By Joe Carson, former chief economist at Alliance Bernstein
The Federal Reserve's commitment to its "actual outcome" based policy framework is being tested. The economy grew exceptionally fast in the first half of 2021, generating significant wage pressures at higher levels of unemployment than anyone expected and substantial inflation in all areas.
An outcome-based policy is only credible if it adapts, sometimes quickly, to conditions on the ground, abandoning what was expected or hoped to be the case. As the economic growth and inflation risks have shifted from too little to too much, any reasonable person would conclude that the current scale of monetary accommodation is too much. Sound policymaking is as much about managing risks as it is hitting arbitrary targets. Staying the course increases the odds of a bad outcome.
In the first half of 2021, payroll employment increased by 3.26 million, a substantial gain. The civilian unemployment rate of 5.9% in June is only 0.1 percentage points below the start of the year, but the marginal change in the jobless rate masks the tightness in the labor markets. Average hourly earnings for production and non-supervisory private-sector workers increased at an annualized rate of 4.3% in the first half of 2021. The jump in wage growth is noteworthy on its own, but even more so when one considers the compositional shifts in employment.
Roughly 60% of the job growth in the first half of 2021 occurred in lower-than-average wage industries---retail trade, leisure and hospitality, and other services. Composition employment shifts to lower-wage industries artificially dampen reported average wage growth, so the reported gain of 4.3% in average hourly earnings understates the wage pressure companies are experiencing in attracting new workers. Record job openings of 9.3 million, almost equal to the number of people unemployed (9.8 million), will keep upward pressure on wages.
Consumer prices (CPI) increased 6.5% annualized through the first five months of 2021, and core CPI rose 5.2%. June data is not available. Policymakers have called the jump in consumer prices transitory, citing the surge in used car and truck prices and airline fares as examples. Yet, overlooked or ignored in the analysis of inflation is the relatively small gain in owners' housing costs when housing inflation is hitting record highs.
The owners' rent index became part of the CPI in 1983. In the near 40 year history of this series, there has never been a single year the core inflation ran 4% or higher, and owners' housing costs didn't match or exceed the core rate. In the first five months of 2021, the owners' rent index ran 300 basis points below the core CPI inflation rate. But it will catch up soon.
An article published by Fannie Mae on June 9 stated the "lagged effect" from house price inflation will soon flow into the reported inflation measures, and the increase in implied owners' rent could more than double from 2% to 4.5% in the next year. Owners' rent weight in the CPI is six times the combined weight of used car and truck prices and airline fares. As such, the transitory inflation of today will become persistent inflation tomorrow.
Real GDP increased 6.4% annualized in Q1. The consensus estimate for Q2 is running between 7% and 8%. That would result in nearly as much GDP in the first half of 2021 as policymakers expected at the year's outset.
The rebound in economic growth has proven to be much stronger than policymakers expecting, spurring shortages and widespread cost pressures from all sides. And the cost pressures show no signs of abating at mid-year.
The Institute of Supply Management June survey of purchasing agents in manufacturing showed the prices paid index rose four points to 92%. That represents the highest reading of 2021, and it's also the highest reading since 1979. The price paid index correlates with the producer price index for intermediate materials and supplies. Those prices have increased 12.2% (not annualized) since the start of the year, the most significant gain in nearly 50 years.
Sound policymaking is as much about managing risks as it is hitting arbitrary targets. Policymakers shifted to an "outcome-based" framework last year, attempting to simultaneously show their commitment to hitting employment and inflation targets. Yet, the trade-off between economic growth, employment, and inflation has changed, and a credible outcome-based policy needs to account for the change in a less accommodative monetary policy.