services are the largest component (28%) of Core Services ex-Shelter, but have a complex and lagged computation and update only once a year in October. Medical services inflation has been negative since last October as a consequence of excess consumer demand for post-pandemic doctors’ visits, however, we expect this mechanical effect will abate later this year and thereafter lift core services inflation.

Tuition is another example of a service with intermittent price resets, given prices are set on the basis of the academic year. We expect the broad-based upward wage pressure in education to be passed through to higher education consumer prices later this year when students return to school.

And so…I expect “higher for longer” inflation and interest rates.

Inflation and GDP Growth in the G7 Revisited

In August 2022, I wrote a post showing that among G7 nations, the US had the highest inflation during the pandemic, but also the highest rate of real economic growth. But since the economic situation is evolving rapidly, I wanted to update that data from mid-2022 (I also use core inflation, but I’ll use total inflation in this post).

Here’s how inflation has looked during the pandemic:

While the US had the most cumulative inflation for much of the pandemic, the cooling of inflation in the US and the acceleration in Europe has changed things a bit. By late 2022, the UK and Italy had caught up to the US, and Germany is closing in too. These countries have cumulative inflation of between 15 and 17 percent since January 2020.

Japan looks to be the winner here. But wait, we don’t only care about low and stable inflation. We also want economic growth. Here’s the data through the 4th quarter of 2022 (we’ll start to get 2023q1 data from countries next week):

By this measure, the US comes out as the clear winner, with real GDP being about 5 percent higher than the end of 2019. That might not sound impressive for 3 years of growth, until you realize that 5 of the 7 nations had growth below 2 percent, with Germany and the UK actually still smaller than the end of 2019! And this doesn’t take account of the cumulative losses. Notice that the US had the second smallest dip in 2020q2 as well.

It’s hard to know exactly what the right non-COVID counterfactual would be, since these countries all had different rates of growth before the pandemic. But adding up the GDP scaled to 100 before the pandemic, the US is the only G7 country where these 12 quarters of data add up to more than 1,200. The other countries haven’t even had enough growth since the 2020 recession to make up for the losses during the recession, to say nothing of what their potential growth would have been. Japan comes the closest to making up the losses, while the UK stands out as the worst.

Here’s the figures for all the G7 countries, with 100% meaning they have had enough growth to offset the losses from the 2020 recession:

US: 100.8%

Japan: 99.3%

Canada: 98.6%

Germany: 98.0%

France: 97.1%

Italy: 96.9%

UK: 94.5%

Workers Finally Get a Real Annual Raise

Back in December I pointed out that, thanks to slowing inflation, real wages had been rising since June 2022 (using either the CPI or the PCEPI for inflation adjustments).

With the latest monthly data, we can now report more good news for wage earners: CPI-adjusted wages have increased over the past 12 months. That had happened since 2021. In the past 12 months, wages of production and non-supervisory workers are up 5.1%, just a hair more than the annual increase in the CPI of 5.0%. It’s not much, and we’re not back to our pre-pandemic norm of 2% real wage growth. But it is more good news that we may finally getting past our post-COVID inflationary hangover.

Job Market Still Red-Hot; Inflation and High Rates Not Going Away Soon

As noted earlier, the main driver in inflation since 2021 has not been supply chain issues, but ongoing wage increases in (mainly) the service industry, fueled by a tight labor market. Some headlines note recent decreases in job openings, etc., suggesting that the end of inflation is near. The point of this post is that measures of labor market tightness remain at very high levels, and so it will be a while yet before the Fed can claim victory over inflation and start meaningfully reducing interest rates.

Below I will post a set of charts (courtesy of Seeking Alpha article by Wolf Richter) which make the following point: most measure of labor tightness remain at least as high as they were in late 2019, just before the pandemic hit. It is true that things have loosened up in the past few months, but that just means the labor market has gone from white-hot to merely red-hot. Let the data speak:

We hold that the current  tightness of the labor market is largely a result of pandemic policies which incentivized a whole tranche of experienced workers to take early retirement and also put lots of cash in our pockets which we are spending generously on services .  Those workers are not coming back, but at some point in the next 1-2 years the excess Covid cash will run out and we may finally get the long-expected recession. But if the government rushes in with enhanced unemployment benefits to ease the recession pain, we would expect inflation to remain well above the nominal 2% target

Whiteboard Macroeconomics

There’s nothing that economists love more than a good blackboard (or in modern times, a whiteboard) to work out some basic models of how we think the world works. Supply and demand rules in microeconomics, but macroeconomics has a few good blackboard models too.

So I was excited to see when a member of Congress was using a whiteboard to work through some basic economic logic, as Rep. Katie Porter did in this video she tweeted using the textbook macroeconomics aggregate demand and aggregate supply model:

However, while I haven’t taught macroeconomics in about a decade, it seems there are a few flaws in her analysis. Flaws enough that this probably wouldn’t get a passing grade on an oral exam. I could detail them myself, but… I will leave this to the readers as an exercise! For fun, even if you don’t think this is the best model in the world, just assume it’s a good model. What did Rep. Porter miss? Leave a comment.

