"The Irony Is If Higher Rates Mean Higher Wage Growth, And Higher Inflation"
By Michael Every of Rabobank
Our Fed watcher Philip Marey has responded to Fed Chair Powell’s chat yesterday with a 50bps upward shift in his Fed Funds call for 2023. Rather than pausing at 5.00% after a 25bps hike next month, Philip now sees the Fed raising rates to 5.50% via an additional two hikes over the year – and he is flagging upside risks that Fed Funds may need to go as high as 6%. (See ‘Long Road Ahead’.) I know markets have the memory of goldfish, and everybody was always right, but 12 months ago that view would have been seen as science fiction.
This forecast revision, clearly sign-posted by Philip in advance, was not driven by Powell’s comments on goods disinflation (though notice the 2.5% m-o-m January surge in US used car prices on one industry measure). Rather it was because the Fed Chair stated the current US labor market dynamic “feels more structural than cyclical,” and his biggest worry is inflation in core services ex-housing as well as possible new exogenous shocks.
“Structural”. There’s a difficult word for markets to deal with. They can cope with the idea that there has been a nasty cyclical shock, because of ‘exogenous events nobody foresaw’, so rates had to go higher; but the idea there might be a permanent change in the economy so rates have to STAY HIGHER, is something nobody is contemplating. Including the Fed. How else do they project inflation coming back down to 2% by 2024, and only a moderate increase in unemployment at the same time? Do structural changes on the endogenous and exogenous fronts simultaneously resolve themselves in 18 months? How?
[ZH: here's how, as we explained last year "3.9 Trillion Reasons Why The Fed Will Raise Its Inflation Target"]
Relatedly, oligopoly specialist @matthewstoller tweets: “If the Fed doesn't continue to tighten financial conditions I worry inflation could re-accelerate. Auto industry giants have gotten used to high mark-ups and are not increasing production to meet demand.” He isn’t alone in that view.
In May 2022, the Boston Fed concluded: “The US economy is at least 50% more concentrated today than it was in 2005… Our findings suggest that the increase in industry concentration over the past two decades could be amplifying the inflationary pressure from current supply-chain disruptions and a tight labour market.” In April 2022, the Economic Policy Institute argued ‘Corporate profits have contributed disproportionately to inflation. How should policymakers respond?’, lobbying for an excess profits tax not rate hikes, by showing contributions to growth in unit prices in the US corporate sector for 1979-2019 being corporate profits (11.4%), non-labour input costs (26.8%), and labour costs (61.8%) vs. Q4/2020–Q4/2021’s corporate profits (53.9%), non-labour input costs (38.3%), and labour costs (7.9%). In other words, a supply shock and ‘costs-plus’ price increases in a concentrated corporate sector led US prices higher (after loose fiscal policy). Now we might have a structurally tight labour market on top!
That’s as President Biden will reportedly say in his State of the Union address that he is building a “blue-collar America” where “no one is left behind”. (Apart from the white-collar workers who are easily replaced with ChatGPT?) Wage pressures much! On the other hand, Biden’s appointment of Lina Khan at the FCC is seeing a slow, grinding reversal of the Borkian revolution that led to such high levels of corporate concentration – but that will take far longer to take effect, if at all, than a third consecutive ‘blue-collar’ White House.
Indeed, imagine if powerful firms pay out higher interest costs, and higher wages, yet can raise prices to cover them? I think that used to be called a wage-price spiral.
Plus we have endogenous issues encapsulated in China refusing to take a phone call from the Pentagon to discuss balloons, Saudi Arabia to issue non-US dollar debt despite its currency being pegged to it, and Belarus’s president boasting, “The world will soon see new powerful monetary unions with a new reserve currency.” (Again, I don’t see these attempts working, or offering global peace or stability, but that doesn’t mean they won’t try, and that they don’t limit Western central banks’ room for policy manoeuvre.)
But don’t worry: inflation goes back to 2% anyway. Everywhere. Because reasons.
Of course, this is not just a US issue.
For example, yesterday’s other central bank action, where the RBA 25bps rate hike to 3.35% as expected, saw an accompanying statement that further rate increases will be needed in the coming months. In other words, local housing-obsessed analysts saying rates would not go close to 4% were wrong – and they may be even more wrong than that.
Albeit anecdotally, what we are seeing unfold in parts of Australia is that as mortgage rates reset higher, those carrying investment rental properties are not selling off their holdings. Instead, they are raising rents to ensure they feel no pain; and given there is a housing shortage, and less homes will be built as rates rise, renters either have to pay, or go live in the streets.
That might mean a deflationary collapse in demand as more money flows from the bottom, rent-paying strata of society up into the hands of the propertied class – which is the neo-feudal political-economy asset-based policies logically converge towards. (And why Henry George’s ideas about a land value tax are logical, as Martin Wolf argued in the Financial Times recently.) Or it might mean Aussie renters insist that they won’t live like serfs, and need much higher wages - which given the very tight labor market, they can get.
The irony would then be higher rates mean higher wage growth, and then higher inflation.
Of course this is not a forecast. Yet it underlines that if you don’t understand the structure of the political-economy then you can’t accurately forecast ‘just’ the economy. That’s the same argument we made in the geopolitical modelling exercise we just did for the UK and Eurozone regarding balance of payments and balance of power crises.
Quite literally, structure your arguments better if you want to be able to differentiate between economic science fiction and what is now economic science fact, i.e., Fed Funds heading for 5.5%, with a risk of a 6% peak.