CEA: Inflation was transitory.
CEA: Inflation was transitory.
A review of inflation expectations
The White House Council of Economic Advisors posted some interesting analysis of recent inflation today, concluding that 80% of the post-pandemic inflation was from transitory supply-side factors.
Here is the key chart.
There are some interesting take-aways here, some of which might lead me to adjust my expectations a bit.
My position has been that the Fed didn’t lower inflation. It was transitory. The Fed was relatively loose, and real interest rates were highly negative when inflation relented in July 2022. If anything, that loose policy stance has kept us out of disruptive deflation since transitory inflation reverted. But, now the Fed posture is tight, and needs to be loosened a bit.
I think that description basically fits the CEA analysis. You could say that the 1% or so of excess inflation associated with the interaction between supply chain disruptions and employment capacity (“slack” in the chart) reflects the relative looseness and then tightening of Fed policy over the course of 2021 to the present.
The CEA displays this in annual terms (year-to-date for 2023). I think it might be helpful to look at quarterly trends. Figure 2 displays annualized quarterly inflation according to core PCE (black), core PCE less Housing (red) and core CPI (blue). There are several issues to note here.
In the CEA chart, the YTD 2023 inflation is still elevated by about 1.7% so far in 2023. But, as the quarterly data shows, this is largely from early in the year. In the 3rd quarter, core PCE inflation was 0.3% above target and core PCE excluding housing was 0.4% below target. And the trend is sharply downward.
You can see the distorting effect of the housing shortage on inflation in Figure 2. Core PCE inflation generally either hit the 2% target between 1995 and 2020 or fell short. And, if we exclude housing from the measure, it was even lower.
Housing is a larger component in CPI than it is in PCE, and you can see that playing out over the last 30 years. This is a major reason why CPI inflation has trended higher than PCE inflation over this time. Whenever PCE inflation that includes housing is higher than PCE inflation that excludes housing, CPI inflation is even higher.
The height of the tragically mistitled 2000s housing boom was the one period where core CPI, core PCE, and core PCE excluding housing were all at a similar level and were all roughly at the 2% target. Because building an adequate amount of housing was finally creating a sustainable economic foundation! Killing it led to a return of the deviation of housing inflation and an inflated CPI inflation measure. The lagging nature of federal housing inflation methodology meant that, in 2021, housing briefly gave too low of an inflation reading and then after 2021, gave a high inflation reading because it is just now measuring the inflation from 2021 and early 2022.
In other words, the 1.6% inflation reflected in core PCE excluding housing is the most important current measure shown in Figure 2. Supply chain woes were probably responsible for 2%+ inflation in 2023 Q1 and for negligible inflation in Q3.
Surely supply chain issues have some mean reversion. That means that there could be several percentage points of disinflation ahead as sectors like residential investment and automobile sales continue to normalize.
Prices in the aggregated measures are generally up about 15% since the end of 2019. Residential investment and used car prices have levelled off or retreated slightly, but they are both about 35% above 2019 levels.
To me, this is the big fat bullseye that the Fed can aim for. These supply chain categories are poised for more reversal. There are some distortions that might come of them - used car owners more likely to default on loans worth more than the vehicle, homeowners unwilling to sell homes for a loss, fire sales on commercial real estate where a negative rent trend kills the pro forma valuation, etc. I think in the current environment, those distortions won’t necessarily be devastating at a macro scale.
So, we could move along with aggregate inflation well below 2% for a while and be, more or less, fine. I think that’s where we are currently headed.
But, in spite of the apparent current poor sentiment caused by persistent (if outdated) inflation concerns, we would probably be better off with stated inflation rate close to 2% going forward, which would mean that inflation related to monetary posture would be above target moving forward while deflation related to healing supply chains pulls the average down.
I have been arguing that the Fed was loose in 2021 and 2022, which kept us from shifting into deflation in 2023. But, the CEA analysis suggests that most of that work is still ahead of us.
In other words, I would flip the script here. The comment I see constantly these days is that “the Fed has finally brought down inflation, but the job isn’t done yet.” I would say, instead, “The Fed didn’t bring down inflation, but it’s job isn’t done yet. It should continue taking a loose position to keep prices from declining over the next year.”
I don’t think any of this is an emergency. We’ll probably be relatively fine either way. Core prices have accumulated about 7% of excess inflation since 2019. This is apparently what people are upset about. That’s been over for 16 months now. We aren’t going to accumulate any more. Maybe, with some supply chain deflation, the trend will move back down, and the total cumulative excess inflation will be well below 7% when all is said and done.
Either way, I think it would be a stretch for anyone to care much about it a year or two from now, when inflation and inflation expectations remain anchored. I think moving ahead with a 2% trend from here forward would be the better of these options, avoiding the minor dislocations that might be associated with some more asset deflation. But, really, this is the Fed’s soft landing to claim at this point.
I am glad to see some whispers about expecting a Fed rate cut sooner than previously anticipated. We are continuing the pattern of JPow! doing the right thing, leaving one to wonder if he knew where all of this was going to lead all along, and has simply been steering expectations where they needed to go while expressing “concerns”.
Residential Investment
The leveling out of residential investment input prices has been associated with a retrenchment of real residential investment back down to capacity, relieving the price pressure on inputs. Residential investment has been tentatively returning to positive growth.
Input prices remain somewhat elevated. This suggests that the current Fed posture and nominal economic growth rate are still robust and that my worries about the Fed being too tight are overdone. That would be great news. The Fed isn’t going to raise rates higher or increase the delay before the first cut at this point, so I don’t think there is a danger of triggering an overbearing Fed reaction at this point. And, the hotter things run, the more the current monetary posture will naturally be hitting at the end of the spectrum I would prefer to see.
The main fear I have here is that this suggests there is less room for growth in real residential investment than I think there is. But, I refuse to believe that capacity has suddenly gotten stuck at single digit growth rate maximums. Even during the Great Moderation, real residential investment has always managed to grow more than 10% annually when the demand was there.
Reports from builders suggest that they expect supply chain woes to continue to improve, potentially returning to normal in the cohort of units that will be completed in mid-2024. This has been more noticeable in construction times than in prices, though, suggesting that moderating demand rather than supply chain expansion has been the main factor.
All of this means that supply chain capacity growth still needs to be confirmed. The one area that appears to be an especially persistent problem is electrical transformers. Builders are waiting for utilities to finish out new infrastructure so that units can be completed. There doesn’t appear to be any immediate end in sight to this delay.
Transformer prices remain elevated. Recently flattened, but with no sign of retreat.
This is probably a factor that bears watching. One potential path going forward is that residential supply chain capacity, in general, expands, but new projects are held up waiting on transformers.
Once this issue gets settled, I expect unit completions from homebuilders to really make a move higher. On the producer end, homebuilders are already giving significant incentives and discounts related to lower costs and normalized margins. If input costs can fall further, the downward pressure on new home prices will continue (though, with little effect on homebuilder margins). A bit more inflation would hardly be the worst thing in the world, in that context. And, in the end, if it helps to keep pushing residential investment up to capacity, then it all will redound to moderation in rents, pushing down consumer inflation.
There are many reasons to be optimistic about 2024 and beyond.