The return of the dual mandate

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Coming out of the September FOMC meeting, a common view was that the Fed had all but won the war on inflation and was now very focused on the labor market. After all, Powell suggested that the labor market was no longer a source of inflation pressure and any further weakening would be unwelcome. Indeed, this may mean a “Powell put” when it comes to labor market weakness.

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By contrast, in a series of posts I have argued that the labor market may be a poor proxy for the overall economy. Other parts of the economy have held up better. It is not the only source of inflation pressure. This is particularly the case today with persistently high rent and OER inflation. Like all data, the labor market statistics are subject to measurement error and revisions. Again, this can be seen clearly with recent estimated benchmark revisions to payrolls. Finally, the labor market, national income and national product data have been sending different signals about just how robust the economy is. Why are the labor market statistics “right” and the others “wrong”?

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In my last post I wrote about the broader growth picture. I pointed out that the Gross Domestic Income data had been revised up and now roughly match the strength in Gross Domestic Product. I also argued that causation could run from GDP to payrolls. The slowdown in payroll growth may mean companies are under-hiring relative to demand for their products. As such the risks to payroll growth go both ways.

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Mission Accomplished!?

Today’s data was a reminder that the inflation picture still matters…a lot. The traditional core came in strong, rising 0.3 mom (3.8% annualized). More important, better measures of underlying inflation like the trimmed mean (3.7% annualized) and median (4.1%) were also strong. Of course, the PCE numbers that the Fed targets tend to be softer, but they will quite likely come in on the strong side as well.

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It is certainly possible that inflation is getting stuck above the 2% target. The chart shows two measures of underlying inflation along with the implicit 2.5% or so CPI target. So far this year there have been five strong months (Jan, Feb, Mar, Apr, Sep) and four weak or moderate months. That is hardly compelling evidence of a return to target.

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Inflation fundamentals are also ambiguous. The unemployment rate has risen from a low of 3.4% to 4.1%, a tenth above the median FOMC estimate of the “long-run” rate. However, the range on the Committee is from 3.5% to 4.5%. ?Most forecasters are in the high end of this range: the CBO pegs the “noncyclical” rate at 4.4% and the median member of the Survey of Professional Forecasters sees a 4.4% “natural rate.”

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Equally important, the unemployment rate is by no means the only measure of excess capacity in the economy. Both GDP and GDI continue to grow faster than most measures of potential GDP and most measures suggest there is now a positive gap between actual GDP and potential GDP. For example, according to the CBO the output gap is 2.1% and rising.

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Short and shallow

I still see the Fed’s 50 bp cut as a one-off, make-up move for not cutting in July. My baseline view is still for 25 bp cuts in November and December followed by cuts at every other meeting until a low of 4%. However, with each bit of strong economic (and market) news, the case for an even shorter, shallower cutting cycle grows. return of the dual mandate