The Allure of Overconfidence

I say what economists are supposed to say. I tell everyone who will listen that they should invest in index funds and then don’t check their balances. I explain that abnormal returns stem from abnormal information. Individuals are unlikely to have abnormal insight about publicly traded companies because other people have more time and resources to find that information. Further, even if a professional has abnormal insight, it’s not likely to persist over time. Index funds get around the problem of idiosyncratic risk and the brevity of abnormal insight by riding on the back of the more informed. I say all of this and I believe it in my heart.

I teach macroeconomics and I’ve published about asset volatility. I know more about inflation and the macroeconomy than the typical investor. From mid-2020 through now the S&P500 has gained 11.3% annually. My personal return has been 21% annually. It’s true, however, that the first half of 2022 was rough. But I can’t help but feel happy and confident.*

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Why Have Economists Continually Underestimated Projected Inflation?

I keep reading about how inflation has peaked (even peaked many months ago) and so any minute now the Fed will relent on raising interest rates, and will in fact start reducing them. Every data point that seems to support an early Fed pivot and a gentle “soft landing” for the economy is greeted with optimistic verbiage and a rip higher in stocks.

Except – – other meaningful data points regularly appear which show that inflation (especially core inflation) is remaining stubbornly high. The Personal Consumption Expenditures (PCE) Index is the Fed’s preferred way to track core inflation. It did peak in early 2022, and is falling, but very slowly and fitfully. Just when it seems like it is about to cascade downward, along comes another uptick.  The latest report for 02/24/23 showed the PCE index (excluding the volatile categories of food and energy) increasing 0.6 percent during the month of January, which translated to a 4.7 percent year-on-year gain. That was considerably higher than the 0.4 percent monthly gain (4.3 percent year-on-year) that economists expected.

Source: MV Financial

The chart below illustrates the chronic tendency of the economists at the Fed to lowball the estimates of future inflation. Each of the ten bars depicts quarterly projections of what inflation would be for 2023, starting back in September 2020 (first, green bar).  No one in the craziness of 2020 could be held particularly responsible back then for accurately projecting 2023 conditions. But the Fed embarrassed themselves badly into late 2021 by airily dismissing inflation as “transitory”, due mainly to supply chain constraints that would quickly pass. (See towards the middle of the chart, yellow Sept 2021 and blue Dec 2021 bars projecting a mere 2.2% inflation for 2023.)

Source: Jeremy LaKosh

Only as of December 2022 did estimates of inflation jump up to 3.1% for 2023, and that estimate will surely get revised upward even further.

Many factors probably went into this systematic failure on the part of the Fed economists. There are probably political reasons for erring on the rosy optimistic side, which I will not speculate on here.

One factor in particular was mentioned in the Minutes of the Jan 31/Feb 1 Fed meeting that I thought was significant:

A few participants remarked that some business contacts appeared keen to retain workers even in the face of slowing demand for output because of their recent experiences of labor shortages and hiring challenges.

Jeremy LaKosh notes regarding this feature, “If true across the economy, the idea of keeping employees for fear of facing the labor force shortage would represent a fundamental shift in the employment market. This shift would make it harder for wage increases to mitigate towards historical norms and keep upward pressure on prices.”

This all rings true to my anecdotal observations. In bygone days, when business slowed down, factories would lay off or furlough workers, with the expectation on all sides that they would call the workers back (and the workers would come back) when conditions improved. However, employers have had to struggle so hard this past year to find willing/able workers, that employers are loath to let them go, lest they never get them back. I have read that even though homebuilders are not sure they can sell the houses they are building, they are so worried about losing workers that they are keeping them on the payroll, building away.

Other inflation data points show big decreases in prices for goods (and energy), but not for services. Wages, of course, are the big driver for service costs.

So the inflation story in 2023 seems to come down largely to a labor shortage. This is a large topic cannot be fully addressed here. I will mention one factor for which I have anecdotal support, that the enormous benefits (stimulus money plus enhanced unemployment) paid out during 2020-2021 set up a large number of baby boomers to leave the workforce early and permanently. Studies show that this is a major factor in the drop in workforce participation rate post-Covid. Maybe some of those folks had not planned ahead of time for such early retirement, but they got a taste of the good life (NOT getting up and going to work every day) in 2020-2021 along with the extra cash to pad their savings, and so they decided to just not return to work. That exodus of trained and presumably productive workers has left a hole in the labor force which now manifests as a labor shortage, which drives up wages and therefore inflation and therefore interest rates, which will eventually crater the economy enough that struggling firms will finally lay off enough workers to mitigate wage gains.

I wonder if this unhappy scenario could be staved off with increased legal migration of targeted skilled workers from other countries to alleviate the labor shortage. Dunno, just a thought.

