Not Everything Happens with One Click of a Button

Advancements in technology have shaped our expectations, leading us to anticipate instant results at the click of a button. We've grown accustomed to ordering and receiving food within minutes, reading news in real-time, and instantly sharing amusing content with countless "friends." However, not everything is this simplistic. This reality becomes particularly apparent when considering the consequences of inflation and interest rate increases. Recent releases such as the June Fed meeting minutes, the Labor Department's June jobs report, and today’s Consumer Price Index data release have made it “clear” to regulators and consumers alike that tackling inflation requires more than one “simple” click of a button.

We unknowingly accept a fundamental economic concept: the cost of goods we purchase today will be at least 2% more expensive next year compared to the current year, and we are generally okay with this. However, when our demand for goods keeps increasing, it drives prices up by more than the anticipated 2%. This basic principle of supply and demand economics doesn't require explanation. What I'd like to propose for your consideration is that multiple market conditions are combining to pressure Jerome Powell and the Federal Reserve to enact corrective measures which are hampering the U.S. economy’s return to the commonly accepted 2% inflation target. How did we come to this point exactly?

• We are in a relatively good labor market, with unemployment at 75-year lows.
• Wages continuing to grow at a +4% YoY clip (+4.4% in June 2023 according to the Labor Dept.).
• Consumers have experienced a 20% increase in disposable income in Q2 2023 compared to the same period in 2019, and they are spending it! This rise in disposable income is primarily driven by the strong job market with higher-paying jobs.
• Consumer personal consumption (i.e., the things we buy) is nearly 30% higher today than during the same period in 2019, largely driven by the combo of increased cost of the goods we routine buy (price inflation), and increased employment at higher-paying jobs that allows consumers to afford higher prices.?

I believe these three factors primarily contribute to the high levels of inflation that were already evident in the U.S. economy before the Federal Reserve started to raise interest rates in March of 2022. Both consumers and regulators are caught in this strange cycle simply because of our collective actions. Solving for all three of the above factors simultaneously with a single click of a button is nearly impossible. It is becoming more evident it will take several clicks (i.e., 10+ clicks)

Allow me to present my unpopular opinion: Jerome Powell and his colleagues at the Federal Reserve are making the right call with their rate increases, regardless of their unpopularity or the hardships they entail. I also feel it is crucial for regular consumers like you and me to understand that it takes time for the "positive" results of these painful decisions to manifest. In the June meeting minutes, regulators indicated that the lagged impact of policy efforts was a major contributing to factor in skipping a rate increase at the June meeting. This means the committee is still waiting to see the impacts of their rate increases in the economic data they use to inform their rate decisions.

The graphic above shows that the Federal Reserve aims to keep year-on-year price increases (i.e., inflation) around 2%. However, there have been instances in history when maintaining a 2% rate was unattainable. The early 1980’s is one example. Another is the Great Recession of 2007-2009, where the 12-month year-on-year change in inflation peaked at 5.6% in July 2008, causing widespread panic. In the post-Covid period, the 12-month year-on-year change in inflation reached a staggering 9.1% in June 2022. Fast forward 12 months and following 10 interest rate hikes since March 2022, the year-on-year increase has dropped to 3.0%. Yes, prices are still increasing, but at a much slower rate than 12 months ago. Undoubtedly, higher interest rates are painful and will lead to additional changes in our economic environment (e.g., more interest paid on mortgages, auto loans, and revolving credit card debt, etc.). Nevertheless, the rate increases are necessary to restore the economy to a more normal equilibrium. Here's how I see it:

• The robust labor market will need to soften, but not collapse. More sectors will be impacted by layoffs beyond Tech and Financial Services. These layoffs will trickle into the economy, but not flood it all at once like it did at the outset of Covid. It's important to remember that the 75-year average unemployment rate is approximately ~5.5%, and as of June 2023, unemployment stands at 3.6%. Unfortunately, reaching a 4.25-4.75% unemployment rate will be painful, but it will contribute to a slowdown in spending and help drive prices down.
• The June nonfarm payroll numbers showed an increase of 209,000 jobs, which was ~13% below economists’ expectations. This growth is still strong compared to historical data, but June’s data shows the slowest month for job creation since December of 2020. Despite the number or job openings declining, openings still outnumber available workers by a 1.6-to-1 margin, and the Fed will continue to stress the importance of reducing that disparity as they look to tamp down the demand that pushed inflation higher.
• A decline in available jobs and flat wage growth will result in reduced income to spend on goods and services (aka consumer demand). This decrease will increase supply and subsequently drive down prices for everyday staples like groceries. The question remains regarding how long it will take for those lower prices to begin to filter into everyday life. Current inflation figures show easing in some areas (i.e., whole milk -3.4% YoY in May, and citrus fruits -5.3% YoY), but not in others (i.e., paper products +12.4% YoY, and baby formula +10.1% YoY)

There is compelling data demonstrating the effectiveness of the Fed's efforts in combating inflation. One metric that holds particular significance for the Fed is the Personal Consumption Expenditures Price Index. Unlike the widely acknowledged Consumer Price Index (CPI), this index offers a unique perspective as it incorporates changes in consumer behavior and substitution effects. Essentially, it measures the average price change for a "basket" of goods and services, encompassing essentials such as food, housing, transportation, healthcare, and more. When prices of specific goods or services increase, consumers may adapt by shifting their spending to alternative options, a phenomenon known as substitution effects. This flexibility in consumer behavior is captured by the "chained" or "chain-weighted" methodology employed in this index, which the Fed considers providing the most comprehensive data on the inflationary impacts on consumers' purchasing patterns. The release of May's data revealed notable progress towards the Fed's 2% inflation target, further reinforcing the efficacy of their approach.

• The index increased just 0.3% in the month of May and the overall index figured rose 3.8% (up 4.6% when removing Food/Energy data), the smallest monthly increase since April of 2021.
• Personal income grew 0.4% MoM but spending rose just 0.1%. This is one of the first signs consumers are beginning to slow spending, which is something the Fed wants.
• The data is a small step in the right direction to get inflation to the 2%. There is plenty of work ahead, however.

Positive downward momentum in the Personal Consumption Expenditure Price Index gives the 18 Federal Open Market Committee members more reason to continue raising rates. The data from this index indicates curbing inflation is a slow slog and not a quick fix, but their efforts are working. Couple this index data with the recent strong jobs reports and the committee has more reason to vote for rate increases in the coming meetings to drive consumer’s consumption demands and inflation down. The next public release of the index Is July 28th, two days after the next FOMC meeting. But the 18 members will have early access to this data for use in that meeting.

The Federal Reserve’s efforts to tame inflation are slowly showing signs of progress. However, it is crucial to understand that the effects of these adjustments are not instantaneous or necessarily enjoyable. It is essential to set aside our longing for immediate satisfaction at the touch of a button and acknowledge that restoring the U.S. economy to its former (pre-Covid) state will require time and may entail discomfort that surpasses our expectations. If you prefer to avoid confronting these unpleasant realities, you are welcome to click the back arrow in the upper left corner and promptly exit this post.