Twenty Years of Animal Protein Affordability

Have you heard the hubbub about eggs? People say that they’re expensive. My wife told me that if she’s going to pay an arm and a leg, then she may as well get the organic, pasture raised eggs. Absolutely. That’s what the substitution effect predicts. As the price ratio of low-quality to high-quality eggs rises, we’re incentivized to consume more of the high-quality version. It has to do with opportunity costs.

Consider a world in which the low-quality eggs cost $2 and the high-quality eggs cost $6 per dozen. Every high-quality egg costs 3 low-quality eggs. You might still choose the high-quality option, but you know that you’re giving up a lot by doing so. Consider the current world where low-quality eggs are priced on par with high-quality eggs. Now, the opportunity cost of consuming the fancy, pasture-raised eggs has fallen. When consuming one high-quality egg costs you one low-quality egg, it’s much easier to opt for the high-quality version. You’re not giving up as much when you purchase it.

For vegetarians, the recent price swing has probably been rough. Not eating meat, they’re facing the price squeeze more so than their omnivorous counterparts. Through the magic of math, median wages, and average retail prices, the figure below charts the affordability of eggs and dairy products.* The median person has been facing falling egg affordability for two decades. Indeed, it’s only been the past few years, punctuated by the Covid crisis, that consumers experienced more affordable eggs.

Dairy products, however, have become much more affordable. The median American can now afford 50% more of their namesake cheese. Further, we can afford 20-25% more whole milk and cheddar cheese. So, the vegetarians are not so poorly off after all.

But how do meatier sources of protein compare?

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Bulls and Bears Spar Over Pace of Inflation Decline and Rate Cuts

The stock market drools and rips higher at the slightest sign that inflation is abating, since that portends rate cuts instead of rate hikes by the Fed, and a return to the golden days of easy money. But what do the latest data show? Here I’ll show several charts to show what we know so far.

First, regarding U.S. inflation, here are a pair of charts from a raging bull article by Dan Victor titled The Fed Pivot Debate And Why Bulls Are Winning.

The last couple months’ data points in the lower chart show that inflation (as estimated by CPI) has essentially leveled out and may be starting to decline a little.  That is fine but it still leaves inflation far above the Fed’s 2% target. Victor defines a Fed “pivot” not as actually cutting rates, but simply a halt to raising them. By that somewhat anemic definition, sure, a Fed pivot could well come in the next few months. But that leaves rates still very high by recent standards.  The real question is when will inflation come down low enough to justify significant rate cuts. The Fed screwed up so abysmally last year with its ridiculous “this inflation is only transitory supply chain issues” that they really cannot afford to relent too soon, and let inflationary psychology take hold.

Side comment: the big “blowout” jobs number for January (last bar on the right, on the top chart above) caused a huge buzz. But there are strong reasons to discount it as an artifact of  “  revisions, adjustments, control factors, and recoding  “, per Jeffrey Snider.

On the other side of the bull/bear divide, Wolf Richter published a glass-half-empty article noting how the Bureau of Labor Statistics recently revised its CPI numbers, and the changes shifted the numbers so as to undermine the argument that inflation has started to drop rapidly:

The chart above with revisions (red line) shows core CPI barely declining over the past 9 months or so, and no trend for an acceleration in that decline. The chart below shows CPI for Services (where we consumers spend most of our money, and which is closely correlated to wages) is holding nearly steady around a red-hot 0.55%/month or about 6.6% annualized. It could be longer than the market thinks before there are substantial rate cuts.

And from the Eurozone, there is this chart, courtesy of Bloomberg via Yahoo, depicting the results of polling economists as to the future course of inflation there:

The consensus view is that inflation in Europe will not approach the 2% target until well into 2024. The European Central Bank is expected to hike by 0.5% in March, followed by another 0.25% to reach 3.25%. (This is much lower than the Fed’s interest rates, but that is probably because the U.S. is still working off the orgy of COVID-related payments that dumped trillions in peoples’ pockets here in 2020-2021). Cuts by the ECB are not expected until the second quarter of 2024.

THIS JUST IN: The January CPI data just came out today (2/14), and pretty much matches up with the picture presented above. Inflation is falling, but ever so slowly, and so it becomes more likely that the Fed will keep its rates higher for longer:

“The Consumer Price Index (CPI) for January showed a 0.5% increase in prices over the past month, an acceleration from the prior reading, government data showed Tuesday. On an annual basis, CPI rose 6.4%, continuing a steady march down from a 9.1% peak last June. Economists had expected prices to climb 6.2% over the year and jump 0.5% month-over-month, per consensus estimates from Bloomberg. …

Core CPI, which strips out the volatile food and energy components of the report, climbed 5.6% year-over-year, more than expected, and 0.4% over the prior month. Forecasts called for a 5.5% annual increase and 0.4% monthly rise in the core CPI reading.”

(For another recent take on the inflation picture, see James Bailey’s The Murky Macro Picture, on this blog).